CHAPTER –ONE
RODUCTION TO MANAGERIAL ECONOMICS
Introduction
Managerial economics, meaning the application of economic methods to the managerial
decision-making process, is a fundamental part of any business or management course. It has
been receiving more attention in business as managers become more aware of its potential as an
aid to decision-making, and this potential is increasing all the time. This is happening for several
reasons:
 It is becoming more important for managers to make good decisions and to justify them,
as their accountability either to senior management or to shareholders increases.
 As the number and size of multinationals increases, the costs and benefits at stake in the
decision-making process are also increasing.
 In the age of plentiful data it is more imperative to use quantitative and rationally based
methods, rather than „intuition‟.
 The pace of technological development is increasing with the impact of the „new
economy‟. Although the exact nature of this impact is controversial, there is no doubt that
there is an increased need for economic analysis because of the greater uncertainty and
the need to evaluate it.
Improved technology has also made it possible to develop more sophisticated methods of
data analysis involving statistical techniques. Modern computers are adept at „numbercrunching‟, and this is a considerable aid to decision-making that was not available to most
firms until recent years.
1.2 Definition of Managerial Economics
Douglas - “Managerial economics is the application of economic principles and methodologies
to the decision-making process within the firm or organization.”
Pappas & Hirschey - “Managerial economics applies economic theory and methods to business
and administrative decision-making.”
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Salvatore - “Managerial economics refers to the application of economic theory and the tools of
analysis of decision science to examine how an organisation can achieve its objectives most
effectively.”
Howard Davies and Pun-Lee Lam - “It is the application of economic analysis to business
problems; it has its origin in theoretical microeconomics.”
Mansfield, "Managerial economics is concerned with application of economic concepts and
economic analysis to the problems of formulating rational managerial decision.”
Managerial economics may be defined as the study of economic theories, logic and methodology
which are generally applied to seek solution to the practical problems of business. Managerial
economics is thus constituted of that part of economic knowledge or economic theories which is
used as a tool of analyzing business problems for rational business decisions. Managerial
economics is often called as Business Economics or Economics for Firms.
Managerial
economics is the specialized discipline of management studies which deals with application of
economic theory and techniques to business management.
Moreover, it is the application of micro-economics concepts, knowledge, logics and principles to
determine the firms Demand, Production, Cost, and Pricing, Market structure and government
regulation. Managerial economics is concerned with the art of economizing, i.e. making rational
choices to yield maximum return out of limited resource and efforts. Managerial economics is
synonyms with business economics which involves economics as a basic discipline useful for
certain functional areas of business management. It establishes rules and principles to facilitate
the attainment of chosen economic goal of business management such as;
 Minimization of cost
 Maximization of revenue and profit
Managerial economics attempts to bridge the gap between the purely analytical economics and
problems faced in real business.
Positive economics explains the economic phenomenon as: what is, what was and what will be.
Normative economics prescribes what it ought to be. Managerial economics is a blending of pure
or positive science with applied or normative science. It is positive when it is confined to
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statements about causes and effects and to functional relations of economics variables. It is
normative when it involves norms and standards, mixing them with cause-effect analysis.
Features managerial economics:

It involves an application of economic theory- especially; microeconomics analysis to
practical problem solving in real business life. It is essentially applied microeconomics

