Managerial
Economics
Third Edition
About the Authors
Geetika is a Professor at the School of Management Studies, Motilal Nehru National Institute of
Technology (MNNIT) Allahabad, and has recently completed her term as Dean (Academics). She
was nominated by the Government of India to the Asian Institute of Technology, Thailand, on Faculty
Secondment. She also served as Adjunct Professor in the same institute, for supervising doctoral students
in the area of High Tech Entrepreneurship. Dr. Geetika has 30 years of teaching experience at graduate
and postgraduate levels and 28 years of experience in guiding and examining doctoral and postdoctoral
theses in India and abroad. Her interests lie in Managerial Economics, Entrepreneurship and Strategic
Management. She has many research projects, including two international projects, to her credit. Fourteen
students including one international candidate have received their PhD degrees under her supervision.
She has published more than 80 research papers in refereed national and international journals and
conference proceedings. She has also authored three books and edited four. She holds a key position
in institute administration, and is the Chairperson of IPR Standing Committee and Women’s Grievance
Committee. She is also associated with various academic bodies of other institutions of eminence and
participates in social activities such as nurturing orphans, environment protection and rehabilitation.
Piyali Ghosh is an Assistant Professor in OB/HR domain at the Indian Institute of Management,
Ranchi. Prior to this, she was working with School of Management Studies, Motilal Nehru National
Institute of Technology Allahabad, for nine years. Dr. Ghosh completed her PhD in Human Resource
Strategies: An Analysis with Special Reference to the Indian Info Tech Industry from the same institution
as senior research fellow of UGC. She also holds an MA in Economics from CSJM University,
Kanpur, and an MBA from the University of Allahabad. Four research scholars have been awarded
doctoral degrees under her supervision and one is presently working under her joint supervision.
Dr. Ghosh has another published title on Industrial Relations and Labour Laws with McGraw Hill
Education, besides having around 40 research papers published in national and international journals
and more than 10 research papers in various conferences.
Purba Roy Choudhury is an Associate Professor of Economics at the Bhawanipur Education Society
College, Kolkata, under the University of Calcutta. She obtained her PhD degree from Jadavpur
University, Kolkata, with an MPhil and MA in Economics from the same university. For the past 16
years, she has been teaching courses in Economics, Statistics and Econometrics to the students of
BSc (Economics), BBA and BCom under the University of Calcutta. She was also a visiting faculty at
the School of Social Work and Community Service of National Council of Education, West Bengal. Dr.
Roy Choudhury has 11 papers published in national and international journals and 15 research papers
presented in various national and international conferences. She has also participated in many research
and training workshops, summer schools and faculty development programmes.
Managerial
Economics
Third Edition
Geetika
Professor
School of Management Studies
Motilal Nehru National Institute of Technology Allahabad
Allahabad
Piyali Ghosh
Assistant Professor
Indian Institute of Management Ranchi
Ranchi
Purba Roy Choudhury
Associate Professor
Department of Economics
Bhawanipur Education Society College
Kolkata
McGraw Hill Education (India) Private Limited
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This book is dedicated to…
My Parents, for being so wonderful….
Geetika
My Mother, for all those moments of her pride in my achievements…
Piyali Ghosh
My Parents, for their constant support….
Purba Roy Choudhury
Foreword
Preface to the Third Edition
Preface to the First Edition
xix
xxi
xxv
PART 1
1.
INTRODUCTION
Basic Concepts and Principles
3
Introduction 3
4
Basic Assumptions 4
Types of Economic Analysis 6
Kinds of Economic Decisions 9
Managerial Economics 10
Economic Principles Relevant to Managerial Decisions 12
Managerial Economics and Functions of Management 15
Relation of Managerial Economics with Decision Sciences 16
Summary 17
Key Concepts 18
Questions 18
Check Your Answers 21
Caselet 1—The ‘Retail Dahi’ 21
Caselet 2—Baby Steps for Baby Food 22
Appendix 1.1—Basic Mathematics for Economic Analysis 22
2.
Theory of Firm
Introduction 33
Forms of Ownership 34
Public Sector in India 46
Objectives of Firm 46
33
viii
Contents
Principal Agent Problem 53
Summary 54
Key Concepts 55
References and Further Reading 56
Questions 56
Check Your Answers 58
Caselet 1—The Utterly, Butterly Cooperative 58
Caselet 2—Asymmetric Information in Healthcare 59
Case 1—Vistara: Scaling New Heights in the Skies 59
Case 2—Dabur India Limited: Growing Big and Global 60
PART 2
3.
CONSUMER BEHAVIOUR, DEMAND AND SUPPLY
Consumer Preferences and Choice
65
Introduction 65
Consumer Choice 66
Consumer Preferences 73
Consumer’s Income 79
Revealed Preference Theory 83
Consumer Surplus 84
Summary 85
Key Concepts 86
Questions 86
Check Your Answers 89
Caselet 1—The Androids-Windows Battle 89
Caselet 2—From Economy to First Class 90
Caselet 3—Retail Sector: Riding the Changing Waves of Consumerism 91
Case 1—Maggi Noodles: Trouble in Oodles 91
Case 2—Making Magic: The Multiplex Way 92
4.
Demand and Supply Analysis
Introduction 95
Demand 96
Law of Demand 103
Supply 112
Law of Supply 114
Market Equilibrium 116
Summary 122
Key Concepts 122
Questions 123
95
Contents
ix
Check Your Answers 126
Caselet 1—Price Cut to Stay Alive 126
Caselet 2—The Yoga of Advertising 127
Caselet 3—The Demand and Supply of Mobile App Economy 127
Case 1—The Rough Ride from Feature Phones to Smartphones 128
Case 2—Power for All: Myth or Reality? 129
5.
Elasticities of Demand and Supply
131
Introduction 131
Price Elasticity of Demand 132
Revenue and Price Elasticity of Demand 141
Income Elasticity of Demand 141
Cross Elasticity of Demand 143
Promotional Elasticity of Demand 145
Importance of Elasticity of Demand 146
Elasticity of Supply 147
Degrees of Price Elasticity of Supply 148
Determinants of Price Elasticity of Supply 150
Effect on Market Equilibrium 151
Summary 152
Key Concepts 153
Questions 153
Check Your Answers 157
Caselet 1—Regaining its Lost Empire 157
Caselet 2—CNG Vehicles Have Arrived 158
6.
Demand Forecasting
Introduction 161
Meaning of Demand Forecasting 162
Techniques of Demand Forecasting 163
Subjective Methods of Demand Forecasting 164
Quantitative Methods of Demand Forecasting 169
Limitations of Demand Forecasting 187
Summary 188
Key Formulae 189
Questions 190
Check Your Answers 193
Caselet 1—The Pilot CNG 194
Caselet 2—Forecast to Reduce Risk 195
Case—Forecasting Electricity Price 196
161
x
Contents
PART 3
7.
COST AND PRODUCTION
Cost and Revenue
Introduction 199
Kinds of Costs 200
Costs in Short Run 204
Costs in Long Run 210
Costs of a Multi Product Firm 213
Costs of Joint Products 214
Concepts of Revenue 215
Break-even Analysis 221
Economies of Scale 224
Economies of Scope 226
Cost and Learning Curves 227
Summary 228
Key Concepts 229
References and Further Reading 229
Questions 230
Check Your Answers 233
Caselet—Would IndiGo? 234
Case 1—Cement Industry in India 234
Case 2—Disrupting FMCG the Swadeshi Way
8.
199
236
Production Analysis
Introduction 238
Types of Inputs 239
Production Function 242
Production Function with One Variable Input 243
Production Function with Two Variable Inputs 248
Elasticity of Substitution 253
Isocost Lines 257
Producer’s Equilibrium 258
Expansion Path 260
Returns to Scale 260
Different Types of Production Functions 261
Technical Progress and its Implications 265
Summary 267
Key Concepts 268
Questions 268
Check Your Answers 271
238
Contents
Caselet—Alternative Fuels 272
Case 1—Expanding the Volvo Way 272
Case 2—3D Printing: the Future of Technology
9.
xi
273
Financial Evaluation of Long-Term Projects
275
Introduction 275
Project 275
Types of Projects 276
Features of Project Evaluation 278
Importance of Project Evaluation 279
Decision Criteria and Relevant Variables 280
Methods of Project Evaluation 282
Capital Rationing 289
Summary 290
Key Concepts 291
Questions 291
Check Your Answers 294
Caselet—Turnaround of Indian Railways 295
Case 1—Strategy 2025 295
Case 2—Geovic Feasibility Study 296
PART 4
MARKET MORPHOLOGY AND EQUILIBRIUM CONDITIONS
10. Perfect Competition
Introduction 301
Market Morphology 302
Perfect Competition 303
Demand and Revenue of a Firm 305
Market Demand Curve and Firm’s Demand Curve 308
Short Run Equilibrium 309
Market Supply Curve and Firm’s Supply Curve 312
Long Run Equilibrium 314
Perfect Competition: Existence in Real World 315
Summary 316
Key Concepts 316
Questions 316
Check Your Answers 320
Caselet 1—FOREX Trading: Competition or not? 320
Caselet 2—Does Perfect Competition Exist? 321
Case 1—The Fantastic Plastic 322
Case 2—Indian Stock Market: Does it Explain Perfect Competetion? 323
301
xii
Contents
11. Monopoly and Monopsony
326
Introduction 326
Monopoly 327
Reasons and Types of Monopoly 328
Demand and Marginal Revenue Curves for a Monopoly Firm 333
Price and Output Decisions in Short Run 334
Price and Output Decisions in Long Run 336
Supply Curve of a Monopoly Firm 337
Price and Output Decisions of Multi Plant Monopoly 338
Price Discrimination 340
Price and Output Decisions of Discriminating Monopolist 345
347
Monopsony 349
Summary 351
Key Concepts 352
Questions 352
Check Your Answers 355
Caselet 1—The Pure Joy of Monopoly 355
Caselet 2—Is Government Monopoly also Harmful? 356
Case 1—Discriminating all the Way: Indian Railways 357
Case 2—WalMart: Monopsony Power 358
12. Monopolistic Competition
Introduction 360
Monopolistic Competition 361
364
Demand and Marginal Revenue Curves of a Firm 365
Price and Output Decisions in Short Run 365
Price and Output Decisions in Long Run 367
Monopolistic Competition and Advertising 369
Comparison between Monopolistic Competition, Monopoly and Perfect Competition 370
Summary 371
Key Concepts 372
Questions 372
Check Your Answers 375
Caselet 1—The Toy World 375
Caselet 2—Booming Business: Indian Hotel Industry 376
Case 1—The Jewel in the Crown 377
Case 2—David Fights Goliath: The Nirma Story 378
360
Contents
13. Oligopoly
xiii
381
Introduction 381
Oligopoly 382
Duopoly 387
Price and Output Decisions 387
Collusive Oligopoly 395
Price Leadership 400
Recent Global Trends 402
Summary 402
Key Concepts 403
Questions 403
Check Your Answers 406
Caselet—Battle in the Domestic Skies 407
Case 1—Jio: The New Samurai in Telecom Battle 408
Case 2—Duopoly in Air 409
14. Choice Under Uncertainty and Game Theory
411
Introduction 411
Risk and Uncertainty in Decision-Making 412
Game Theory 413
Nash Equilibrium 419
Prisoner’s Dilemma 421
Types of Games 422
Applications of Game Theory in Economics 424
Summary 431
Key Concepts 432
Questions 432
Check Your Answers 436
Caselet—Winning over the Winner 437
Case—The Herbal Strategy 437
PART 5
PRICING DECISIONS
15. Product Pricing
Introduction 441
Cost Based Pricing 443
Pricing Based on Firm’s Objectives 446
Competition Based Pricing 446
Product Life Cycle Based Pricing 448
Cyclical Pricing 452
441
xiv
Contents
Multi-Product Pricing 454
Peak Load Pricing 458
Surge Pricing 459
Sealed Bid Pricing Strategy 460
Retail Pricing 461
Administered Pricing 462
Export Pricing 462
International Price Discrimination and Dumping 463
Summary 464
Key Concepts 465
Questions 466
Check Your Answers 468
Caselet 1—Multiplex Pricing 469
Caselet 2—India the Dump-yard for China 469
Caselet 3—From Xiaomi to Mi 470
Case—Indian Railways: Surging Ahead or Backwards? 470
16. Input Pricing
472
Introduction 472
Wages 473
Interest 479
Rent 482
485
Summary 490
Key Concepts 491
References and Further Readings 492
Questions 492
Check Your Answers 494
Caselet 1—Government Revises Minimum Wage Rate 495
Caselet 2—The Interesting Interest Rates 495
Case 1—JSW: Expanding with Grits of Steel 496
Case 2—From Wages to Packages: the Journey of Software 497
17. Externalities, Public Goods and Role of Government
Introduction 499
Externalities 500
Types of Externalities 501
505
Role of Government in Controlling Externalities 505
Public Goods 506
Public Goods and Other Goods 507
499
Contents
xv
Characteristics of Public Goods 508
Public Goods and Market Forces 509
Role of Government 510
Summary 513
Key Concepts 514
Questions 514
Check Your Answers 516
Caselet 1—Death in Air 516
Caselet 2—Millennium Development Goals 517
Case—Bhopal Gas Tragedy: The Lingering Toxic Legacy 517
PART 6
MACROECONOMIC ASPECTS OF MANAGERIAL DECISIONS
18. Macroeconomic Phenomena
521
Introduction 521
Circular Flow of Economic Activities and Income 522
Macroeconomic Variables 526
Consumption Function 530
Investment Function 532
Fiscal Policy and Budget 534
IS-LM Analysis 538
Summary 542
Key Concepts 543
Questions 543
Check Your Answers 546
Caselet 1—How Basic is the Universal Basic Income? 547
Caselet 2—Massive Scheme for City Modernisation 548
Case 1—India on the Growth Trajectory 548
Case 2—Skill Development Programmes 549
19. National Income
550
Introduction 550
Concepts of National Income 551
Measurement of National Income 559
Uses of National Income Data 564
565
Balance of Payments 566
Current Account 567
Capital Account 568
568
xvi
Contents
569
Importance of Balance of Payments 570
Summary 570
Key Concepts 571
Key Equations 571
Questions 572
Check Your Answers 576
Caselet 1—Industry or Services? 576
Caselet 2—Raising the Exemption Limit 577
Case 1—India’s External Sector 577
Case 2—National Income of India 578
Introduction 582
Demand and Supply of Money 587
594
597
601
603
607
607
Summary 610
Key Concepts 611
Questions 611
Check Your Answers 614
Caselet 2—Wage-Price Spiral 615
Case 1—The Long and Short of Demonetisation 616
21. Business Cycles
Introduction 619
Features of Business Cycles 620
Phases of Business Cycles 621
Concepts of Multiplier and Accelerator
Causes of Business Cycles 628
Effects of Business Cycles 637
Controlling Business Cycles 638
Summary 642
Key Concepts 643
619
623
Contents
xvii
Questions 643
Check Your Answers 645
Caselet 1—Is IT Ringing Recession Bells? 646
Caselet 2—The Turning Point 646
Case 1—Volatility in World Economy 647
Case 2—IT Industry Growth Cycle: Manifesting or Synchronism 648
References
651
Index
656
be mastered; but to sense the aesthetic structure of economic analysis requires only a feeling for
logic and a capacity for wonderment that such mental constructs really do have a life-and-death
Paul A. Samuelson
When the authors requested me to contribute a foreword, I was hesitant since I felt that there were
many more knowledgeable persons than me to do the honours. Then I realised that this was a book for
managers who have either not had any formal education in economics, or have, with the passage of
time, forgotten, to a varying extent, what they had learnt in their studies. The book is on ‘Managerial
Economics’, a subject that is taught in most business schools to students aspiring for managerial’
positions. Having been a manager myself for over three decades, that too in the country’s central bank
(Reserve Bank of India) which is intimately concerned with a variety of economic issues, I decided to
attempt this foreword in deference to the authors’ wishes. Another important factor, that impelled me to
accede to the request, is the fact the Reserve Bank has always espoused the cause of economic education
which I am associated with, as the chairman of a Steering Group. I also happen to be an alumnus of the
University of Allahabad and ‘university brotherhood’, as aptly put by one of the authors, Geetika, who
hails from the same University, was a compelling enough reason for undertaking this privileged task.
Interestingly, managers in all organisations, while running their businesses, wittingly or unwittingly,
contend with economic issues and problems and take logical decisions that are shaped by one’s sense
of economics. Indeed, the working of organisations is inextricably linked with economics and it would
be useful for scholars and professors in economics, such as the authors, to disseminate knowledge of
the subject as simply and comprehensively as possible. A basic knowledge of economics is essential for
managers to be able to run their businesses intelligently. This helps in the analysis of several economic
problems that they daily encounter and leads to decisions that are in the organisation’s best interest.
Managerial Economics by Geetika, Piyali Ghosh and Purba Roy Choudhury, aims at making
economics simple to understand. It will not only help the students in having conceptual clarity with
respect to various topics, but will also aid the teachers in making their presentations and lectures more
xx
Foreword
absorbing. The book gives a good conceptual overview of the entire range of topics which would be of
interest to existing and prospective managers. The layout of the book is well-planned with each chapter
language used is simple, almost conversational in nature, and avoids jargon and ‘tyranny of words’. Key
Concepts, Summary, Questions and Case Study appearing at the end of every chapter makes it easier to
recall and refresh what one has read through. Case studies (Reality Bites) used to illustrate the theories
add value to each chapter and facilitate better understanding. Interestingly, another feature of the book
is that it carries with it a supplementary instructors’ manual for teachers which would help them in
preparing their lectures and even chapter-wise PowerPoint slides for presentation. Indeed this book has
not one, but several USPs.
I congratulate the authors for their splendid overview of economics and I am certain that this book
will prove to be useful for all those who want to improve their understanding of the subject and bring it
to bear while strategising their businesses and in dealing with issues and problems. It has been a pleasure
writing this foreword.