It is a science as well as art facilitating better managerial discipline. It explores and
enhances economic mindfulness and awareness of business problems and managerial
decisions.
It is concerned with firm‟s behavior in optimal allocation of resources. It provides tools to help
in identifying the best course among the alternatives and competing activities in any productive
sector whether private or public.
Generally, it is a science as well as an art of facilitating better managerial discipline; it enhances
and explores economic mindfulness and awareness of business problems and managerial
decision. Managerial economics applies economic theory and methods to business and
administrative decision making. Managerial economics prescribes rules for improving
managerial decisions. Managerial economics also helps managers recognize how economic
forces affect organizations and describes the economic consequences of managerial behavior. It
links economic concepts with quantitative methods to develop vital tools for managerial decision
making.
1.3 How is managerial economics useful?
Managerial economics applies economic theory and methods to business and administrative
decision making. Managerial economics prescribes rules for improving managerial decisions.
Managerial economics also helps managers recognize how economic forces affect organizations
and describes the economic consequences of managerial behavior. It links economic concepts
with quantitative methods to develop vital tools for managerial decision making.
Evaluating Choice Alternatives
Managerial economics identifies ways to efficiently achieve goals. For example, suppose a small
business seeks rapid growth to reach a size that permits efficient use of national media
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advertising. Managerial economics can be used to identify pricing and production strategies to
help meet this short-run objective quickly and effectively. Similarly,
Managerial economics provides production and marketing rules that permit the company to
maximize net profits once it has achieved growth or market share objectives.
Management Decision Problems
•
•
•
•
•
•
Investment and Financing
•
•
•
Economic Concepts
•
•
Product Selection, Output, and
Pricing
Internet Strategy
Organization Design
Product Development and Promotion
_Strategy
Worker Hiring and Training
Marginal Analysis
Theory of Consumer
Demand
Theory of the Firm
Industrial
Organization and Firm
_Behavior
Public Choice Theory
Quantitative Methods
•
Numerical Analysis
•
Statistical Estimation
•
Forecasting Procedures
•
Game Theory Concepts
•
Optimization Techniques
•
Information Systems
Managerial Economics
Use of Economic Concepts and Quantitative Methods to Solve _Management Decision Problems
Optimal Solutions to Management Decision Problems
The Ten Economic Principles for Managers
Ten Economic Principles for Managers:
Principle No. 1: The role of managers is to make decision. Small and large firms differ greatly
in the number of managers they have and in the magnitude of resources they
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Command, but one thing is certain: no firm has unlimited resources. Because of this, managers
must make decisions about how the resources available to the firm are employed.
Principle No. 2: Decision alternatives always among alternatives. If there were no alternative
to an action, there would be no choice. Sometimes a choice is between changing and not
changing something. However, other choice may be between or among different types of
changes.
Principle No. 3: Decision alternatives always have cost and benefits. Economists would say
that increasing output would be a rational decision if the additional benefit exceeds the additional
cost. This is known as the marginal or incremental approach to decision making. The managerial
or incremental approach involves analyzing changes associated with a decision and making the
decision based on the difference between the changes in benefits and the changes in costs.
Principle No. 4: The anticipated objective of management is to increase the firms’ value.
What makes a firm valuable to its owners is the firm‟s ability to generate profit. The principal
agent problem occurs when one party acts on behalf of another in a situation where the parties
may have conflicting goals.
Principle No. 5: the firm’s value is measure by its expected profit. Firm‟s value is equal with
the present value of firm‟s future profit earnings.
Principle No. 6: The firm’s sales revenue depends on demand for its product. What ever a
firm‟s product or service, its ability to generate revenue from sales depends on the actions of the
buyers.
Principle No. 7: The firm must minimize cost for each level of output. There are two major
things to consider when trying minimizing costs; Technology of production and input price.
Principle No. 8: The firm must develop- a strategy consistent with its market.
Principle No. 9: The firm’s growth depends on rational investment decisions. In managerial
economics, the process of evaluating new investments of the firm is called capital project
analysis.
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Principle No. 10: Successful firms deal rationally and ethically with laws and regulations.
Modern societies generally have developed explicit rules of the game to govern business
behavior. These include fair trade and antitrust laws, consumer protection codes, security
regulations, environmental protection laws and accounting standards, to mention just a few.
1.4 Effective Management from an Economic Perspective
Economic “tools” are guides to good resource allocation decision-making. Elements of good
decision-making can be divided into six categories
1. Identify Goals and Constraints: This is critical for defining the dimension of the problem.
Objectives are simply what you would like to accomplish. Constraints are the natural
(and perhaps unfortunate) consequence of scarcity.
a) Having a well-defined objective in mind when making an allocate decision is critical.
(Very concretely, imagine how one might decide to allocate time to this course if it were
uncertain whether your intention was to get a good grade or to merely pass)
b) Also, it is necessary to evaluate the constraints available in the decision process. (For
example, time is typically the constraint in making personal allocate decisions. Most of
our applications will focus on the decisions of a profit-maximizing firm. Here the
objective is typically profits. Constraints arise in the form of pricing limitations, and
production considerations.)
2. Recognize the Nature and Importance of Profits: When discussing the firm, profits take on
a special role. However, when making allocate decisions you must have the correct definition of
profits in mind.
a. Accounting Profits
A
=
TR
-
TCA
TR
-
(TCA +TCI)
b. Economic Profits
E
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=
The difference in the definitions is implicit costs. Implicit costs are measured in terms of
foregone alternatives. Economic costs are the sum of implicit and implicit costs. Economic
costs can be measured in terms of choices foregone, or opportunity costs.
The concept of economic profit
The goal of the firm is profit (  ) maximization. What is profit? As per our discussion in other
discipline the conventional notion of profit is relatively straightforward: profit is defined as
revenue mines cost (  = TC – TC). But the definition of cost is quite different for the economist
than for the accountants.
Example:
Consider an individual who has an MBA degree and is considering investing $200,000 in a retail
store that she would manage. The projected income statement for the year as prepared by an
accountant is as shown below,
Sales
$90,000
Less; cost of goods sold
40,000
Gross profit
$50,000
Less; advertising expense
Depreciation expense
$10,000
10,000
Utilities expense
3000
Property tax
2000
Miscellaneous expense
5000
Net accounting profit
30,000
$20,000
The use of this concept may result in making the wrong decision. The economist recognizes
other costs defined as “implicit costs”. These costs are not reflected in cash outlays by the firm,
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but are the costs associated with the foregone opportunities. It is not included in accounting
system but must be included in any rational decision making framework.
Therefore, there are two major implicit costs in the preceding example.
a) The owner has $200,000 invested in the business, suppose the best alternative use for this
money is a bank account paying 5%interst rate. So, this investment would return 200,000
 5%=10,000 annually. Thus $10,000 should be considered as the implicit or opportunity
cost.
b) Managers‟ time and talent, annual wage return on an MBA degree from a reasonable
good business school may be $40,000.
Thus the income statement should be amended in the following way.
Sales
$90,000
Less; cost of goods sold
40,000
Gross profit
$50,000
Less; explicit cost:
Advertising expense
$10,000
Depreciation expense
10,000
Utilities expense
3000
Property tax
2000
Miscellaneous expense
5000
30,000
Accounting profit (profit before implicit costs)
$20,000
Less; implicit costs:
Return on $200,000 of invested capital
Foregone wage
Net economic profit
$10,000
40,000
50,000
$-30,000
3. Understanding Incentives. If profits restrict the behavior of firms via incentives, in the
market, it is also important to understand the effects of incentives within the firm.
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a) Institutional organization affects performance. The way an institution is organized
often puts incredible limitations on the power of personalities to exert influence.
Sometimes this is healthy (e.g., in the U.S. government, laws severely restrict the
power of the presidency.) In other environments institutional restrictions are an
important handicap. For example, the recent scandals at Enron and WorldCom are
not a consequence of “bad guys”. Rather the institutional structure of these firms, and
the oversight process for these firms, not only allowed, but encouraged illegal
behavior. Reorganizing the structure of an institution, as well as the laws regulating
the oversight process, can make firms more reliable and more efficient.
b) The way people are rewarded can influence their incentive to work
Example: Suppose you pay someone $75,000 to manage your restaurant. Would this person do
better than someone paid $50,000? There is no particular reason to suppose that the answer
should be in the affirmative. A compensation package that more nearly aligns the interests of the
owner and the manager would be one that provided incentives to the manager that paralleled the
interests of the owner.
4. Understand Markets. Markets are the regulating force for firms, and the source of incentives
for their activities. These incentives arise via transactions, and are the consequence of competing
interests. For every transaction, there are two parties.
a. Consumer-Producer Rivalry: Consumers and producers are simultaneously trying to take
advantage of each other. They are limited by reputation and bargaining skills. As a consequence
of bargaining, each gets less than they want, but not more than it is worth, or less than it costs.
b. Consumer-Consumer Rivalry: Consumers compete with each other for products. In the
process, the purchasing consumer pays more than (s) he wants, but not more than it is worth to
him or her. (Example: This is most clearly seen in auctions for specialized consumer goods, such
as antiques. Bidding by rival potential purchasers drives up the price.)
c. Producer-Producer Rivalry: Producers compete with each other, and as a consequence,
offer better quality, and higher quantities at a lower price than they would like. (Again, this is
most directly seen in a procurement auction)
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d. The Role of Government: Provided that the conditions that I mentioned above are satisfied,
there is no need for the government to intervene.
However, when one or more of these
assumptions fails, the Government frequently intervenes to restore the balance.
5. Recognize the Time Value of Money. It is important to realize that money earned in the
future is not valued the same as money earned today. Allocate decisions should be adjusted
accordingly. (This concept is discussed in detail in chapter 2 )
6. Appreciate Marginal Analysis: Marginal decisions are an easy way to optimize totals.
Calculus is just a formal expression of marginal analysis. A final principle in intelligent decisionmaking pertains to the unit of analysis used.
One can often cut through a very difficult
optimization process by confining attention to incremental changes. (this concept is discussed in
detail in chapter 2 )
1.6 Scope of Managerial Economics
Economic theories are grouped under two broad categories: (i) Microeconomics, and (ii)
Macroeconomics. Both micro and macro theories are applied to business analysis and decisionmaking directly or indirectly. Managerial economics comprises, therefore, both micro -and
macro-economic theories. What parts of micro and macroeconomics are covered in managerial
economics varies depending on the purpose of analysis.
The scope of managerial economics comprehends all those economic concepts, theories and
tools of analysis which can be used to analyze the business environment and to find out solution
to practical business problems. In other words, managerial economics is economics applied to
the analysis of business problems and decision- making. Broadly speaking, it is applied
economics.
The areas of business issues to which economic theories can be directly applied may be broadly
divided into two categories: (a) operational or internal issues; and (b) environmental or external
issues.
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Operational Issues and Microeconomics
Operational problems are basically of internal nature. They include all those problems which
arise within the business organization, and fall within the purview and control of the
management. Some of the basic internal issues are : (i) choice of commodity, i.e., what to
produce; (ii) choice of size of the firm, i.e., how much to produce; (iii) choice of technology, i.e.,
choosing the factor-combination; (iv) choice of price, i.e., how to price the commodity; (v) how
to promote sales; (vi) how to face price competition; (vii) how to expand the investment; (viii)
how to manage profit and capital; (ix) how to manage inventory, i.e., stock of both finished
goods and raw materials. These problems may also figure in forward planning. All these
questions and alike confronted by the managers of a business enterprise are related to various
economic theories.
Business Environment and Macroeconomics
Environmental issues pertain to the general business environment in which a business operates.
They are related to the overall economic, social and political atmosphere of the country. The
factors which constitute economic environment may be mentioned as: (i) the type of economic
system of the country, (ii) general trends in production, employment, income, prices, saving and
investment, etc, (iii) structure and trends in the working of financial institutions, e.g., banks,
financial corporations, insurance companies, etc., (iv) magnitude and trends in foreign trade, (v)
trends in labor and capital markets, (Vi) government's economic policies, e.g., industrial policy,
monetary policy, fiscal policy, price policy, etc., (vii) social factors like value systems of the
society, property rights, customs and habits, (viii) social organizations like trade unions,
consumers' cooperatives and producers' union, (ix) social structure and class character of the
various social groups.
1.7 Functions: Roles and Responsibilities of Managerial Economics
A managerial economist in a business firm may carry on a wide range of duties, such as:
 Demand estimation and forecasting
 Preparation of business or sales forecast: to provide forecasts of changes in costs and
business conditions based on market research and policy analysis.
 Analysis of the market survey to determine the nature and extent of completion
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 Analyzing the issues and problems of the concerned industry.
 Assisting the business planning process of the firm
 Discovering new and possible fields of business endeavor and its cost- benefit analysis as
well as feasibility studies
 Advising on pricing, investment and capital budgeting policies
 Evaluation of capital budgets
 Building micro and macro-economic models of particular aspects of the firm‟s activities
that are useful in solving specific business problems. Most models may be prediction
oriented.
 Briefing the management on current domestic and global economic issues and emerging
challenges. Interpretation, analysis and reporting of current economic matters, upcoming
developments in business, government and foreign or global sectors.
1.8 Economic Concepts and Principles in Managerial Decision Analysis
Economic theories, concepts and analytical tools are of great help to a businessman in arriving at
better decisions in actual business life. The following economic concepts are fundamental to
business analysis and decision making, visa:
1. Opportunity cost: The opportunity cost of a decision is the sacrifice of the next best
alternative course of action available. A decision is cost free if it involves no sacrifice.
There is no managerial decision which is cost free.
2. Equi-marginal principle: It is very significant in determining optimal condition in
resource allocation. According to the equi-marginal principle, a factor input should be
employed in different activities in such a proportion that its value of marginal product is
equal in all the uses, so that optimum level is reached.
3. Incremental principle: The incremental concept refers to the change in total revenue
and cost due to a specific decision. When incremental benefit or revenue exceeds the
incremental cost resulting from a particular decision it is regarded as profitable.
4. Time perspective: Economic widely use the concepts of functional time period, shortrun and long-run in their analysis. This time perspective of short and long period is also
important in business decision making. Especially, the business managers have to review
the long-range effects on costs and revenues decision. The really important problem in
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decision making is to maintain the right balance between long-run, short-run and
intermediate-run perspectives.
5. Discounting principle: A present gain is valued more than a future gain. Thus, in
investment decision making, discounting of future value with the present one is very
essential. If a decision affects costs and revenues at future dates, it is necessary to
discount those costs and revenues to present values before a valid comparison of
alternative is possible.
1.9 Business Objectives and Theories of Firm
Profit Maximization
The traditional objective of the owner-managed firm is assumed to be short-run profit
maximization. This presumption of profit maximization is the building block of neoclassical
economics, not only for the theory of the firm but also for the theories of price and competitive
markets. For firms where there is a divorce between ownership and control the assumption is that
managers still maximize profits on behalf of the owners. Thus, the firm‟s owners and managers
have a single objective.
Sales Revenue Maximization
An alternative model recognizing the importance of profit, but assuming that managers set the
goals of the firm, is that of sales maximization. This model was developed by Baumol (1959)
who argued that managers have discretion in setting goals and that sales revenue maximization
was a more likely short-run objective than profit maximization in firms operating in oligopolistic
markets.
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CHAPTER-FOUR
DEMAND AND DEMAND FORECASTING
Introduction
The term “demand” implies a “desire” backed by ability and willingness to pay. Unless a person
has an adequate purchasing power or resource and not prepared to spend his resource, his desire
for a commodity would not be considered as his demand. For example, desire without purchasing
power and willingness to pay do not affect the market, nor do they generate production activity.
A demand with three attributes Desire to buy
 Willingness to pay and
 Ability to pay becomes effective demand.
Only effective demand figure is important in economic analysis and decisions. In economics
sense, the term demand for a commodity (i.e. quantity demanded) has always refers to “the
price”, “a period of time”, and “a place”.
A Meaningful statement regarding the demand for a commodity should therefore contain the
information regarding,
 Quantity demanded
 Price of the commodity
 Period of demanded
 Place of demanded
The Law of Demand
The law of demand states that the quantity demanded for a commodity increases when its
price decreases and falls when its price rises, other thing remains constant. This is an
empirical law, i.e., this law is based on observed facts and can be verified with new data.
As the law reveals, there is an inverse relationship between the price and quantity
demanded. The law holds under the condition that “other things remain constant”. “Other
things” includes income, price of the substitute and complements, taste and preferences
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of the consumer, etc. this condition of other things constant called by the economists as
citrus paribus
Exceptions to the law of demand:

Luxury goods-certain commodities are demanded just because they happen to be
expensive

Speculation- when people speculate about change in the price of a commodity in the
future.