Vishwavir Saran Das
Former Executive Director
Reserve Bank of India
“If four things are followed - having a great aim, acquiring knowledge, hard work,
and perseverance - then anything can be achieved.”
Dr. A.P.J. Abdul Kalam
Knowledge is like an ocean, the deeper you dive into it, the better you are rewarded. Similarly, more
you learn, greater is your understanding. To excel in life one must refresh it by being updated. With this
doctrine of learning, we have revisited our book for its third edition. The world is dynamic and factors
affecting decision-making change with time. Hence, we have updated the book with fresh information
and new cases in light of recent developments. In this pursuit, we bring to you this edition, with a
promise to make the journey of knowledge more interesting and rewarding to teachers, students and all
knowledge seekers.
The year bygone had ended with a major decision of demonetisation and the country is still trying
to come to the terms with the long and short of it. Hence, this makes it a perfect time to introduce the
revised edition. Furthermore, the entire economy has braced up for the new GST regime which is
expected to have far-reaching impact on big and small businesses. On the international front, it is being
envisaged that new visa norms in the US are likely to pose a threat to Indian Information Technology
sector leading to major shifts in outsourcing strategy. The telecom sector is experiencing a new kind
of competition among service providers with the entry of Jio. Many of such changes at national and
international level have been incorporated in this edition at relevant places.
WHAT
IS
NEW
IN THE
THIRD EDITION?
In view of the market insights related to the previous editions, the subject matter of the current edition has
been amended/rearranged. Every chapter has been revisited and refreshed to include new facts, updated
Reality Bites
economic phenomena. To nurture creativity among students, Think Out of the Box questions have been
refreshed and added at appropriate places. Readers shall also notice more sequential arrangement of
chapters, for instance, the chapter on Consumer Preferences now precedes Demand and Supply, while
Financial Evaluation of Projects has now been placed just after Cost and Revenue. This new arrangement
of chapters ensures that the foundations are built for the course before delving into the advanced topics
xxii
Preface to the Third Edition
in Managerial Economics. This edition retains the conversational style of writing as we are convinced
that it enhances the learning process.
New Chapter: An altogether new chapter titled Externalities, Public Goods and Role of Government
has been added in Part 5. This chapter acts as a bridge between microeconomics and macroeconomics,
driven by the philosophy that whenever you link your knowledge of micro-theoretical concepts with the
scenario and policy framework. The chapter introduces the concept of externalities, categorising it into
positive and negative externalities, and consumption and production externalities. It also discusses the
impact of externalities on the market forces, besides explaining the nature of public goods, and analysing
the role of government in reducing externalities and providing public goods.
New Cases, Caselets and Reality Bites: The basic objective of the course on Managerial Economics
is to link economic principles to managerial decision-making process. We have used triple tools to
facilitate this process via Reality Bites (within a chapter), small Caselets, and Cases (at the end of each
chapter). These triple tools are drawn from the most recent real-life situations, and concurrent economic
scenario, to support the learning process. Every chapter ends with at least two new caselets and one new
full-length case. In all, 20 new full-length Cases, 22 Caselets and 28 Reality Bites have been added in
this edition.
The examples and cases are based on recent developments such as the nationwide ban faced by
Maggi, surge pricing by Uber, layoffs across the IT sector in the context of restrictions on the H1B visa,
ban on the sale of alcohol on highways by the Supreme Court, and smog in Delhi, to mention a few.
The impact of Jio on telecom sector has been encapsulated as a case in the chapter on Oligopoly. The
spectacular case of Patanjali Ayurved Limited, a new entrant to Indian FMCG market, has been covered
under Game Theory. Similarly, the chapter on Macroeconomic Phenomenon has reality bites on GST
and highlights of Budget 2017 along with an end-of-chapter case on Universal Basic Income, which
are the most recent economic measures in the country. Furthermore, the chapter on Business Cycles has
Reality Bites on Brexit and commodity market pricing cycles.
Additional Knowledge Material: The content has been thoroughly updated, enhanced and rearranged,
primarily on basis of our understanding and observation of changing needs of the curriculum along
with the comments and opinion of reviewers, students and other distinguished readers. The chapter on
Elasticity now includes an elaborate discussion on the elasticity of supply, including its degrees and
determinants. Revenue occupies a deserving portion of the chapter on cost, which has been renamed
as Cost and Revenue. The chapter on Monopoly has been renamed as Monopoly and Monopsony,
an appendix, now features as a part of the chapter on National Income. The chapter Macroeconomic
of money.
With all these changes, amendments and additions, we believe that the book has the freshness of a
new title and maturity of a seasoned learning resource.
Preface to the Third Edition
xxiii
ACKNOWLEDGEMENTS
Words fall short in expressing our gratitude to all the persons who have motivated us to write this book as
well as people who have inspired and driven us to revise the book on a regular basis. First of all, we bow
in reverence to the Supreme Power who causes all that happens in this universe, for giving us vivacity
and capability to take up this task.
We wish to render our heartfelt thanks to all the students, teachers and other readers, who have
lies in the fact that a number of reputed higher education institutions have adopted it as a textbook along
with a large number of knowledge enthusiasts who have accepted it for personal reading. We also want
to thank all the teachers of Managerial Economics who have found it worthy of their reference and it is
readers that binds us to constantly add value to their quest for knowledge in the domains of Managerial
Economics.
on a recurring basis. Sincere thanks to our esteemed reviewers who have painstakingly reviewed all
chapters and given their candid opinion. Part 5 of this edition, especially the chapters on Macroeconomic
Phenomena and National Income, has been substantially revamped on the basis of such feedback.
We profoundly appreciate the content development and production teams at McGraw Hill Education,
addition.
This edition is dedicated to everyone who wishes to learn Managerial Economics with practical
outlook in a learning-by-doing mode. We present the third edition with the belief that it would make the
journey of knowledge and decision-making more enriching and enjoyable. We seek continued support
and patronage of all our readers in this expedition to education and erudition.
Geetika
Piyali Ghosh
Purba Roy Choudhury
Teaching and learning should be like pleasure trips, like excursions, to explore new vistas, and to attain
greater heights of knowledge. The basic purpose of teaching should be to nurture inquisitiveness in such
a manner that clear value addition takes place. There are already marvels in the form of textbooks, and
plenty of them. Yet we have dared to enter into this arena, but with a mission. While teaching the course
of Managerial Economics to students of management and engineering, we strongly felt the need for a text
a mere bundle of theories, which, instead of solving many of their queries, increase the mysteries of
economic functions. At the same time, understanding of economic theories, principles, and concepts
is essential for laying a strong foundation for all areas of management. And why only management?
Economics provides a basis for understanding, comprehending and utilising the knowledge acquired
under any programme of study, be it engineering, computers, information technology, law or even
medicine! How to make a choice from among various alternatives? How are prices determined? Are
the principles of price determination of products different from those of services? Are the rules of game
taken? Why are countries divided into developed and less developed categories? Why do economies
questions through economics. So, needless to say that basic understanding of economic theory is useful
to everyone. As a buyer you need to know as much economics as a producer (or seller) needs to know.
which talk of economic theory and analysis. So why this new title? Is it just another in the lot? We do not
pertinent to talk about some of the salient features of this book, which would differentiate it from the lot.
What is new and different?
In a competitive world, differentiation is the best strategy, and we have adopted that. The whole
book is written in conversational mode, so that even the naïve can comprehend the concepts, without
being lost in the maze of theories and laws. We have presented a judicious blend of micro and macro
economics, without making the book very bulky and unmanageable. We have also combined theories
xxvi
Preface to the First Edition
understand various phenomena with the help of a set of equations. Some of the chapters in this book
discuss those issues which are very important to understand the business syndrome, but normally are
not found in textbooks on Managerial Economics. There are end chapter cases and a number of small
cases (which we have named Reality Bites) along with the text of each chapter to illustrate the theories,
with a large number of other examples mentioned within the text.
The chapters on Theory of Firm (Chapter 2), Input Pricing (Chapter 15) and Money
(Chapter 17) are included in the book to provide a comprehensive description of
managerial economics. Somehow these aspects have not received due attention at the hands of other
authors. You will appreciate that unless one knows the various forms of business organisations and the
objectives of companies, one would not be very comfortable in taking crucial decisions regarding a
company’s future. Similarly, pricing of products is very important, but pricing of factor inputs is no less
important, and is, in fact, a critical decision-making area. It will be of particularly great interest to those
who are seeking jobs, as it will help them know how their salary packages are decided upon. Pricing of
inputs will be equally useful to those who plan to start their own enterprise and wish to know how to
determine the amount of funds needed for payments to various resources.
Special Inputs
important aspects of economic life of people at large.
We have made an attempt here to discuss all these issues and more at length in exclusively designed
Another very useful dimension of the book is its emphasis on a wide spectrum of
Reality Bites along with the text
of each chapter. These small cases testify the complexity of economic theory as applicable to the real
Reality Bites on
Real-Life Cases
acknowledge our indebtedness to all whose knowledge pool helped us in developing these cases. You
will also see that most of these cases discuss very recent information, which is fresh in the minds of most
of us, but we have not been relating that to economic theory. These cases are aimed at diffusing the myth
that economics is theory and not practice, as you know managerial economics is bringing economic
theory to practice. They also infuse life into any prosaic discussion on mundane theories.