Consumer’s psychological bias or illusion when the consumer is wrongly biased against
the quality of a commodity with the price change.
Change in quantity demanded- it refers to the changes in the quantities purchase by consumers
on account of the changes in price.
Change in demand- an increase in demand really means that more is now demanded than before
at each and every price. It refers to changes in demand caused by the change in various other
determinants of demand, price remain unchanged.
Types of demand
Individual and market demand
The quantity of a commodity which an individual is willing to buy at a particular price of the
commodity during a specific time period, given, his money income, taste and price of other
commodities (particularly substitutes and complements) is known as “individual demand” for a
commodity.
The total quantity which all the consumers /users of a commodity are willing to buy at a given
price per time unit, given their money income, test and price of the other commodities (mainly
substitutes) is known as market demand for a commodity. In other words, the market demand for
a commodity is the sum of individual demand by all the consumers (buyers) of the commodity,
over a time period, and at a given price, other factors remaining the same.
Graphically, market demand curve is horizontal summation of individual demands.
E.g. consider a market that consists of only two buyers. Demand cure for these two are
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Per unit.
These demand curves show the relationship between price and quantity demanded. Consumer 1s
demand curve is shown in the first panel (D1D1) and that of consumer 2 in the second panel
(D2D2). At a price of $10, the individual quantities are 5 and 8 units, respectively. Hence, the
total market demand (DMDM, as shown in the third panel) is 13 units. The market demand at any
price is the sum of the individual quantities demanded at that price.
Demand for consumer goods and producer goods
Goods and services that are demanded by the customer for direct satisfaction of their wants , i.e
for consumption purpose ,food, clothes services of doctor, lawyer and teacher etc. Goods that
demanded by producers in the process of production are called producer goods. Eg. Tools, raw
materials, equipment, buildings, offices. Demand for consumer goods is direct and autonomous.
Demand for perishable and durable goods
Perishable goods have no durability. They cannot be stored for a long period of time, fish, eggs,
milk, vegetables etc. Durable goods have a long life and can be stored e.g., furniture, car etc.
Perishable goods give one shot service where as durable goods can be used for several years. A
perishable goods demand is always immediate, durable goods demand is postponed.
Autonomous demand and derived demand
Spontaneous demand for goods is based on a urge to satisfy some want directly, such demand is
called autonomous demand. Demand for consumer goods is autonomous. It is a direct and final
demand. When the demand of a product depends on the demand of some other product, it is
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called derived demand. eg, Demand for doors derived from demand for houses .Demand for all
capital goods are derived .Most demands are derived demands.
Industry demand and firm /company demand
A firm is a business unit, whereas industry is a group of closely competitive firms. A firm‟s
demand relates to the market demand for all the firms output. An industry‟s demand refers to the
total demand for a commodity produced by a particular industry eg , car industry, sugar industry,
iron and steel industry etc. The basic relationship of the firms or industry demand depends upon
market structure.
Short run demand and long run demand
Short run demand refers to existing demand with its immediate reaction to price changes, income
fluctuations etc. Whereas long run demand is that which will ultimately exist as a result of the
changes in pricing , promotion or product improvement ,after time is allowed to let the market
adjust itself to the new situations.
Joint demand and composite demand
Joint or complimentary: tow goods that are demanded in conjunction with one another at a same
time to satisfy the same want , such goods are said to be complimentary or joint in nature. Eg;
bread and butter, car and fuel, pen and ink, key and lock. Composite demand: A commodity is
said to be in composite demand when it is wanted for several different uses. Eg; steel is needed
for cars railways, buildings etc.
Determinants of market demand
The knowledge of the determinants of the market demand for a product and the nature of
relationship between the demand and its determinants proves very helpful in analyzing and
estimating demand for the product. It may be noted at the very outset that a host of factors
determines the demand for a product.
In general, however, the following are the factors which determine, by and large, the market
demand for a product.
 Price of the product,
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 Price of the related goods----substitutes, complements and supplements,
 Level of consumers' income,
 Consumers' taste and preference,
 Advertisement of the product,
 Consumer's expectations about future price and supply position,
 Demonstration effect and 'band-wagon effect',
 Consumer-credit facility,
 Population of the country (for the goods of mass consumption)
 Distribution pattern of national income (ref. market demand).
To this list, one may add such factors as off-season discounts and gifts, number of uses of a
commodity, level of taxation and general social and political environment of the country
(especially with respect to demand for capital goods).
All these factors are however not equally important. Besides, some of them are not quantifiable.
For example, consumer's preferences, utility, demonstration effect, expectations, etc., are
difficult to measure.
The Demand Function
The market demand function can also be expressed mathematically. If the primary
determinants of demand are the price of the product, income, consumer preferences, and the
prices of other goods and services and advertisement, the demand equation can be written as
QD  f ( p, I , pO , T , Ad )
Where P is the price of the good or service, I is income, P 0 represents the prices of other
goods, T is a measure of consumer tastes and preferences and A d advertisement expenditure.
The above Equation suggests that there is a correspondence between the quantity demanded
and the variables on the right-hand side. However, the equation implies only that there are
general relationships. It says nothing about their nature and magnitude. For example, the
above equation provides no information about how quantity demanded would be affected by
an increase in income.
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Demand function also expressed as
Qd= f (p ,x1 ,x2 ,…..xn)
Where Qd = Quantity demanded, p = price, x1, x2, xn are other determinants of
demand.
In economics , a very simple statement of demand function is adopted. Where all
variables , that determine demand are held to be constant , except for price. So demand
function denotes as
Dx = f (Px).
Total Revenue and Marginal Revenue
One indication of a firm's success is the total revenue generated by the sale of its products.
Rankings of firm size are usually made on the basis of total revenue. Similarly, growth is
often expressed in terms of increases in total revenue. In that it reflects the ability of the
firm to satisfy consumer demands, the use of total revenue as a measure of success has
some merit.
The first two columns of the below table provide information about the demand faced by a
firm. By multiplying price times‟ quantity, the total revenue associated with each pricequantity pair is determined.
Note that total revenue increases as price goes from $1 to $5 and then decreases for
prices greater than $6. This suggests that sound pricing decisions require information
about demand. In some cases higher prices may increase total revenue, whereas in other
circumstances a price increase can have the opposite effect.
Marginal revenue is defined as the change in total revenue associated with the sale of one
more unit of the product. For example, as quantity goes from four to five, total revenue
increases from $28 to $30. Hence the marginal or extra revenue associated with the fifth
unit is $2. Note that marginal revenue declines as quantity increases. Beyond six units,
marginal revenue is negative. The explanation stems from the inverse relationship between
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price and quantity. To sell extra units, the firm must reduce the price of all the units sold.
Negative marginal revenue means that the dollars received from selling the extra unit are
not sufficient to compensate for the dollars lost as a result of selling all other units at a
lower price. Clearly, a firm should not increase output beyond the point where marginal
revenue is zero. The total and marginal revenue data of below Table can be plotted on a
graph. If fractional units are allowed, the line has the appearance of a smooth curve, as
shown in Figure. Note the relationship between the total and marginal revenue curves. As
long as total revenue is increasing, marginal revenue is positive. At the maximum point on
the total revenue curve, marginal revenue is zero. But beyond that point, marginal revenue
is negative.
Figure also shows the relationship between the marginal revenue curve and the demand
curve. Note that the two curves intercept the price axis at the same point. Using calculus, it
can easily be shown that for linear demand equations, the value of the slope of the
marginal revenue curve is twice the value of the slope of the associated demand curve.
Because the two curves have the same Price intercept, this implies that the quantity
intercept of the marginal revenue curve is exactly half that of the demand curve. TABLEhowing The Information Of Price , Quantity , TR and MR.
Price
Quantity
Total Revenue
Marginal Revenue
$10
1
$10
-
9
2
18
$8
8
3
24
6
7
4
28
4
6
5
30
2
5
6
30
0
4
7
28
-2
3
8
24
-4
2
9
18
-6
20 | P a g e
1
10
10
-8
Total Revenue, Marginal Revenue, and Demand Curve
The marginal revenue equation can be derived from the demand equation.
Price Elasticity Total and Marginal Revenue
Table 3-2 reproduces the price, quantity, total revenue, and marginal revenue information from
Table 3-1. It also shows the point price elasticity at each price.
Note that the absolute value of the elasticity becomes smaller as prices decrease.
At P = $10, the elasticity is -10.00, while at P = $1, it is -0.10.
Often, it is useful to classify demand relationships on the basis of price elasticity. The
following classification is frequently used:
If absolute value of: then demand is said to be:
Ep > 1 Elastic
Ep = 1 Unitary elastic
Ep < 1 Inelastic
21 | P a g e
TABLE-3-2 The below table can be used to interpret the three elasticity categories. The figure
Price
Quantity
Absolute value of Price
Total revenue
Marginal revenue
elasticity
$10
1
-10
$10
-
9
2
-4.50
18
$8
8
3
-2.67
24
6
7
4
-1.75
28
4
6
5
-1.20
30
2
5
6
-0.83
30
0
4
7
-0.57
28
-2
3
8
-0.38
24
-4
2
9
-0.22
18
-6
1
10
-0.10
10
-8
Determinants of price elasticity
Availability of substitutes: Products for which there are good substitutes
Tend to have higher price elasticity‟s than products for which there are few adequate
substitutes. Motion pictures are a good example. Movies are a form of recreation, but there are
many alternative recreational activities. When ticket prices at the movie theater increase, these
substitute activities replace movies, thus the demand for motion pictures is relatively elastic.
Proportion of income spent Demand tends to be inelastic for goods and services that account
for only a small proportion of total expenditures. Consider the demand for salt. A one-pound
container of salt will meet the needs of the typical household for months and costs only a few
cents. If the price of salt were to double, this change would not have a significant impact on the
family's purchasing power. As a result, price changes have little effect on the household
demand for salt. In contrast, demand will tend to be more elastic for goods and services that
require a substantial portion of total expenditures.
22 | P a g e
Time period: Demand is usually more elastic in the long run than in the short run. The
explanation is that, given more time, the consumer has more opportunities to adjust to changes
in prices. As indicated previously, in the short run, people living in an electrically heated home
have few options to reduce electricity consumption. But over a longer period, they may switch
to gas or improve the energy efficiency of the home. Similarly, higher electricity prices may
ultimately cause consumers to use other energy sources for cooking and clothes drying.
Try to understand the influence of the following factors on elasticity of demand:

Nature of commodity ( luxury or necessity good)

Consumers income

Durability of the commodity

Habit

Complementary goods

Recurrence of demand

Possibility of postponement
Price elasticity and decision making
Information about price elasticity‟s can be extremely useful to managers as they contemplate
pricing decisions. If demand is inelastic at the current price, a price decrease will result in a
decrease in total revenue. Alternatively, reducing the price of a product with elastic demand
would cause revenue to increase. The effect on total revenue would be the reverse for a price
increase. However, if demand is unitary elastic, price changes will not change total revenues.
The relationship between elasticity and total revenue can be Shown using simple calculus. Total
revenue is price times quantity. Taking the derivative of total revenue with respect to quantity
yields marginal revenue:
MR 
 (TR )  ( PQ )
P

 PQ
Q
Q
Q
Equation above states that the additional revenue resulting from the sale of one more
unit of a good or service is equal to the selling price of the last unit
(P), adjusted for the reduced revenue from all other units sold at a lower price (Q dP/dQ). This
equation can be written
 Q P 

MR  P1 
 P Q 
23 | P a g e
But note that (Q/P) P / Q = 1 E P , thus

1 

MR  P1 
 EP 
The above Equation indicates that marginal revenue is a function of the elasticity of demand. For
example, if demand is unitary elastic E P  1 then
1 