The chapter-end cases are also drawn from real-life situations—mostly from India, but also from
international arena, wherever relevant. Most of these cases are tested in the classroom.
Theory Blends with Mathematics Knowledge of optimisation techniques is essential for understanding
economic theories. Therefore this book is designed in such a way that theories are accompanied by
mathematical explanations involving calculus, while avoiding overdose of either. For beginners, all
the essential mathematical tools used in managerial decisions are explained in a lucid manner in the
chapter. The appendix is crafted in the same manner as the remaining book,
i.e., mathematical tools are explained with the help of graphs and examples, so that even those who are
not very comfortable with numbers can brush up their quantitative aptitude.
Preface to the First Edition
Learning Orientation
xxvii
Our attempt is to promote learning, and the best way to learn is through
of sharing and adding value to the knowledge pool. A very unique feature of the text is the induction of
Think Out of Box questions, essentially the outcome of our vast teaching experience. Over the course
manner. Taking clue from that, these questions are designed and framed to satisfy the quest of the
although they have not been explicitly discussed as such.
Sequential and Lateral Learning Each chapter is designed in a manner to help sequential and lateral
learning. Each chapter starts with Objectives and proceeds with sections and sub sections, elaborating
and discussing various aspects of the chapter content, to end into Key Concepts and Summary. At the
end of each chapter a combination of objective type and discussion questions are given. The objective
type questions are designed to help you brush up your learning from the chapter, whereas the discussion
questions test your understanding of theory, quantitative analysis and application of theory. The end
chapter-end case study further helps you learn the application of theory to real-life situations.
At the same time, the text is accompanied by specially designed Remember boxes and Think Out
of Box questions. Remember boxes keep you updated with knowledge acquired in earlier chapters and
sections. This is aimed at saving time required to refer back to earlier chapters and sections, just in the
same way as prompting helps actors performing on stage! Think Out of Box questions, on the other hand,
facilitate you to hone your creativity.
Who can benefit from the book?
experience on knowledge of economics. The course content is wide, comprehensive and compact. In
fact in consonance with our objective of bringing an entire ocean in a pitcher, we studied the syllabi of
all major universities, business schools, and technical institutions, as also that recommended by UGC,
and have assimilated that all in this book. In this way, the contents of the book are expected to satisfy
the needs of an ideal textbook for students of all management programmes, as well as engineering
programmes. Students of microeconomics can use this book as an elementary text.
Although the book is designed to promote self learning, yet no one can deny the role of a teacher in an
effective learning process. Therefore the book has many supplements to facilitate teachers of the course
Supplementary Material To aid the adopters of this book, a specially designed instructor’s manual
has been prepared, which consists of solutions to all the problems in the book and explanation of
replicating the same. There is also an accompanying website with user-friendly features.
xxviii Preface to the First Edition
ACKNOWLEDGMENTS
The most precious moments are those when we get an opportunity to remember and thank everyone
who has in some way or the other motivated and facilitated us to achieve our goals. The three of us were
initially placed at three different locations, but this endeavour brought us together, and our commitment
to the work quality helped us maintain coordination and harmony in making the book a cognate whole.
This book is a humble attempt to assimilate bits and pieces of a wide plethora of interaction with
innumerable minds that we have come across in our noble task of teaching. We are fully aware of the
fact that it will not be possible to thank each and everyone individually, and we know that our generous
benefactors would pardon us for this.
First of all we thank God Almighty for giving us the power to pen down this book in its present
shape. We thank the entire teaching community and students for being the motivating force behind
this endeavour and for their inputs and insights, enriching the quality of the book. The support that we
received from colleagues and students at our institutes and the staff of different libraries we had visited
We fall short of words to thank our families and our dear ones, who have stood besides us while we
were engrossed in writing this book, oblivious of their needs for our time and attention.
We are also indebted to the reviewers of our chapters, whose invaluable inputs have helped us to
book in record time.
We sincerely wish that through this book we are able to reach out to the millions of minds that are
inclined towards an understanding of the subject of Managerial Economics. Here’s hoping that it is a
book worth treasuring by students and teachers alike!
Geetika
Piyali Ghosh
Purba Roy Choudhury
Part
1
Introduction
Part One is designed to usher you into the realm of managerial economics by introducing the basic
concepts and principles of economics, the meaning, nature and scope of managerial economics.
The first chapter prepares the foundation for more advanced knowledge, whereas the second
chapter tells you about the various forms of business and objectives of firms. This would help you
understand the behaviour of firms discussed in later chapters.
Chapters
1. Basic Concepts and Principles
2. Theory of Firm
Chapter
1
Basic concepts
and principles
2. Know the basic difference between microeconomics and macroeconomics.
3. Analyse how decisions are made about what, how and for whom to produce.
4. Explain the concept of managerial economics and demonstrate its importance in
managerial decision-making.
5. Discuss the scope of managerial economics and its relationship with various other
disciplines and functional areas.
Chapter Objectives
1. Introduce key economic concepts like scarcity, rationality, equilibrium, time
perspective and opportunity cost.
IntroductIon
“The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to avoid being deceived by economists.”
Joan Robinson
This may be your first expedition into the realms of Managerial Economics and you may have very little
idea as to what the subject is about, or to what areas it can be applied. You may be surprised to learn that
even picking up this book to read involved a decision; you might have selected this book from among
several other titles on the same subject. Also when you chose to open this text, you made a decision
which implied foregoing a number of other options, such as going out with your friends, or listening
to music, or surfing the Internet. What point are we trying to make here? We are actually trying to give
you the first feel of Managerial Economics as a subject. This process of selecting any one option among
several alternatives available, which may seem to be a simple decision to you, plays a central role in
economic analysis. In a broader spectrum, this analysis can be applied to economic problems such as
pricing, investment and inflation. But this is not the end of it! When applied to managerial decisionmaking, economic analysis can be applied to problems encountered by businesses, like management of
resources, costs and profits. It would also affect you as a consumer! So be prepared to be surprised to
find out how useful the knowledge of Managerial Economics is and how pervasive its applications are!
4
Managerial Economics
Before we introduce you to Managerial Economics and its nuances, we would briefly explain about
the subject of Economics (of which Managerial Economics is a specialised branch) and the kinds of
economic decisions that are relevant to any economy.
defInItIon
and
Scope
of
economIcS
Economics is the art of making the most of life.
GB Shaw
The term economics comes from the Greek word oikos (house) and
nomos (custom or law). Economics is often defined as a body of
knowledge or study that discusses how a society tries to solve the
human problems of unlimited wants and scarce resources. It is the
scientific study of the choices made by individuals and societies with
regard to the alternative uses of scarce resources employed to satisfy wants. Adam Smith (1723–1790),
hailed as the Father of Economics, saw economics as “…..an enquiry into the nature and causes of the
wealth of nations.” Alfred Marshall (1842–1924) gave a comprehensive outline of the subject, defining
it as “…the study of mankind in the everyday business of life.” Lionel Robbins (1898–1984) defined
economics to be “the science which studies human behaviour as a relationship between ends and scarce
means which have alternative uses.”
There exists considerable debate as to whether economics is a
Economics is a social science, since it deals
science or an art. It has a theoretical aspect and is also an applied
with the society as a whole and human
science in its practical aspects. However, we cannot regard economics
behaviour in particular, and studies the
as an exact science. Economics is an “art” as well, as it is a systematic
production, distribution and consumption
of goods and services.
body of knowledge; unlike science, it lays down precepts or specific
solutions for specific problems.
It is, thus, a science in its methodology, and art in its application. So shall we finally consider it a
science or an art? We should better consider economics as a social science, since it deals with the society
as a whole and human behaviour in particular, and studies the production, distribution and consumption
of goods and services. This point can be better summed up with the words of Keynes, “……the theory of
Economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method
rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps the possessor to
draw correct conclusions.”
Economics is defined as a body of
knowledge or study that discusses how a
society tries to solve the human problems
of unlimited wants and scarce resources.
BaSIc aSSumptIonS
Economic theories are based on certain simplifying assumptions and economic laws are applicable
subject to certain conditions, that is, they hold good only under a given set of assumptions. These
assumptions are nothing but tools in the hands of economists to convert the complications to their
own advantage and simplicity. Let us explore some of the basic assumptions of economic theory in
this section.
Basic Concepts and Principles
5
Ceteris Paribus
Ceteris paribus is a Latin phrase, literally translated in English as “with other things (being) the same” or
“all other things being equal.” The term is most often used in isolating description of a particular event
from other potential environmental variables. This assumption is applied to all economic analysis to create an environment where causal relationship between two variables is
Ceteris paribus (Latin) literally translated in
to be studied. According to Marshall1 , “….the study of some group of
English means “with other things (being)
tendencies is isolated by the assumption other things being equal: the the same” or “all other things being equal”.
existence of other tendencies is not denied, but their disturbing effect
is neglected for a time. The more the issue is thus narrowed, the more exactly can it be handled: but also
the less closely does it correspond to real life. Each exact and firm handling of a narrow issue, however,
helps towards treating broader issues, in which that narrow issue is contained, more exactly than would
otherwise have been possible.”
Suppose we want to analyse the effect of the price of a commodity on its demand. Apart from price,
there can be a host of other factors like income of the consumers, prices of other (related) commodities,
tastes, etc. that may affect the demand for that commodity. If we assume that all the other factors are
constant at a particular point of time, it would be easier to isolate the effect of price on the quantity
demanded of the commodity. Thus, the task of analysis becomes much simpler. Summing up, we can
say that the term “ceteris paribus” is used in economic analysis when the economist wants to focus
on explaining the effect of changes in one (independent) variable on changes in another (dependent)
variable, without having to worry about the possible effects of other independent variables on the
dependent variable under examination.
Rationality
Economists make the assumption that people act rationally. This
Rationality implies that consumers and
means that consumers and producers measure and compare the costs producers measure and compare the costs
and benefits of a decision before going ahead. Examples are: whether and benefits of a decision before going
eating at home is cheaper than going to a restaurant; whether the ahead.
owner of a firm also acts as the manager of the firm; whether to train
the existing workers or recruit new workers for the newly opened unit of the firm and so on. However,
it may be more enjoyable to eat at the restaurant; the owner can employ a manager; training existing
workers may be costlier than hiring trained workers and so on. Thus, rationality involves making a
choice that gives the greatest benefit relative to cost. All the conventional economic theory rests on the
assumption that both consumers and producers behave rationally; while firms aim at maximising profits
and minimising costs, consumers aim at maximising utility and minimising sacrifice. Rationality in
decision-making is a precondition for attaining optimality under the given constraints. It involves clarity
of objective and feasibility of achieving that objective under given conditions.
1
Marshall, A. (1920), Principles of Economics, Book V, Chapter V in paragraph V.V.10, 8th edition, Macmillan and Co.
Ltd., London.
6
Managerial Economics
typeS
of
economIc analySIS
Different approaches to the same problem may lead to different conclusions. Economic analysis can be
divided into the following categories: 1. Micro and macro, 2. Positive and normative, 3. Short and long
run, and 4. Partial and general equilibrium.
1. Micro and Macro
Initially, there was only one “economics”. The Great Depression of
the 1930s saw the emergence of the area of macroeconomics and
thereafter, the field of economics has been broadly ‘split’ into two
distinct areas of study: microeconomics and macroeconomics.
Microeconomics (“micro” meaning small) looks at the smaller picture
of the economy and is the study of the behaviour of small economic units, such as that of an individual
consumer, a seller (or a producer, or a firm), or a product. It focuses on the basic theories of supply and
demand in individual markets (say of cars, food items, mobile phones, etc.), and deals with how
individual businesses decide how much of something to produce and at what price to sell it, and how
individual consumers decide on how much of something to buy. In other words, microeconomics
analyses the market behaviour of individual consumers and firms, in an attempt to understand their
decision-making processes.
Macroeconomics (“macro” meaning large) is that branch of
Macroeconomics (“macro” meaning large) is
economic analysis that deals with the study of aggregates. As opposed
that branch of economic analysis that deals
to microeconomics, in macro analysis we study the industry as a unit,
with the study of aggregates.
and not the firm. In macroeconomics, we talk about aggregate demand
and aggregate supply, national income, national capital formation, employment, inflation etc.
Microeconomics deals at the firm’s level and takes into consideration the decision-making power of
individual units, whereas macroeconomics deals with the economy level and takes into consideration the
impact of government policies on the aggregates like national income and employment.
However, micro and macro economics are not to be taken as substitutes of each other; rather they
complement each other. To quote Paul Samuelson “…if you read one branch of economics carefully,
but ignore the other, you will be half-educated”. We would be discussing more on this issue in our
subsequent chapters of national income and beyond.
Microeconomics (“micro” meaning small)
looks at the smaller picture of the economy
and is the study of the behaviour of small
economic units.
2. Positive and normative
Positive statements are factual by nature;
normative statements involve some degree
of value judgment, and cannot be verified
by empirical study or logic.
Before we explain positive and normative analyses in economics, we
need to explain the meanings of positive and normative statements.
Essentially positive statements are factual by nature, whose truth
or falsehood can be verified by empirical study or logic. Normative
statements, on the other hand, involve some degree of value judgment,
Basic Concepts and Principles
7
and cannot be verified by empirical study or logic. As an illustration, compare the following two
seemingly similar statements:
1. The distribution of income in India is unequal.
2. The distribution of income in India should be equal.
The first statement is a positive one, while the second is a normative one. Normative statements often
imply a recommendation, as in the above example, that income should be redistributed. For this reason,
such statements often involve the words “ought” or “should”. Let us now move on to explain positive
and normative economics.
Positive economics establishes a relationship between cause and Positive economics establishes a
effect; it analyses problems on the basis of facts. Stated in very simple relationship between cause and effect. It is
terms, positive economics studies the world as it is and is as such “what is” in economic matters.
devoid of (economic) value judgments. For example, a positive
economic theory might describe the probable effect of an increase in price of petroleum on the price of
cars, but it would not provide any instruction on what policy should be followed.
Human beings are inherently sensitive and emotional, and thus, Normative economics is concerned with
normative aspects of human problems cannot be ignored altogether questions involving value judgments. It is
in any economic analysis. Normative economics is concerned with “what ought to be” in economic matters.
questions involving value judgments; it is that branch of economics
that incorporates value judgments about what the economy should be like. It looks at the desirability
of certain aspects of the economy, say inflation as better than deflation, redistribution of wealth
in the economy, etc. It is “what ought to be” in economic matters, as opposed to “what is” in
positive economics.
3. Short Run and long Run
The introduction of different periods of time in market analysis was an important contribution of
Marshall to economic theory. He was the first economist who had defined periods in market as: market
period (in which the goods produced for sale on the market are taken as given data and prices quickly
adjust to clear markets, e.g., market for perishable goods); short period (in which industrial capacity is
assumed to be given); long period (in which the stock of capital goods, such as equipments and
machines, is not taken as given); very long period (in which technology, population, habits and other
factors are not taken as given, but are allowed to vary).
Following Marshall’s depiction, we can define short run to be a time
Short run is a time period not enough
period not enough for consumers and producers to adjust completely for consumers and producers to adjust
to any new situation. In production decisions, short run is a period completely to any new situation.
when it may not be possible to change all the inputs. In other words,
when one refers to the short run, the analysis is focused on a planning period in which some input is fixed
and others are variable. Thus, the manager has to select different levels of the variable input to combine
with the fixed input, in order to optimise the level of production. Usually, it is capital that is fixed and
labour that is variable in the short run.
The long run is a time period long enough for consumers and producers to adjust to any new situation.
It is a “planning horizon” in which all inputs can be varied. Thus, in the long run, the managerial
8
Managerial Economics
economist deals with decisions of whether to adjust capacity; whether
to introduce a larger plant or continue with the existing one; whether
to change product lines, and so on.
In terms of accounting or finance, a short run would be any time
period less than a year, and long run may be five to six years, or even as high as 20 years. Though
one cannot exactly define the length of short run and long run but at any given time, the managerial
economist must be concerned with both short run and long run analyses since long run consists of many
short runs. Ignoring either of the problems of optimising in the short run or in the long run may lead
to dire consequences. We would be discussing more on these concepts in the chapters on production
and cost.
A long run is a “planning horizon” in which
consumers and producers can adjust to any new
situation.
4. Partial and General Equilibrium
Before we explain the aspects of partial and general equilibrium, let us
throw some light on what is equilibrium. Equilibrium generally refers
to a state of balance that can occur in a model. Whenever there is any
disturbance, all systems tend to move towards equilibrium. The concept of an economic equilibrium is,
however, fundamentally very complex. The standard example of an economic equilibrium is the balance
between price and quantity of a commodity in a supply and demand model, in which the supply curve
shows the various quantities supplied at a given price by profit maximising firms and demand curve
shows the various quantities demanded at a given price by utility maximising consumers. The intersection
of the supply and demand curves is the point that maximises both profit and utility.
Let us now turn your attention towards the concept of partial
Partial equilibrium analysis studies the
equilibrium.
Developed by Augustin Cournot (1801–1877) and
internal outcome of any policy action in a
Marshall, partial equilibrium analysis studies the internal outcome of
single market only.
any policy action in a single market only; this means that the effects
are examined only in the market(s) which is directly affected, and not on other markets. Thus, we refer
to partial equilibrium analysis when a single firm or a single consumer is in equilibrium, whereas other
firms or consumers in the industry may not be in equilibrium. Thus, if one particular firm in the Indian
cement industry is in equilibrium, as per partial equilibrium analysis, other firms in the industry may not
be in equilibrium.