MR  P1 
0
 1
Because marginal revenue is zero, a price change would have no effect on total revenue. In
contrast, if demand is elastic, Ep < -1 and (1 + 1/Ep> 0. Hence, marginal revenue is positive,
which means that, by increasing quantity demanded, a price reduction would increase total
revenue. Equation also implies that if demand is inelastic, marginal revenue is negative,
indicating that a price reduction would decrease total revenue.
Some analysts question the usefulness of elasticity estimates. They argue that elasticity‟s are
redundant, in that the data necessary for their determination could be used to determine total
revenues directly. Thus managers could assess the effects of a change in price without
knowledge of price elasticity. Although this is true, elasticity estimates are valuable, in that they
provide a quick way of evaluating pricing policies. For example, if demand is known to be
elastic, it is also known that a price increase will reduce total revenues.
Demand
Price
Quantity Demanded
Revenue
Cost
Profit
Increase
More decrease
Decrease Decrease
?
Decrease More increase
Increase
Increase
?
Increase
Increase
Decrease
Increase
elasticity
Elastic
Inelastic
Less decrease
Decrease Less increase
Unitary elastic
Increase
Same
Decrease Increase
Decrease
Proportional Constant
Decrease
Increase
Proportional Constant
Increase
Decrease
decrease
Decrease Same
increase
24 | P a g e
CHAPTER FIVE
DECISION MAKING UNDER RISK AND UNCERTAINITY
Managerial Decisions under Certainty
So far we have discussed the price and output decision of a firm to maximize the profit. This
decision making of an organization is strongly influenced by the structure of the market so that
the managerial decisions are different based on the characteristics of the market structure. To this
end, we have seen several pricing decision of managers by understanding the characteristics of
each market structure. Such type of decision making is undertaken in a simple case by which a
firm has a single plant and produces a single product in a single market at a single price.
Although a single case provides a great insight into a firm‟s decision process, this is frequently
not the type of situation faced by real world firms or corporations. In this chapter, we show
advanced managerial pricing and other organizational decisions in which the managers have
faced some real world complexities that arise when the firm (1) the firm produces a single
product in multiple products (2) changes different prices for the same product sold to different
groups of buyers (3) produce multiple products that are related in consumption and production.
(1) Multi-plant firms: for a firm that costs using two plants, A & B, with marginal costs MC A
and MCB respectively, the total cost of producing any given level of total output QT (=QA+QB) is
minimized when the manager allocates production between the two plants so that the marginal
costs are equal MCA = MCB.
(2) Firms with multiple market: A manager who wishes to maximize a total revenue from
selling a given amount of output in two separate markets (A & B) should allocate sales between
the two markets so that MRA = MRB. And charging lower price in more elastic market and
higher price in less elastic market, that is, if  A   B , then PA  PB .
(3) Firms with multiple products: when a firm produces two products, X & Y, that are related
in consumption either as substitutes or complements, the manager of the multiple product firm
maximizes profit by producing and selling the amounts of X and Y for which MRX = MCX and
MRY = MCY are simultaneously satisfied. And profit maximizing price and output will be
determined. Note that the above optimization problem can be extended for „n‟ number of plants,
markets and products.
25 | P a g e
Managerial Decisions under Risk and Uncertainty
In the decision rules discussed so far an assumption of certainty has been developed in which the
manager is certain about the marginal benefits and marginal costs associated with the decision
he/she has taken. However, decision can also be undertaken under the condition of risk and
uncertainty. For instance, although a manager does not know the marginal benefits and marginal
costs in advance, he/she may decide to invest in a new production facility with the expectation
that the new technology will reduce production cost. As a result, there are basic rules that the
decision makers can used to make decision under risk and uncertainty.
Before dealing with decision making rules under risk and uncertainty, it is better to define the
terms risk and uncertainty. Accordingly, Risk is a decision making condition under which a
manager can list all outcomes and assign probabilities to each outcome. Uncertainty is a
decision making condition under which a manager cannot list all possible outcomes and/or
cannot assign probabilities to the various outcomes.
Rules of Decision under Risk
Expected value rule: since the costs and benefits are not known in advance, the decision is
based on expectation. So the decision with the maximum or highest expected value would be
chosen.
Coefficient of variation rule: the expected value rule only focuses on a decision which gives
maximum expected value regardless of the level of risk associated with the decision but this rule
considers both the expected value and the coefficient of variation for risk which directly related
with the level risk. Thus, according to this rule the decision to be chosen should be the one with
the higher expected value, smallest coefficient of variation, and low level of risk.
Note that if we consider the managers‟ attitude towards risk-risk averse, risk loving and risk
neutral- these attitudes become directly related to the marginal utility for profit. Thus, the
marginal utilities for profit of the risk averse, risk lover and risk neutral decision makers will be
diminishing, increasing and constant respectively. This phenomenon is known as the expected
utility theory of decision under risk.
Rules of Decision under Uncertainty
Maximum rule: identify the best outcome for each possible decision and choosing a decision
with the maximum payoff of all the best outcomes. Maxi-min rule: identify the worst outcome
for each decision and choosing a decision with the maximum worst payoff. Note that the
26 | P a g e
maximum rule is suitable for managers with optimistic outlook on business decision while the
maxi-min rule is suitable for managers with pessimistic outlook.
27 | P a g e
CHAPTER SIX
THEORY OF PRODUCTION AND COST ANALYSIS
Production refers to the economic process of converting of inputs into outputs and is a field of
study in microeconomics. Production is uses resources to create a good or service that is suitable
or exchange.
This
can
include manufacturing,
storing, shipping,
and packaging.
Some
economists define production broadly as all economic activity other than consumption. They see
every commercial activity other than the final purchase as some form of production.
A production process can be defined as any activity that increases the similarity between the
pattern of demand for goods and services, and the quantity, form, and distribution of these goods
and services available to the market place. Production is a process, and as such it occurs through
time and space. Because it is a flow concept, production is measured as a “rate of output per
period of time”. There are three aspects to production processes:
1. The quantity of the good or service produced,
2. The form of the good or service created,
3. The temporal and spatial distribution of the good or service produced.
Factors of production
Factors of production are various types of resources used in the production of goods and
services. They are:
Land (natural resource) - natural resources used in the creation of products, paid in
economic rent, because they are simply irreproducible.
Labor - human efforts provided in the creation of products, paid in wage.
Capital goods - human-made goods or means of production (including machinery,
building and so forth) used in the production of other goods, paid in interest.
Income from exploiting the 3 production factors comprises the national income. Capital and
labor are active factors while land is passive. One can only shift capital and labor rather than
land which is given limited, to get a production-factor combination, which is further reflected in
the technology a firm employs to produce products and services.
28 | P a g e
Labor operates capital to produce. The ratio of labor over capital is a major decision almost all
firms must make. In the decision process, decision makers must understand that neither too much
labor per unit of capital nor too much capital per unit of labor is acceptable since either way
efficiency is not achieved. The 2 factors must come around someplace that both of them
contribute equally to the final economic value realized.
The Production Function
Production function is an equation that asserts the relationship between the quantities of
productive factors used and the maximum amount of product obtained at certain technological
level. It states the amount of product by every possible combination of factors, assuming the
most efficient available methods of production. The production function can thus measure the
marginal productivity of a particular factor of production and determine the cheapest
combination of productive factors. Dozens of production functions are applicable under different
circumstances, usually taking the form of:
Q = f(X1,X2,X3,...,Xn)> where Q is the quantity produced, and X1, X2, X2, ..., Xn are the
factors of production.
Marginal product is a product of the law of diminishing returns. As a result of diminishing
returns that an additional unit of inputs is responsible for a handful of outputs that's smaller than
the outputs previous unit of inputs is responsible for. For simplicity assume that all inputs or
factors of production can be grouped in to two broad categories, labor (L) and capital (K).
The general equation for the production function is
Q  f K , L ---------------------------------- (a)
This function defines the maximum rate of output (Q) per unit of time obtainable from a
given rate of capital and labor input. Output may be in physical units such as automobiles
or microcomputers, or it may be intangible, as in the case of medical care, transportation, or
education.
The production function is really an engineering concept that is devoid of economic
content. That is, it simply relates output and input rates. The production function does not
yield information on the least-cost capital-labor combination for producing a given level of
29 | P a g e
output, nor does it reveal that output rate that would yield maximum profit. The production
function only shows the maximum output obtainable from any and all input combinations.
Prices of the inputs and the price of output must be used with the production function to
determine which of the many possible input combinations is best given the firm's objective.
The definition of the production function as defining maximum output rates is important.
Obviously, firms can fail to organize or manage resources efficiently and produce less than the
maximum output for given input rates. However, in a competitive environment, such firms are
not likely to survive because competitors using efficient production techniques will be able to
produce at lower cost, sell at lower prices, and ultimately drive inefficient producers out of the
market. Thus only firms using the best production methods (i.e., maximizing production from
any input combination) are to be considered.
Economists use a variety of functional forms to describe production. The multiplicative form,
generally referred to as a Cobb-Douglas production function,
Q  AK  L ---------------------------------- (b)
is widely-used in economics because it has properties representative of many production
processes. It will be used as the basis for many of the examples found in this chapter.
Consider a Cobb-Douglas production function with parameters A = 100,  = 0.5, and  =
0.5. That is,
Q  100K 0.5 L0.5 --------------------------- (c)
The production table shows the maximum rate of output associated with each number of input
combinations. For example, given the production function (c), if two units of labor and four units
of capital are used, maximum production is 283 units of output. If K = 8 and L = 2 the output
rate will be 400. Table 4-1 below shows production rates for various input-rate combinations
applied to the production function (c).
Three important relationships are shown by the data in this production table.
First, the table indicates that there are a variety of ways to produce a particular rate of output.
Production Table 4.1 for the Production Function Q  100K 0.5 L0.5
(K)
8
7
283
265
400
374
490
458
565
529
632
592
693
648
748
700
800
748
6
245
346
424
490
548
600
648
693
30 | P a g e
5
224
316
387
447
500
548
592
632
4
200
283
346
400
447
490
529
565
3
173
245
300
346
387
424
458
490
2
141
200
245
283
316
346
374
400
1
100
141
173
200 224
245
265
283
1
2
3
4
6
7
8
5
Rate of Labor Input (L)
For example, 245 units of output can be produced with any of the following input combinations.
Combination
K
L
A
6
1
B
3
2
C
2
3
D
1
6
This implies that there is substitutability between the factors of production. The firm can use a
capital-intensive production process characterized by combination a, a labor-intensive process
such as d, or a process that uses a resource combination somewhere between these extremes,
such as b or c. The concept of substitution is important because it means that managers can
change the mix of capital and labor in response to changes in the relative prices of these
inputs.
Second, in the above Table if input rates, are doubled, the output rate also doubles. For example,
maximum production with one unit of capital and four units of labor is 200. Doubling the input
rates to K = 2, L = 8 results in the rate of output Doubling to Q = 400. The relationship between
output change and proportionate changes in both inputs is referred to as returns to scale.
In Table 3-1, production is characterized by constant returns to scale. This means that if both
input rates increase by the same factor (e.g., both input rates double), the rate of output also will
double. In other production functions, output may increase more or less than in proportion to
31 | P a g e
changes in inputs. Returns to scale have implications for the size of individual firms and the
number of firms in an industry.
For example in producing a product, if output increases more than in proportion to increases in
inputs, that industry is likely to have only a few large firms. In contrast to the concept of returns
to scale, when output changes because one input changes while the other remains constant, the
changes in the output rates are referred to as returns to a factor. Note that in the table, if the rate of
one input is held constant while the other is increased, output increases but the successive
increments become smaller. For example, from Table 4-1 it is seen that if the rate of capital input
is held constant at 2 and labor is increased from L = 1 to L=6 , the successive increases in output
are 59, 45, 38, 33, and 30.
As discussed below, this relationship holds for virtually all
production processes and is the basis for an important economic principle known as the law of
diminishing marginal returns.
In this three-dimensional diagram, capital and labor are shown on the K and L axes and output is
measured on the vertical axis, which is perpendicular to the K, L plane. The rate of output
generated by a given capital-labor combination is found by identifying the point representing an
input combination (such as K1 and L1] in Figure 4-1) and drawing a perpendicular line up to the
production surface. The height of this perpendicular line defines the rate of output QI
corresponding to the input combination K1 and L1• In general, any point on the production surface
defines the maximum output possible from the input combination associated with that point.
Although the production table provides considerable information on production possibilities, it
does not allow for the determination of the profit-maximizing rate of output or even the best way
to produce some specified rate of output. For example, the production data in Table 3-1 show
four different combinations of capital and labor that will generate 245 units of output. Which is
the best combination? Similarly, of the infinite number of possible output levels, which one will
result in maximum profit for the firm? The production function alone cannot answer these
questions. As indicated previously, the production function, while a fundamental part of the
decision-making process, is an engineering relationship and must be combined with data on the
price of capital, labor, and output to determine the optimal allocation of resources in the
production process.
32 | P a g e
Production with one Variable Input
The period of time during which one of the inputs is fixed in amount is defined as the short run.
In contrast, all inputs are variable in the long run. The period of time for the short run will vary
among firms. Generally, at any point of time, the firm is operating in the short run. That is the
input rates of one or more factors are fixed. But most firms are continuously planning or
considering changes in the entire scale of operation that would involve changes in all input rates.
Thus it is said that the firm plans in the long run but operates in the short run. For example, an
automobile manufacturer may have six plants with maximum production capacity of 1.5 million
vehicles per year. To build a new plant may take several years. At any particular time, the firm
operates the existing plants-a short-run decision, but based on current and projected demand
conditions, the firm will plan to augment or reduce plant capacity in the future-a long-run
decision.
The problem of optimal production will be approached in two ways. In this section it is assumed
that the period of production is of such length that the rate of input of one factor of production is
fixed. That is, the period is not long enough to change the input rate of that factor. The problem,
then, is to determine the optimal rate of the variable input given the price of output, the price of
the variable input, and the production technology as described by the production function.
The Product Functions
For a two-input production process, the total product of labor (TPL) is defined as the maximum
rate of output forthcoming from combining varying rates of labor input with a fixed capital
__
input. Denoting the fixed capital input as K , the total product of labor function is
  
TPL  f  K , L 


Similarly, the total product of capital function is written as
 
TPK  f  K , L 


Two other product relations are relevant.
First, marginal product (MP) is defined as the change in output per one-unit change in the
variable input. Thus, the marginal product of labor is
MPL 
Q
L
33 | P a g e
and the marginal product of capital is
MPK 
Q
K
For infinitesimal changes in the variable input, the marginal product function
is the first derivative of the production function with respect to the variable input. For the
general Cobb-Douglas production function,
Q  AK  L
The marginal products are
MP K 
dQ
 AK  1 L
dK
And
MPL 
dQ
  AK  L 1
dL
Second, average product (AP) is total product per unit of the variable input and is found by
dividing the rate of output by the rate of the variable input. The average product of labor
function is
APL 
TPL
L
and the equation for the average product of capital is
APK 
TPK
K
Consider a hypothetical production function. If capital is fixed at two units, the rates of
output generated by combining various levels of labor with two units of capital (i.e., the
total product of labor) are as shown in Table 4-2. The average and marginal product of labor
are also shown in the table.
34 | P a g e
Table 4.2 Total, Average and marginal product of labor for K=2
Rate of Labor
TPL
APL
Input(L)
MPL
0
0
-
-
1
20
20
20
2
50
25
30
3
90
30
40
4
120
30
30
5
140
28
20
6
150
25
10
7
155
22
5
8
150
19
-5
Diminishing Marginal Returns
Consider a cloth manufacturer having a 5,000-square-foot building, having 100
sewing machines. Obviously, having only one or two workers in such a plant would
be inefficient. As more labor is added, production should increase rapidly as more
machines are placed in operation and better coordination achieved among workers
and machines. However, as even more labor is added, the efficiency gains will slow
and output will increase but at a slower rate (i.e., marginal product will decline).
Finally, a point may be reached where adding more labor actually will cause a
reduction in total output that is, where marginal product becomes negative. Because
only so many workers can be put in a finite space, enough labor could be added so
that the production process would come to a standstill, reducing output to zero.
This example illustrates an important economic principle known as the law of
diminishing marginal returns. This law states that when increasing amounts; of the
variable input are combined with a fixed level of another input, a point will be
reached where the marginal product of the variable input will decline. This law does
35 | P a g e
not result from a theoretical argument but is based on actual observation of many
production processes. Virtually all studies of production systems have verified the
existence of diminishing marginal returns.
Relationships among the Product Functions
A set of typical total, average, and marginal product functions for labor is shown in
Figure 4-2. Total product begins at the origin, increases at an increasing rate. At initial
stages, MP increases as additional variable factors (labor) are employed. Then reaches
maximum and declines. After certain range it becomes negative with employment of
additional variable factors. The level of output at which marginal product reaches
maximum is called the point of diminishing marginal productivity.
Starting from this point until MP=0 the level of output increases at decreasing rate
and reaches its maximum when MP=0. After this point additional employment of
labor leads to a reduction of output which arises from negative marginal product of
labor.
36 | P a g e
Fig:4.2 Total Average and Marginal Product of Labor
The total product function can be thought of as a cross section or vertical slice of a threedimension production surface such as that shown in Figure 4-3. Suppose the capital stock is
fixed at K1. The total product of labor function f (K1, L) is shown as the line starting at K1 and
extending through point a. Similarly, if the labor input is fixed at L3, the total product of
capital function is shown as the line beginning at L 3 and going through points a and b. Other
total product functions are shown as the lines beginning at LI, L2, K2, and K3.
The Relationship between Marginal and Average Curves
The average product curve slopes upward as long as the MP is above it; whether the
marginal product curve is itself sloping upward or downward is irrelevant. If an additional
worker is to raise the AP of all workers, that additional worker‟s output must be greater.
Over the range 0 to L1, and then increases at a decreasing rate. Beyond L 3, total
product actually declines. The explanation is as follows. Initially, the input proportions are inefficient-there is too much of the fixed factor, capital. As the labor input is
increased from 0 to L1 output rises more than in proportion to the increase in the labor
input. That is, marginal product per unit of labor increases as a better balance of labor
and capital inputs is achieved. As the labor input is increased beyond L1, diminishing
marginal returns set in and marginal product declines; the additional units of labor
still result in an increase in output, but each increment to output is smaller. When the
labor input has increased to L3, total product reaches a maximum, and then, beyond L3,
the amount of labor has become excessive and slows the production process with the
result that total product actually declines.
Several relationships among the total, average, and marginal product functions are important:
1. Marginal product reaches a maximum at L1, which corresponds to an inflection point (a)
on the total product function. At the inflection point, the total product function changes
from increasing at an increasing rate to increasing at a decreasing rate.
2.
Marginal product intersects average product at the maximum point on the average product
curve. This occurs at labor input rate L2• Recall that whenever marginal product is above
average product, the average is rising-it makes no difference whether marginal product is
rising or falling. When marginal product is below average product, the average is falling.
37 | P a g e
Therefore, the intersection must occur at the maximum point of average product.
3. Marginal product becomes negative at labor input rate L3. This corresponds to the point
where the total product curve reaches a maximum.
Optimal Employment of Factor of Production
In general, to maximize profit, the firm should hire labor as long as the additional revenue
associated with hiring another unit of labor exceeds the cost of employing that unit. For
example, suppose that the marginal product of an additional worker is four units of output and
each unit of output is worth $10,000. Thus the additional revenue to the firm will be $40,000 if
the worker is hired. If the additional cost of a worker (i.e., the wage rate) is $30,000, that worker
will be hired because $10,000, the difference between additional revenue and additional cost,
will be added to profit. However, if the wage rate is $45,000, the worker should not be hired
because profit would be reduced by $5,000.
Formally stated, the basic principle is that additional units of the variable input should be hired
until the marginal revenue product (MRP) of the last unit employed is equal to the cost of the
input., The MRP is defined as marginal revenue times marginal product and represents the value
of the extra unit of labor .Thus labor is hired until MRPL equals the wage rate (w):
MRPL = w--------------------(d),
Similarly, if the labor input was fixed and the capital stock could be varied, capital would be
employed until the marginal revenue product of capital equaled the price of capital (r), that is,
MRPL = r
(e)
Table 4-3 shows the total product, marginal product, total revenue, and marginal revenue product
of labor for the production function Q = 100 K5L5 and where the capital input rate has been
fixed at four units and the price of output is $2. In the example, MRPL can be determined either
by multiplying each MPL entry by $2 (the output price per unit) or by finding the change in total
revenue for each one-unit increase in labor.
It is easily seen that the two methods are equivalent. Marginal revenue product is equal to
marginal revenue multiplied by marginal product. That is,
MRPL = MR . MPL
But
MR 
TR
Q
38 | P a g e
And
MPL 
Q
L
Substituting, it is seen that
MRPL 
TR Q TR