General equilibrium theory, on the other hand, is that branch of
General equilibrium analysis explains
economics
that seeks to explain economic phenomena like production,
economic phenomena in an economy as
consumption
and prices in an economy as a whole. Why do we need
a whole.
general equilibrium analysis after all? Wouldn’t partial equilibrium
have been sufficient? No. As we have explained, partial equilibrium analysis studies the internal
outcome of any policy action in a single market only, following this, any decision regarding the price
of one commodity would be taken in isolation from the prices of other commodities. This, however, is
unrealistic! Under the general equilibrium framework, if the price of fuel goes up, the fares of public
commuting vehicles would go up; this may put a pressure on firms to hike the conveyance allowance
given to the workers. In sharp contrast to this, under partial equilibrium analysis, a petroleum company
would hike the price of petrol without considering its possible effects on the prices of other commodities.
General equilibrium analysis would propose that the equilibrium price of fuel cannot be determined in
Equilibrium is a state of balance that can
occur in a model.
Basic Concepts and Principles
9
isolation and would need to incorporate a host of several other variables. This is the crux of general
equilibrium analysis, as it tries to give an understanding of the whole economy, by looking at the macro
perspective. Hence, general equilibrium is the state in which all the industries in an economy are in
equilibrium; as a corollary it is implied that all the firms in an industry are in equilibrium.
KIndS
of
economIc decISIonS
The fundamental problems faced by an economy have been summed up in this section.
What to Produce?
The first major economic decision of any economy relates to the type and the range of goods to be
produced. Since resources are limited, one must choose between different alternative combinations of
goods and services that may be produced. Allocation of resources between the different types of goods,
example, consumer goods and capital goods, is another major concern to any economy. At firm level,
this decision would involve review of market demand and availability of raw materials and technology.
This can also be referred to as the problem of choice.
How to Produce?
Having decided on what to produce, the economy must determine
the techniques of production to be used. This can also be viewed as
the problem of efficiency; efficiency is maximised when the limited
stock of resources yields the maximum possible volume of goods and
services, or renders the maximum benefit to the society. We would
discuss the concept of efficiency subsequently in detail.
Fundamental economic problems:
What to produce?
How to produce?
For whom to produce?
Are resources used economically?
Are resources fully employed?
Is the economy growing?
For Whom to Produce?
This means how the national product should be distributed. This is essentially the problem of distribution.
Once the goods are produced, they need to be distributed among the various economic agents. In a
market economy, such a distribution is done on the basis of “ability to pay” principle; this implies that
those who have more in terms of wealth and income would have more of the commodities than those
who have less. However, in a command economy such a distribution is done on the basis of “according
to need” principle; this implies that people would be rewarded according to their needs and not their
ability to pay.
Are Resources Used Economically?
In a world of scarcity, resources need to be efficiently employed. This is the problem of economic
efficiency or welfare maximisation, dealt with by the branch of economics known as welfare economics,
the purpose of which is to explain how a socially efficient allocation of resources can be identified and
achieved. At this level, let us be contended with the idea that resources would be fully and efficiently
employed if it is NOT possible to increase the output of one commodity without reducing the output of
another commodity. We would also let you get a touch of this problem while discussing price and output
determination under different market forms.
10
Managerial Economics
eality
ites
What to Produce? The Coca Cola Way
Marc Mathieu, Senior VP Global Brand Marketing & Creative Excellence, The Coca Cola Company, in
conversation with S. Mukherjee and S. Dobhai says that as a beverage company Coca Cola aims to
offer all possible alternatives by spending lot of time in understanding consumer’s lifestyle and needs.
It recognises that there are moments when people want to be more focused on nutritional values and
there are moments when one requires mental recharge; sometime one wants vitality and energy boost.
Therefore, the company aims to cover and cater to these different needs through its beverage portfolio.
The portfolio claims to offer an appropriate level of sweetness and functional benefits along with right
packaging and communication.
Source: Economic Times, 9/01/2008.
Are Resources Fully Employed?
An economy must endeavour to achieve the fullest possible use of its available resources, as unemployment
of resources is equivalent to economic waste. The economy should be so organised as to keep all factors
of production (including labour) fully employed. Keynes defined full employment as a situation in
which involuntary unemployment is reduced to the minimum possible level. Modern economists like
Marshall are of opinion that full employment should be a goal of economic policy.
Is the Economy Growing?
Another problem of any economy is to make sure that it keeps expanding or developing with time, and
that its productive capacity continues to increase, so that it maintains conditions of stability. An economy
seeks to achieve economic growth mainly to improve the standards of living of its people, it is through
economic growth that an economy can get more of everything, without having less of anything. There
are three major sources of growth: growth of labour force, capital formation and technological progress.
We would explain this concept further when we discuss Production Possibility Curves in this chapter.
managerIal economIcS
Economic principles, theories and concepts have been used extensively for finding solutions to
managerial situations, hence, several economists have identified a new branch of economics, regarded as
Managerial Economics. This point onwards, we would introduce you to the subject matter of Managerial
Economics and its various aspects.
Firms are essentially concerned with the conversion of available inputs into desirable output(s), with
the help of suitable technology. The difference between revenue earned from selling the output produced
and costs incurred out of inputs procured constitutes the profit of any firm. In order to earn (or maximise)
profits and also to attain other objectives, managers of any firm need to make several choices, including
choice of production techniques, quantity of output, number of workers and price at which the output
is to be sold.
In all these cases, they need to weigh the alternatives available, in order to make the best choice.
Such economic decision-making by managers and firms is actually the scope of managerial economics.
Basic Concepts and Principles
Identification of the different economic incentives (like profits and
utility) that attract and influence basic economic agents (like firms and
consumers) are the key topics for study and analysis in managerial (or
business) economics.
The following definitions of the subject by eminent economists
would throw further light on its nature and scope.
11
Managerial economics is a means to an end
to managers in any business, in terms of
finding the most efficient way of allocating
scarce organisational resources and
reaching stated objectives.
“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.”
Salvatore
“Managerial economics is the study of allocation of the limited resources available to a firm or other unit
of management among the various possible activities of that unit.”
Henry and Haynes
“Managerial economics applies economic theory and methods to business and administrative decisionmaking.”
Pappas and Hirschey
“Managerial economics is the application of economic principles and methodologies to the decisionmaking process within the firm or organisation.”
Douglas
“We define managerial economics as the integration of economic theory and methodology with analytical tools for applications to decision-making about the allocation of scarce resource in public and private
institution.”
Seo and Winger
As such, managerial economics can be seen as a means to an end for managers in any business,
in terms of finding the most efficient way of allocating scarce organisational resources and reaching
stated objectives.
Managerial Economics: Micro as well as Macro Economics
You must be wondering as to whether it is microeconomics or
Managerial economics is applied
macroeconomics that “influences” this subject! Managerial economics microeconomics to a significant extent;
is applied microeconomics to a significant extent; though it draws though it is drawn extensively from
extensively from macroeconomic theory as well. For example, it draws macroeconomic theory as well.
demand analysis, cost and production analysis, pricing and output
decisions from microeconomics, whereas it also derives market intelligence from the knowledge of national
income, inflation and stages of recession and expansion, which are subject matter of macroeconomics.
Hence, it focuses on areas of both microeconomics and macroeconomics that are of the greatest
importance and concern to the managers in any business organisation.
normative Bias of Managerial Economics
As we have seen in our earlier discussion, positive economics exposes
Managerial economics has a normative bias
us to what is, while normative economics gives value judgements on stating what firms should do, in order to
outcomes or phenomena, i.e., what should be, or what ought to be. reach certain objectives.
Managerial Economics is often prescriptive, stating what firms should
do, in order to reach certain objectives. In other words, managerial economics is said to have a normative
bias. Let us see how.
Economic issues confronting managers would often involve value judgments. In managerial situations
one has to take decisions which will affect an organisation’s future, therefore, a manager cannot be simply
content with being factual. Let us give an example to explain this. The manager of a soft drinks company
12 Engineering Chemistry
may be confronted with a choice of whether or not to advertise for the product. Would the manager go
for advertising simply by following the rival companies? Or would the manager judge whether such
advertising would have any impact on the consumers? Managerial economics decides on whether or not
the probable outcome of a managerial decision is desirable, and whether or not the managers should
pursue courses of action that would lead to such outcomes. Hence, it is basically normative in nature.
Decisions Resulting in Partial Equilibrium
You would appreciate that managerial economics primarily helps a
firm in decision-making, therefore, decisions taken by any firm would
relate to the equilibrium of that particular firm. Hence, the science
of managerial economics basically deals with partial equilibrium
analysis. Under this branch of economics, you would not learn about
the equilibrium of the economy, but about a firm or an industry.
Managerial economics deals with partial
equilibrium analysis, with focus on
equilibrium of a firm or an industry, not the
economy.
economIc prIncIpleS releVant
to
managerIal decISIonS
It is by now clear that managerial economics deals with firms, more specifically with the environment
in which firms operate, the decisions they take and the effects of such decisions on themselves and their
stakeholders (like customers, competitors, employees and the society in which they operate). The key
economic concepts and principles that constitute the broad framework of managerial economics are
explained in the following sections: scarcity, opportunity cost, margin or increment and discounting
principle.
Concept of Scarcity
Human wants are unlimited, but human
capacity to satisfy such wants is limited.
The starting point of any
Demand for
economic analysis is the existence
Resources
Resources
of human wants; human wants
are unlimited, but human capacity to satisfy such wants is limited.
Fig. 1.1 Problem of Scarcity
As shown in Figure 1.1, almost all desirable things are short in
supply, compared to our needs. Similar situation prevails in any business firm: resources available to the
firm are limited, and the managers of the firm need to optimally utilise them.
In view of the scarcity of resources and multiplicity of needs, the
Any economic problem consists of making
economic problem lies in making the best possible use of resources so
decisions regarding the ends to be pursued
as to get maximum satisfaction (from the viewpoint of consumers) or
and the goods to be used for achievement
maximum output (from the viewpoint of producers or firms). Hence,
of such ends.
any economic problem consists of making decisions regarding the
ends to be pursued and the goods to be used for achievement of such ends.
Basic Concepts and Principles 13
Concept of Opportunity Cost
The managerial economist has to make rational choices in all aspects
The managerial economist has to make
of business, since resources are scarce and wants are unlimited. This
rational choices in all aspects of business
problem of choice makes it necessary to sacrifice some of the by sacrificing some of the alternatives,
alternatives against the one selected. Individuals and firms make such since resources are scarce and wants are
decisions based on expecting greater benefits from one alternative unlimited.
over another. In other words, there is an opportunity cost involved in
a choice.
Opportunity cost is the benefit forgone from the next best alternative
Opportunity cost is the benefit forgone
that is not selected. Individuals or firms give up an opportunity(s)
from the next best alternative that is not
to use or enjoy something in order to select something else. Let us selected.
give examples to explain this “choice”. You may be working in your
hometown and suppose you have got another job offer in a city away from your hometown. Now if
you select the new offer, you would be foregoing the benefits of staying at home. This would be your
opportunity cost of the new job. A firm may have to make a choice between buying new computers
for its employees and installing a new server. If it opts to purchase the server, the alternative of buying
computers is foregone and would be the opportunity cost of buying the server.
A firm may even have to make a choice between quantity and quality. It may commit itself to quality
(and hence, remain restricted to a small customer base) by selling its product at high price (such a pricing
is often regarded as market skimming pricing), or it may compromise on quality and lower the price
in order to capture a larger market (such a pricing is often regarded as market penetration pricing). Let
us see the opportunities foregone in each case. If the firm decides to go for the first option, it would be
targeting the “classes”. This way the firm has to sacrifice the opportunity of getting control over a large
segment of market; this becomes its opportunity cost of selling its product at a high price. On the other
hand, if it opts for keeping the price low at the cost of quality, the firm would be targeting the “masses”,
thus, sacrificing its image of delivering high quality product. This loss in image would be the opportunity
cost of selling its product at a low price, against gaining of a larger customer base. Such situations may
often put firms in an ethical dilemma.
The concept of opportunity cost has been explained further in the Cost and Revenue chapter. Another
very important concept, namely that of production possibility curves, that bears close linkage with
opportunity cost, is briefly introduced here and shall be discussed in detail in the chapter named
Production Analysis.
eality
ites
Masses over Classes
Reliance followed aggressive penetration strategy and came out with a low-cost model for its basic
hand-set and services for rapid diffusion of its cellular services. Easy installment and low cost hand-set
and penetration pricing strategy of Reliance and Tata Indicom have given needed boost to the cellphone industry.
Source: Pandya, B. and Jayswal, M. (2007). Materialism among Adolescent: Understanding Conceptual Framework
and Imperatives for Marketers and Society for New Horizons, International Marketing Conference on Marketing &
Society, 8–10/04/2007, IIMK, http://dspace.iimk.ac.in/bitstream/2259/318/1/673-701.pdf.
14
Managerial Economics
Production Possibility Curve
The Production Possibility Curve (PPC) or Production Possibility
Frontier (PPF) or Transformation Curve is a graph that shows the
different combinations of the quantities of two goods that can be
produced (or consumed) in an economy at any point of time, subject to
limited availability of resources. It also depicts the trade off between
any two items produced (or consumed). In other words, PPC shows
that if we want to have more of one good, we must have less of the other good, due to limited availability
of resources. This curve not only represents the opportunity cost concept, but it also actually measures
opportunity cost by indicating the opportunity cost of increasing one item’s production (or consumption)
in terms of the units of the other forgone, which is nothing but the slope of the curve in absolute terms.
Another use of PPC is that it highlights the significance of scarcity of resources and the need to use them
judiciously.
Production Possibilities Curve is a graph
that shows the different combinations of
the quantities of two goods that can be
produced (or consumed) in an economy,
subject to limited availability of resources.
Concept of Margin and Increment
Marginal analysis is one of the cornerstones of economic theory. The
concept of marginality deals with a unit increase in cost or revenue
or utility. According to this concept, Marginal Cost (or Revenue or
Utility) is the change in Total Cost (or Total Revenue or Total Utility) due to a unit change in output. In
other words, Marginal Cost (or Marginal Revenue or Marginal Utility) is the Total Cost (or Total Revenue
or Total Utility) of the last (or nth.) unit (of output). Thus, we may express Marginal Cost (MC) as:
The concept of marginality deals with a
unit increase in cost or revenue or utility.
MCn = TCn – TCn–1
…(1)
where n is the number of units of output.
Applying calculus, we can alternatively define Marginal Cost as:
Marginal Cost =
Change in Total Cost
dTC
=
dQ
Change in Total Output
…(2)
The concept of marginal cost and revenue has been discussed in details in the chapter on cost.
However, there is an inherent problem with the marginal concept and that is, in reality variables may
not be subject to such unit change as explained above. In such cases, it is always more convenient to use
the incremental concept, rather than the marginal concept. In other words, the incremental concept is
applied usually when the changes are not necessarily in terms of a single unit, but in bulk. In such a case,
the additional revenue earned is termed as “incremental revenue”. If a decision to increase revenue also
entails an increase in costs, then the incremental concept would tell whether the decision is right (if the
increment in cost is less than incremental revenue) or wrong. For example, an increase in the sales of a
firm due to introduction of online selling and additional costs of launching the online selling mechanism
would be termed as “incremental revenue” and “incremental costs” respectively. If the former exceeds
the latter, we can infer that the decision of introducing the online mechanism is right. You would know
more about marginal principle in the chapter on cost.
Basic Concepts and Principles
15
Discounting Principle
The core of discounting principle is that a rupee in hand today is worth Discounting principle refers to time value
more than a rupee received tomorrow. In other words, it refers to time of money.
value of money, i.e., the fact that the value of money depreciates with
time. One rationale of discounting is uncertainty about tomorrow, i.e., future. Even if there is no
uncertainty, it is necessary to discount future rupee to make it equivalent to current day rupee.
Why do businesses need to bother about discounting? This is
because most decisions in business situations relate to outflow and Businesses need to bother about
discounting because most business
inflow of money and resources that take place at different points of decisions relate to outflow and inflow of
time. Most outflows normally occur in the current period, whereas money and resources that take place at
inflows occur only in future, therefore, in order to take the right different points of time.
decision, it is necessary to “discount” future inflows to their present
value level. The simple formula for discounting is:
1
PVF =
…(3)
(1 + r )n
where PVF = Present Value Factor, n = period (year, etc.) and r = rate of discount.
Let us summarise the underlying logic as follows:
l
l
l
l
Money earned in a future period has different values in the current period.
`1 now is worth ` (1 + r) in one year’s time, if rate of interest is r.
`1 in one year’s time is worth `1/(1 + r), or `0.91 now, if rate of interest r is 10%.
`1 in two year’s time is worth `1/(1 + r)2, or `0.826 now, if rate of interest r is 10% and so on.
managerIal economIcS
and
functIonS
of
management
All firms consist of organisations that are divided structurally into different functional departments or
units like: Production and Operations, Human Resource (HR), Marketing, Finance and Accounting,
Systems (or IT) and Legal Applications.
All of these functional areas have to find the most efficient way
The principles of managerial economics
of allocating scarce organisational resources and reaching their help in understanding various managerial
objectives in the context of the particular situation and tasks that they functions in a more coordinated manner.
have to perform. Thus, the Production department may want to plan
and schedule the level of output for the next quarter; the Human Resource department may want to plan
how many people to hire in the next quarter and what should be offered as compensation; the Marketing
department may want to know what price to charge for the newly launched product, and how much to
spend on advertising; the Finance department may want to determine whether to build a new factory;
the IT department may want to upgrade the server used in the organisation. The Legal unit must look
into the conformity of all decisions of the firm with the requirements of and restrictions laid by the legal
environment in which the business operates.
Moreover, all these functional areas of an organisation are often found to be at conflict with each
other. For example, the Production unit may opt for a costly machinery to attain economies of scale;
which may require retrenchment of 10% of existing workers, additional training to some 15% employees
along with some new recruitments. The Human Resource department may not find this acceptable
16
Managerial Economics
because they may have some other plans. The Marketing unit may plan for a lavish advertising campaign
to achieve a sales target, whereas the IT unit may introduce a new proposition for internet-based selling
of the product. On the other hand, the Finance department may be planning for cost cutting on all fronts.
The managerial economist needs to understand the inter relationships among these units and the trade
off twined with each decision, so that the overall objectives of the organisation are attained.