Q L
L
Thus marginal revenue product can be written as the change in total revenue per one-unit change
in the rate of labor input. For infinitesimal changes in the labor input, marginal revenue product
is the first derivative of the total revenue function with respect to that input. That is,
MRPL 
d TR 
dL
TABLE 4-3 Total and Marginal Products, Total Revenue, and Marginal Revenue Product
Functions for Labor for the Production Function Q  100K 0.5 L0.5 , K  4and, P  $2
L
TPL
MPL
MR
MRPL
0
0
1
200
200
400
400
2
283
83
566
166
3
346
63
692
126
4
400
54
800
108
5
447
47
894
94
6
490
43
980
86
7
529
39
1058
78
8
565
36
1130
72
The optimal rate of labor to be hired depends on the wage rate. If a unit of labor costs $108, then
four units of labor are hired because the firm will hire labor only as long as MRPL is greater than
or equal to the wage rate. If the wage rate is lower, say $78 per unit of labor, seven units will be
hired. Clearly, if the wage rate is lower, more labor will be purchased.
The marginal revenue product is the labor demand function for the firm. That is, it indicates the
amount of labor that will be hired at any wage rate. In graphing the labor demand curve, the
vertical axis is measured in dollars, and the horizontal axis is measured as the rate of labor input.
39 | P a g e
The labor demand curve is downward sloping because of the law of diminishing marginal
returns.
The MRPL curve corresponding to Table 4-3 is shown in Figure 4-4. The horizontal line at w =
$78 in the figure can be thought of as the supply function for labor facing the firm. This
horizontal supply curve means that the firm can hire all the labor it wants at $78 per unit. The
optimum quantity of labor is determined by finding the intersection of the demand and supply
functions, that is, the point where MRPL = w. The figure shows that seven units of labor should
be hired. If the wage rate increased to $108 (shown by the w = 108 line in Figure 3-4), the
quantity of labor demanded by the firm would fall to four units. If the wage rate is higher than
$108, less labor would be hired as the firm moved up the MRPL, curve.
Example:
The Optimal Labor Input Rate
Suppose that a firm has the production function
Q  2 K 1 2 L1 2
With marginal product functions for labor and capital given by
MPL 
dQ
k1 2
1
 2  K 1 2 L1 21  1 2
dL
L
2
Or
K
L
And
MPK 
dQ
L1 2
L
1
 2  K 1 2 L1 2  1 2 Or
, respectively. Assume that the capital stock
dk
K
K
2
if fixed at nine units (i.e., K = 9). If the price of output P) is $6 per unit, and the wage rate (w) is
$2 per unit, determine the optimal or profit-maximizing rate of labor to be hired. What labor rate
is optimal if the wage rate increased to $3 per unit?
Solution
First, determine the MRPL, assuming that K is fixed at 9 (note that P =MR):
MRPL  P.MPL  P
 9  18
K

 6

L
L
 L
Now, equate the MRPL function and the wage rate and solve for L. That is, set
MRPL = IV
40 | P a g e
and substitute, yielding
18
L
 2 Or L  81
Therefore, 81 units of labor should be employed.
If the wage rate increases to $3 per unit of labor, the profit-maximizing condition MRPL = w
would be
18
L
3
L  36
This example shows that as the price of labor increases, the firm demands less labor. That is, the
labor demand curve is downward sloping.
Production Functions with Two Variable Factors: Isoquants and Isoclines
For the analysis of production function with two variable factors we make use of the concept
called isoquants or iso- product curves which are similar to indifference curves of the theory of
demand. Therefore, before we explain the production function with two variable factors and
returns to scale, we shall explain the concept of isoquants (that is, equal product curves) and their
properties.
Isoquants:
Isoquants, which are also called equal product curves, are similar to the indifference curves of
the theory of consumer‟s behavior. An isoquant represents all those factor combinations which
are capable of producing the same level of output. The isoquants are thus contour lines which
trace the loci of equal outputs. Since an isoquant represents those combinations of inputs which
will be capable of producing an equal quantity of output, the producer would be indifferent
between them. Therefore, isoquants are also often called equal product curves productionindifference curves.
Table: Factor Combinations to Produce a Given or Level of Output:
41 | P a g e
The concept of isoquant can be easily understood from Table 17.1. It is presumed that two
factors labor and capital are being employed to produce a product. Each of the factor
combinations A. B, C, D and E produces the same level of output, say 100 units. To start with,
factor combination A consisting of 1 unit of labor and 12 units of capital produces the given 100
units of output.
Similarly, combination B consisting of 2 units of labor and 8 units of capital, combination C consisting of 3 units of labor and 5 units of capital, combination D consisting of 4 units of labor and
3 units of capital, combination E consisting of 5 units of labor and 2 units of capital are capable
of producing the same amount of output, i.e., 100 units. In Fig. 17.1 we have plotted all these
combinations and by joining them we obtain an isoquant showing that every combination represented on it can produce 100 units of output.
Though isoquants are similar to be indifference curves of
the theory of consumer‟s behavior, there is one important difference between the two. An
indifference curve represents all those combinations of two goods which provide the same
42 | P a g e
satisfaction or utility to a consumer but no attempt is made to specify the level of utility in exact
quantitative terms it stands for.
This is so because the cardinal measurement of satisfaction or utility in unambiguous thermos is
not possible. That is why we usually label indifference curves by ordinal numbers as I, II, III etc.
indicating that a higher indifference curve represents a higher level of satisfaction than a lower
one, but the information as to how much one level of satisfaction is greater than another is not
provided.
On the other hand, we can label isoquants in the physical units of output without any difficulty.
Production of a good being a physical phenomenon lends itself easily to absolute measurement in
physical units. Since each isoquant represents a specified level of production, it is possible to say
by how much one isoquant indicates greater or less production than another.
In Fig. 17.2 we have drawn an isoquant-map or equal- product map with a set of four isoquants
which represent 100 units, 120 units, 140 units and 160 units of output respectively. Then, from
this set of isoquants it is very easy to judge by how much production level on one isoquant curve
is greater or less than on another.
General Properties of Isoquants:
43 | P a g e
The isoquants normally possess properties which are similar to those generally assumed for
indifference curves of the theory of consumer‟s behavior. Moreover, the properties of isoquants
can be proved in the same manner as in the case of indifference curves.
The following are the important properties of isoquants:
1. Isoquants, like indifference curves, slope downward from left to right (i.e., they have a
negative slope):
This is so because when the quantity of a factor, say labor, is increased, the quantity of other
capital i.e., capital must be reduced so as to keep output constant on a given isoquant. This
downward-sloping property of isoquants follows from a valid assumption that the marginal
physical products of factors are positive, that is, the use of additional units of factors yield
positive increments in output.
In view of this when one factor is increased yielding positive marginal products, the other factor
must be reduced to hold the level of output constant otherwise the output will increase and we
will switch over to a higher isoquant.
The assumption that the marginal physical product of a factor is positive is quite reasonable. In
the discussion of the law of variable proportions we saw that in the stage III, when the units of
the variable factor, say labor, become excessive, it causes such an overcrowding on a fixed
capital equipment (or on a given piece of land if land is the fixed factor) that they obstruct each
other resulting in negative marginal products of labor, that is, the use of additional units of labor
reduce total output.
This could happen but no rational producer who aims to minimize cost or maximize profits will
employ units of a factor to the point where its marginal product has become negative because
positive prices have to be paid for them. Thus, in view of the positive prices that have to be paid
for the units of a factor, we rule out the use of the units of a factor that have negative 01 zero
marginal products.
Thus, with labor measured on the X-axis and capital on the X-axis if the isoquant is a horizontal
straight line, this would indicate that the marginal products of labor (MPL) are zero. Likewise,
vertical isoquant would indicate marginal products of capital (MP K) are zero.
44 | P a g e
Further, an upward sloping isoquant implies that either the marginal products of the two factors
are zero or one of the two factors has negative marginal products and the other has positive
marginal products. It is also worth noting that the upward-sloping isoquant implies that the same
output can be produced with the use of less of both the factors, that is, marginal products of at
least one factor is negative.
In this situation when every reduction in both the factors used does not affect output, the
producer will not reach an equilibrium position. It follows from above that over the economically
relevant stage of production when the marginal products of the factors are positive we have
downward sloping isoquants.
2. No two isoquants can intersect each other:
If the two isoquants, one corresponding to 20 units of output and the other to 30 units of output
intersect each other, there will then be a common factor combination corresponding to the point
of intersection.
It means that the same factor combination which can produce 20 units of output according to one
isoquant can also produce 30 units of output according to the other isoquant. But this is quite
absurd. How can the same factor combination produce two different levels of output, technique
of production remaining unchanged?
3. Isoquants, like indifference curves, are convex to the origin:
The convexity of isoquant curves means that as we move down the curve successively smaller
units of capital are required to be substituted by a-given increment of labor so as to keep the level
of output unchanged. Thus, the convexity of equal product curves is due to the diminishing
marginal rate of technical substitution of one factor for the other.
If the isoquants were concave to the origin, it would mean that the marginal rate of technical
substitution increased as more and more units of labor were substituted for capital. This could be
valid if the law of increasing returns applied.
Since it is the law of diminishing returns which is more true of the real world, the principle of
diminishing marginal rate of technical substitution generally holds good and it makes the
45 | P a g e
isoquants convex to the origin. We have seen above that marginal rate of technical substitution
diminishes because of diminishing marginal returns to a factor as we increase its quantity used.
Marginal Rate of Technical Substitution:
Marginal rate of technical substitution in the theory of production is similar to the concept of
marginal rate of substitution in the indifference curve analysis of consumer‟s demand. Marginal
rate of technical substitution indicates the rate at which factors can be substituted at the margin
without altering the level of output.
More precisely, marginal rate of technical substitution of labor for capital may be defined as the
number of units of capital which can be replaced by one unit of labor, the level of output
remaining unchanged. The concept of marginal rate of technical substitution can be easily
understood from the above Table.
Each of the factor combinations A, B, C, D, and E yields the same level of output. Moving down
from combination A to combination B, 4 units of capital are substituted by 1 unit of labor in the
production process without any change in the level of output. Therefore, marginal rate of
technical substitution of labour for capital is 4 at this stage. Switching from input combination B
to input combination C involves the replacement of 3 units of capital by an additional unit of
labour, output remaining the same. Thus, the marginal rate of technical substitution is now 3.
Likewise, marginal rate of technical substitution of labour for capital between factor
combinations C and D is 2, and between factor combinations D and E it is 1.The marginal rate of
technical substitution at a point on an isoquant (an equal product curve) can be known from the
slope of the isoquant at that point. Consider a small movement down the equal product curve
from G to H in Fig. 17.2 where a small amount of capital, say ∆K is substituted by an amount of
labour say ∆L without any loss of output. The slope of the isoquant curve Q 1 at point G is
therefore equal to ∆K/∆L. Thus,
Marginal rate of technical substitution of labor for capital = slope = ∆K/∆L
Table: Marginal Rate of Technical Substitution:
46 | P a g e
Slope of the isoquant at a point and therefore the marginal rate of technical substitution (MRTS)
between factors can also be known by the slope of the tangent drawn on the isoquant at that
point. In Fig. 17.3 the tangent TT‟ is drawn at point K on the given isoquant Q.
The slope of the tangent TT‟ is equal to OT/OT‟. Therefore, the marginal rate of substitution at
point K on the isoquant Q is equal to OT/OT‟. JJ‟ is the tangent at point L drawn to the isoquant
Q. Therefore, the marginal rate of technical substitution of labour for capital at point L is equal
to OJ/OJ‟.
An important point to be noted about the marginal rate of technical substitution is that it is equal
to the ratio of the marginal physical products of the two factors. Since, by definition, output
remains constant on an isoquant the loss in physical output from a small reduction in capital will
be equal to the gain in physical output from a small increment in labor. The loss in output is
equal to the marginal physical product of capital (MP) multiplied by the amount of reduction in
capital. The gain in output is equal to the marginal physical product of labor (MP) multiplied by
the increment in labor.
47 | P a g e
THEORY OF COST AND ITS APPLICATION
Introduction
The term cost can be defined in a number of ways. The correct definition varies from situation to
situation. In popular terminology, cost generally refers to the price that must be paid for an item.
Cost estimation and control is part of the continual process of making products that exceed
customer expectations. Quick fixes don‟t work. This chapter shows how making things faster,
cheaper, and better requires a fundamental appreciation of cost concepts. Cost analysis is made
difficult by the effects of unforeseen inflation, unpredictable changes in technology, and the
dynamic nature of input and output markets. Wide divergences between economic costs and
accounting valuations are common. This makes it extremely important to adjust accounting data
to create an appropriate basis for managerial decisions.
In economics, a cost curve is a graph of the costs of production as a function of total quantity
produced. In a free market economy, productively efficient firms use these curves to find the
optimal point of production, where they make the most profits. There are a few different types of
cost curves, each relevant to a different area of economics.
The Link between Accounting and Economic Cost Valuations
Accurate cost analysis involves careful consideration of relevant decision alternatives. In many
instances, the total costs of making a given decision are clear only when viewed in light of what
is done and what is not done. Careful decision analysis includes comparing the relative costs and
benefits of each decision alternative. No option can be viewed in isolation; each choice plays an
important role in shaping the relevant costs and benefits of all decision alternatives. Evaluation
of a proposal to expand output requires that revenues gained from added sales be compared with
the higher production costs incurred. In weighing a recommendation to expand, managers must
compare the revenues derived from investment and the cost of needed funds. Expected benefits
from an advertising promotion must be measured in relation to the costs of personal selling,
media promotion, and direct marketing. Even a decision to pave the employees‟ parking lot or to
refurbish the company lunchroom involves a comparison between projected costs and the
expected benefits derived from improved morale and worker productivity. In every case, the
48 | P a g e
decision-making process involves a comparison between the costs and the benefits resulting from
various decision alternatives.
Corporate restructuring often involves eliminating nonstrategic operations to redeploy assets and
strengthen core lines of business. When nonessential assets are disposed of in a depressed
market, there is typically no relation between low “fire sale” proceeds and book value, historical
cost, or replacement cost. Conversely, when assets are sold to others who can more effectively
use such resources, sale proceeds can approximate replacement value and greatly exceed
historical costs and book values. Even under normal circumstances, the link between economic
and accounting values can be tenuous. Economic worth as determined by profit-generating
capability, rather than accounting value, is always the most vital consideration when determining
the cost and use of specific assets.
Basic Cost Concepts
Cost analysis is made complex because there are many different definitions and concepts of cost,
and it is not always straightforward to determine which costs to use and how to measure them in
a particular situation. The focus here is on the relevant costs for decision-making. In order to
clarify this aspect the following cost distinctions are important.
Explicit and implicit costs
Explicit costs can be considered as expenses or out-of-pocket costs (rent, raw materials, fuel,
wages); they are normally recorded in a firm‟s accounts. However, the economic cost of using a
resource is its opportunity cost, which is the cost of forgoing the next most profitable use of the
resource, or the benefit that could be obtained from the next-best use. This involves both explicit
and implicit costs. Let us take the example of a student considering undertaking an MBA; the
relevant costs can be classified as either explicit costs or implicit costs.
Explicit costs include fees, books, accommodation, food, transportation, recreation and
entertainment and so on. Not all of these may be directly related to doing an MBA, the last
category for example, so they can be regarded as incidental costs. Money still has to be made
available to pay these costs. Implicit costs are non-cash costs, like the salary that could have been
earned, leisure time forgone (if work required on the MBA exceeds the hours of salaried work),
49 | P a g e
and interest forgone on assets which have to be used to pay MBA expenses. Opportunity costs
would include elements of both, but are not simply the sum of the two; for example,
accommodation is not an opportunity cost if the student would be in the same accommodation
whether they were doing the MBA or not. Opportunity costs should be used for decision-making
purposes, meaning making the fundamental decision whether to do the MBA or not. These costs
then have to be compared with the expected benefits, monetary and non-monetary, of
undertaking an MBA program. This does not mean that the other costs are unimportant; they are
still relevant in cash planning.
Historical and current costs
Historical costs represent actual cash outlay and this is what accountant‟s record and measure.
This means measuring costs in historical terms, at the time they were incurred. Although this is
relevant for tax purposes it may not reflect the current costs.
Current costs refer to the amount that would be paid for an item under present market conditions.
Often current costs exceed historical costs, particularly with inflation. In some situations, for
example IT equipment, current costs tend to be below historical costs because of rapid
improvements in technology. In this case the item being costed may no longer be available, and
the appropriate cost is the replacement cost. This is the cost of duplicating the productive
capability of the item using current technology. Replacement cost is the relevant cost for
decision-making..
Sunk and incremental costs
Sunk costs are costs that do not vary according to different decisions. An example was given
earlier in the case of the MBA student‟s accommodation; the accommodation cost was the same
whether or not the student did the MBA. Often these costs refer to outlays that have already
occurred at the time of decision making, like the cost of market research conducted before
deciding whether to launch a new product.
Incremental costs refer to changes in costs caused by a particular decision. Using the same
example, if the student would have to pay £4,000 for yearly accommodation doing a salaried job
and £6,000 for accommodation to do the MBA, the incremental cost associated with the decision
50 | P a g e
to do the MBA would be £2,000 (assuming simplistically that there are no other costs or benefits
related to the differences in accommodation). Incremental costs are the relevant costs for
decision-making.
Short Run Cost Behaviors
A short-run cost curve shows the minimum cost impact of output changes for a specific plant
size and in a given operating environment. Such curves reflect the optimal or least-cost input
combination for producing output under fixed circumstances. Wage rates, interest rates, plant
configuration, and all other operating conditions are held constant.
Any change in the operating environment leads to a shift in short-run cost curves. For example, a
general rise in wage rates leads to an upward shift; a fall in wage rates leads to a downward shift.
Such changes must not be confused with movements along a given short-run cost curve caused
by a change in production levels. For an existing plant, the short-run cost curve illustrates the
minimum cost of production at various output levels under current operating conditions. Shortrun cost curves are a useful guide to operating decisions.
a. Cost function components.
Fixed costs: Costs associated with fixed input commitments. These costs do not
change with the level of output
Variable costs: Costs associated with the variable components. These costs vary
with the level of output.
b. Total cost relationships. One way to represent these costs is in terms of total
expenditures.
Q
TFC
TVC
TC
0
10
0
10
1
10
6
2
10
10
51 | P a g e
MC
AFC
AVC
ATC
16
6
10
6
16
20
4
5
5
10
3
10
12
22
2
3.333333 4
7.333333
4
10
16
26
4
2.5
4
6.5
5
10
23
33
7
2
4.6
6.6
6
10
35
45
12
1.666667 5.833333 7.5
7
10
53
63
18
1.428571 7.571429 9
8
10
78
88
25
1.25
9.75
11
Graphically, these relationships appear as follows:
100
TC
TC
80
TVC
60
MC
40
MC
TVC
20
TFC
0
0
2
4
6
8
10
FC
Notice that the TVC and the TC curves both take on the shape of a “recliner”: that is, first
increasing at a decreasing rate, and then increasing at an increasing rate. The difference between
the two curves is TFC, which is a fixed amount. The slope of the line tangent to either TVC or
TC is the marginal cost. Marginal costs first decrease and then increase due to the law of
diminishing returns.
C. Average Cost Relationships. The same relationships can be generated by dividing costs by
quantity, to get per unit costs. In this case:
AFC
52 | P a g e
=
TFC/Q
(Average Fixed Costs)
AVC =
TVC/Q
(Average Variable Costs)
ATC
=
TC/Q
(Average Total Costs)
MC
=
TC/Q
These are illustrated in the rightmost columns of the above table. Graphically, these curves are
represented as
30
MC
25
20
15
ATC
10
AVC
5
0
0
2

4
6
8
10
ATC and AVC approach each other as quantity expands. This is because the
difference between the two curves is AFC. AFC is a fixed quantity allocated over
an increasing number of units.

MC intersects ATC and AVC at their minimum points. This follows for the same
reason that MP intersects AP at its peak: The marginal drives the average. The
averages reflect the same information as the marginal. The marginal is more
volatile, however, because it is not weighed down by the effects of any output other
than the current increment.
Examples of fixed costs include the rental costs of buildings; the costs of leasing or purchasing
capital equipment such as plant and machinery; the annual business rate charged by local
authorities; the costs of full-time contracted salaried staff; the costs of meeting interest payments
on loans; the depreciation of fixed capital (due solely to age) and also the costs of business
insurance.
53 | P a g e
Fixed costs are the overhead costs of a business. They are important in markets where the fixed
costs are high but the variable costs associated with making a small increase in output are
relatively low. We will come back to this when we consider economies of scale.
Variable Costs
Variable costs are costs that vary directly with output. Examples of variable costs include the
costs of intermediate raw materials and other components, the wages of part-time staff or
employees paid by the hour, the costs of electricity and gas and the depreciation of capital inputs
due to wear and tear. Average variable cost (AVC) = total variable costs (TVC) /output (Q)

Total fixed costs

Average fixed cost
(TFC)
(AFC)
remain constant as output increases
=
total fixed costs divide d by output
Marginal Cost: Marginal cost is the change in total costs from increasing output by one
extra unit. The marginal cost of supplying an extra unit of output is linked with the marginal
productivity of labour. The law of diminishing returns implies that the marginal cost of
production will rise as output increases. Eventually, rising marginal cost will lead to a rise in
average total cost. This happens when the rise in AVC is greater than the fall in AFC as output
(Q) increases.
Average fixed costs must fall continuously as output increases because total fixed costs are
being spread over a higher level of production. In industries where the ratio of fixed to variable
costs is extremely high, there is great scope for a business to exploit lower fixed costs per unit if
it can produce at a big enough size. Consider the new Sony portable play station. The fixed costs
of developing the product are enormous, but these costs can be divided by millions of individual
units sold across the world.
Multiplan Economies and Diseconomies of Scale
Multiplan economies of scale are cost advantages that arise from operating multiple facilities in
the same line of business or industry. Multiplan diseconomies of scale are cost disadvantages
that arise from managing multiple facilities in the same line of business or industry.
54 | P a g e
Multiplan economies of scale-Cost advantages from operating multiple facilities in the same
line of business or industry
Multiplan diseconomies of scale-Cost disadvantages from managing multiple facilities in the
same line of business or industry
Economies of Scope Concept
Cost analysis focuses not just on how much to produce but also on what combination of products
to offer. By virtue of their efficiency in the production of a given product, firms often enjoy cost
advantages in the production of related products.
Economies of scope exist when the cost of joint production is less than the cost of producing
multiple outputs separately. A firm will produce products that are complementary in the sense
that producing them together costs less than producing them individually. Suppose that a
regional airline offers regularly scheduled passenger service between midsize city pairs and that
it expects some excess capacity. Also assume that there is a modest local demand for air parcel
and small-package delivery service. Given current airplane sizes and configurations, it is often
less costly for a single carrier to provide both passenger and cargo services in small regional
markets than to specialize in one or the other. Regional air carriers often provide both services.
This is an example of economies of scope. Other examples of scope economies abound in the
provision of both goods and services. In fact, the economy of scope concept explains why firms
typically produce multiple products.
55 | P a g e
Chapter -Seven
Pricing Strategy and Practices
Concepts of Pricing
In the narrowest sense, price is the amount of money charged for a product or service. More
broadly, price is the sum of all the values that consumers exchange for the benefits of having or
using the product or service. How are prices set? Historically, prices were usually set by buyers
and sellers bargaining with each other. Sellers would ask for a higher price than they expected to
get and buyers would offer less than they expected to pay. Through bargaining, they would
arrive at an acceptable price. Individual buyers paid different prices for the same products,
depending on their needs and bargaining skills.
Price is the amount of money charged for a product or service, or the sum of the values that
consumers exchange for the benefits of having or using the product or service.
Factors affecting pricing decisions
Internal factors




Pricing Decision
Marketing
objectives
Marketing
mix strategy
Costs
Organization
for pricing
External Factors
Nature of the market and
demand
Competition
Other environmental factors
(economy, resellers,
government)
Fig: Factors affecting pricing decision
Internal Factors Affecting Pricing Decisions
Internal factors affecting pricing include the company's marketing objectives, marketing-mix
strategy, costs and organization.
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Marketing-Mix Strategy
Price is only one of the marketing-mix tools that a company uses to achieve its marketing
objectives. Price decisions must be coordinated with product design, distribution and promotion
decisions to form a consistent and effective marketing program. Decisions made for other
marketing-mix variables may affect pricing decisions. For example, producers using many
resellers that arc expected to support and promote their products may have to build larger reseller
margins into their prices. The decision to position the product on high performance quality will
mean that the seller must charge a higher price to cover higher costs. The perfume houses argue
that their high margins, expensive advertising and exclusive distribution are essential to the
brands and in the public interest.
Costs
Costs set the floor for the price that the company can charge for its product. The company wants
to charge a price that both covers all its costs for producing, distributing and selling the product,
and delivers a fair rate of return for its effort and risk. A company's costs may be an important
element in its pricing strategy. Many companies work to become the 'low-cost producers' in their
industries.
Organizational Considerations
Management must decide who within the organization should set prices. Companies handle
pricing in a variety of ways. In small companies, prices arc often set by top management rather
than by the marketing or sales departments. In large companies, pricing is typically handled by
divisional or product line managers. In industrial markets, salespeople may he allowed to
negotiate with customers within certain price ranges. Even so, top management sets the pricing
objectives and policies, and it often approves the prices proposed by lower-level management or
salespeople. In industries in which pricing is a key factor (aerospace, railways, oil companies),
companies will often have a pricing department to set the best prices or help others in setting
them. This department reports to the marketing department or top management. Others who have
an influence on pricing include sales managers, production managers, finance managers and
accountants.
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External Factors Affect Pricing Decisions
External factors that affect pricing decisions include the nature of the market and demand,
competition and other environmental elements.
• The Market and Demand
Whereas costs set the lower limit of prices, the market and demand set the upper limit. Both
consumer and industrial buyers balance the price of a product or service against the benefits of
owning it. Thus, before setting prices, the marketer must understand the relationship between
price and demand for its product. In this section, we explain how the price-demand relationship
varies for different types of market and how buyer perceptions of price affect the pricing
decision. We then discuss methods for measuring the price-demand relationship.

Competition
Under pure competition, the market consists of many buyers and sellers trading in a uniform
commodity such as wheat, copper or financial securities. No single buyer or seller has much
effect on the going market price. A seller cannot charge more than the going price because
buyers can obtain as much as they need at the going price. Nor would sellers charge less than the
market price because they can sell all they want at this price. If price and profits rise, new sellers
can easily enter the market. In a purely competitive market, marketing research, product
development, pricing, advertising and sales promotion play little or no role.
Thus sellers in these markets do not spend much time on marketing strategy, Under monopolistic
competition, the market consists of many buyers and sellers that trade over a range of prices
rather than a single market price. A range of prices occurs because sellers can differentiate their
offers to buyers. Either the physical product can he varied in quality, features or style, or the
accompanying services can be varied.

Other External Factors
When setting prices, the company must also consider other factors in its external environment.
Economic conditions can have a strong impact on the firm's pricing strategies. Economic factors
such as boom or recession, inflation and interest rate affect pricing decisions because they affect
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both the costs of producing a product and consumer perception of the product's price and value.
The company must also consider what impact its prices will have on other parties in its
environment. How will resellers react to various prices? The company should set prices that give
resellers a fair profit, encourage their support and help them to sell the product effectively. The
government is another important external influence on pricing decisions. Finally, nodal concerns
may have to be taken into account. In setting prices, a company's short-term sales, market share
and profit goals may have to be tempered by broader societal considerations.
Marketing Objectives
Before setting price, the company must decide on its strategy for the product, If the company
has selected its target market and positioning carefully, then its factors to Consider when Setting
Prices. Marketing-mix strategy, including price, will be fairly straightforward. For example, if
Toyota decides to produce its Lexus cars to compete with European luxury cars in the highincome segment, this suggests charging a high price. Travel Lodge positions itself as motels that
provide economical rooms for budget minded travellers; this position requires charging a low
price. Thus pricing strategy is largely determined by past decisions on market positioning.
At the same time, the company may seek additional objectives. The clearer a firm is about its
objectives, the easier it is to set price. Examples of common objectives are survived, current
profit maximization, market-share maximization and product-quality leadership.
Companies set survival as their fundamental objective if they are troubled by too much capacity,
heavy competition or changing consumer wants. In Europe and Japan steel-makers sell steel at a
loss as demand declines. To keep a plant going, a company may set a low price, hoping to
increase demand. In this case, profits are less important than survival. As long as their prices
cover variable costs and some fixed costs, they can stay in business. However, survival is only a
short term objective. In the long run, the firm must learn how to add value or face extinction, 4
many companies use current profit maximization as their pricing goal. They estimate what
demand and costs will be at different prices and choose the price that will produce the maximum
current profit, cash flow or return on investment. In all cases, the company wants current
financial results rather than long-run performance. Other companies want to obtain marketshare leadership. They believe that the company with the largest market share will enjoy the
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lowest costs and highest long-run profit. To become the market-share loader, these firms set
prices as low as possible. A variation of this objective is to pursue a specific market-share gain.
Say the company wants to increase its market share from 10 per cent to 15 per cent in one year.
It will search for the price and marketing program that will achieve this goal.
A company might decide that it wants to achieve product-quality leadership. This normally
calls for charging a high price to cover such quality and the high cost of R&D: For example,
Jaguar's limited edition XJ220 sold for £400,000 each, but had wealthy customers queuing" to
buy one.
New product pricing Strategies
Pricing strategies usually change as the product passes through its life cycle. The introductory
stage is especially challenging. We can distinguish between pricing a product that imitates
existing products and pricing an innovative product that is patent protected. A company that
plans to develop an imitative new product faces a product positioning problem. It must decide
where to position the product versus competing products in terms of quality and price. Figure
below shows four possible positioning strategies. First, the company might decide to use a
premium pricing strategy - producing a high-quality product and charging the highest price. At
the other extreme, it might decide on an economy pricing strategy - producing a lower-quality
product, but charging a low price. These strategies can coexist in the same market as long as the
market consists of at least two groups of buyers, those who seek quality and those who seek
price. Thus, Tag-Heuer offers very high-quality sports watches at high prices, whereas Casio
offers digital watches at almost throwaway prices.-' The good-value strategy represents a way to
attack the premium pricer. The United Kingdom's leading grocery chain always uses the
strapliiie: 'Good food costs less at Sainsburv's'. If this is really true and quality-sensitive buyers
believe the good-value price, they will sensibly shop at Sainsbury's and save money - unless the
premium product offers more status or snob appeal. Using an overcharging strategy, the
company overprices the product in relation to its quality. In the long run, however, customers are
likely to feel 'taken'. They will stop buying the product and will complain to others about it. Thus
this strategy should be avoided.4 Companies bringing out an innovative, patent-protected
product face the challenge of setting prices for the first time.
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They can choose between two strategies: market-shimming pricing and market-penetration
pricing.
Price
High
Premium Strategy
Low
Good value Strategy
High
Quality
Economy Strategy
Low
Overcharging Strategy
Fig. Price positioning Strategy
1. Market-Skimming Pricing
Many companies that invent new products initially set high prices to 'skim' revenues layer by
layer from the market. Intel is a prime user of this strategy, called market-skimming pricing.
When Intel first introduces a new computer chip, it charges the highest price it can, given, the
benefits of the new chip over competing chips. It sets a price that makes it just worthwhile
for some segments of the market to adopt computers containing the chip. As initial sales
slowdown and as competitors threaten to introduce similar chips, Intel lowers the price to
draw in the nest price-sensitive layer of customers.
2. Market-Penetration Pricing
Rather than setting a high initial price to skim off small but profitable market segments, some
companies use market-penetration pricing. They set a low initial price in order to penetrate
the market quickly and deeply - to attract a large number of buyers quickly and win a large
market share. The high sales volume results in falling costs, allowing the company to cut its
price even further. For example, Dell and Dan used penetration pricing to sell high-quality
computer products through lower-cost mail-order channels. Their sales soared when IBM,
Compaq, Apple and other competitors selling through retail stores could not match their
prices.
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