It might, thus, be noted that all the above decisions involve some kind of analysis; the concepts and
principles of managerial economics would facilitate the process of evaluating such relationships and
would, thus, help in making rational decisions across all major managerial functions. The concepts of
opportunity cost and time value of money may be used to evaluate the new machine decision, or the
principle of marginalism may be used to evaluate the advertising campaign, or the basic objective of
the firm may be considered before taking any new decision. Accounting outcomes of any business,
namely profit and loss statement of business can help the managerial economist in decision-making for
the future. Thus, you find that knowledge of managerial economics is a fundamental tool for effective
decision-making in business situations.
relatIon
of
managerIal economIcS
wIth
decISIon ScIenceS
Decision sciences provide the tools and techniques of analysis used in managerial economics. The
theory of managerial economics largely utilises the tools of mathematics and econometrics. The most
important aspects of decision sciences that are used in managerial economics include numerical and
algebraic analysis, optimisation, statistical estimation and forecasting and game theory.
Let us elucidate this point with a simple example. If Qd is the quantity demanded of a commodity
by a firm that depends on factors like P (price of the commodity), Py (price of a related commodity), Y
(income of consumer), t (tastes of consumers), then the demand function can be written as:
Qd = f (P, Py, Y, t)
…(4)
This is an economic relationship, on collecting data of all these variables, we can estimate the
empirical relationship between them, by applying econometric tools. Thereafter, the firm would be in a
position to estimate changes in Qd due to change in any (or all) of these variables at a particular point
of time.
Statistics as a branch of study helps in empirical testing of any theory. Statistical methods like
regression are also used to estimate relationships between economic variables and also to forecast their
values. These techniques find wide applications in estimation of demand and cost functions. A managerial
economist can project future sales of any product with the help of several research techniques. Other
applications of forecasting techniques include forecasting changes in consumption pattern, change in
disposable income, etc. You would know more on forecasting in a subsequent chapter.
These tools and techniques are introduced in the appropriate context later in the book, so that they can
be immediately applied in order to understand their relevance, rather than being discussed in isolation
in the very first chapter.
Figure 1.2 summarises relationships of managerial economics with all the different disciplines and
functional areas of an organisation. As is evident from the figure, the concepts and theories grouped in
the two branches of economics, micro and macro along with the tools of quantitative analysis assist in
carrying out various managerial functions.
Basic Concepts and Principles
17
-
Fig. 1.2 Relationship of Managerial Economics with other Disciplines
Summary
◆
◆
◆
◆
◆
Economics is a body of knowledge or study that discusses how a society tries to solve the
human problems of unlimited wants and scarce resources. It also studies the choices made by
individuals and societies in regard to the alternative uses of scarce resources which are employed to
satisfy wants.
Microeconomics is the study of the behaviour of small economic units, such as that of an
individual consumer, a seller, a producer, a firm, or a product. Macroeconomics is that branch of
economic analysis that deals with the study of aggregates.
Positive economics studies the world as it is and as such avoids value judgments; normative economics is concerned with questions involving value judgements about what the economy should
be like.
Partial equilibrium analysis studies the internal outcome of any policy action in a single market
only, while general equilibrium analysis seeks to explain economic phenomena for an economy
as a whole.
Ceteris paribus is a Latin phrase, literally translated as “with other things (being) the same”. The
assumption of rationality means that consumers and firms measure and compare the costs and
benefits of a decision before going ahead for that decision.
18
◆
◆
◆
◆
◆
Managerial Economics
Managerial economics is a means to an end for managers in any business, in terms of finding the
most efficient way of allocating scarce organisational resources and reaching stated objectives. It
is micro as well as macro in nature, it has a normative bias, and deals with partial equilibrium.
Production Possibility Curve (PPC) is a graph that shows the different combinations of the
quantities of two goods that can be produced (or consumed) in an economy, subject to the limited
availability of resources.
The core of discounting principle is that a rupee in hand today is worth more than a rupee received
tomorrow. It refers to time value of money, i.e., the fact that the value of money depreciates with
time.
The managerial economist needs to understand the interrelationships among the various functional
units of any firm (namely production, marketing, HR, finance, IT and legal) and the trade off
twined with decisions taken by each of such units, so that the overall objectives of the organisation
are attained.
Decision sciences provide the tools and techniques of analysis used in managerial economics,
which largely utilises the tools of mathematics and econometrics, in particular numerical and
algebraic analysis, optimisation, statistical estimation and forecasting.
Key ConCeptS
Microeconomics
Macroeconomics
Opportunity cost
Discounting
Ceteris paribus
Managerial economics
Margin and increment
Production possibility curve
Positive and normative analysis
Rationality
QueStionS
Objective type
I. State True or False
i. “The government should ensure that consumer spending is not deflated” is an illustration of
normative economics.
ii. “Manufacturing output has increased 5 percent in 2007” is an illustration of positive economics.
iii. Macroeconomics studies the choices made by individuals and societies in regard to the alternative
uses of scarce resources which are employed to satisfy wants.
iv. Outflow and inflow of money and resources in business take place at different points of time.
v. Marginal concept is applied usually when the changes are not necessarily in terms of a single unit,
but in bulk.
Basic Concepts and Principles
vi.
vii.
viii.
ix.
x.
19
Economics is a science in its application and art in its methodology.
Positive economics analyses problems on the basis of facts.
A producer can change his product line in the short run.
Opportunity cost is the same as economic cost.
National product is distributed in a capitalist economy according to need principle.
II. Fill in the Blanks
i. If consumers measure and compare costs and benefits before taking a decision, they are
individuals.
ii. Full employment is a situation in which
unemployment is reduced to the minimum
possible level.
iii.
is maximised when the limited stock of resources yields the maximum possible volume
of goods and services.
iv.
involves making a choice that gives the greatest benefit relative to cost.
v. In
the goods produced for sale in the market are taken as given and prices quickly
adjust to clear markets.
vi. PVF refers to Present Value
.
vii. Positive statements are
in nature.
viii. Capital as an input is fixed in the
.
ix. Economic resources are scarce and needs are
.
x. MCn = TCn –
.
III. Pick the Correct Option
i. The subject of economics is:
a. A physical science
b. A natural science
c. An exact science
d. A social science
ii. The most important aspects of decision sciences that are used in managerial economics include
all of these except:
a. Numerical and algebraic analysis
b. Optimisation
c. Game theory
d. Opportunity cost
iii. All of the following are in the purview of microeconomics except:
a. What to produce?
b. How to produce?
c. For whom to produce?
d. Is the economy growing?
iv. The state in which all the industries in an economy are in equilibrium is of:
a. General equilibrium
b. Partial equilibrium
c. Production possibility curve
d. Opportunity cost
v. A long run is a time period:
a. Long enough for consumers and producers to adjust to any new situation.
b. In which industrial capacity is assumed to be given.
20
vi.
vii.
viii.
ix.
x.
Managerial Economics
c. All factors are fixed.
d. Technology is given.
All of the following are sources of growth except:
a. Growth of labour
b. Growth of capital
c. Growth of currency
d. Growth of technology
Welfare economics deals with:
a. Whether resources are optimally generated.
b. How to identify a socially efficient allocation of resources.
c. For whom to produce resources.
d. Whether distribution is done on the basis of “ability to pay” principle.
The problem with the marginal concept is that:
a. Changes in variables may not be in bulk.
b. Changes in variables may not be in single unit.
c. Outflow and inflow of resources may not be equal.
d. Outflow and inflow of resources may not be simultaneous.
The study of unemployment is a part of
a. Normative economics
b. Microeconomics
c. Macroeconomics
d. Descriptive economics
Microeconomics helps determine the following:
a. Equilibrium of the economy.
b. Equilibrium of a firm.
c. Equilibrium of an individual.
d. Equilibrium of an industry.
Analytical Corner
1. What is ‘managerial economics’? How does it differ from economics? Also discuss the nature and
scope of managerial economics.
2. “Managerial economics is the integration of economic theory with business practice for the
purpose of facilitating decision-making and forward planning by management.” Explain.
3. We often use managerial and business economics synonymously. Is it correct? Argue with logic.
4. Discuss the principles of economics which help in effective managerial decision-making.
5. Managerial economics helps in decision-making in the framework of uncertainty and scarcity of
resources. Discuss the statement and elaborate with an example.
6. Distinguish between microeconomics, macroeconomics and managerial economics.
7. Which economic principles are related to managerial decisions?
8. “All choices made by individuals have a cost associated with them known as opportunity cost”.
Explain.
Basic Concepts and Principles
21
9. Describe some of the opportunity costs when you decide to do the following:
i. Go for higher studies after graduation instead of taking a job
ii. Watch a movie tonight instead of studying for an examination tomorrow
iii. Ride a bus to your college instead of cycling
10. Identify an industry of your choice and select a company within that industry; compare the performance of that company with that of the industry over past five years. Then explain the relationship
between micro and macro economics. You may also include performance of economy to further
extend the analysis.
Check Your Answers
State True or False
i. T
ii. T
iii. F
iv. T
v. F
vi. F
vii, T
viii. F
ix. F
x. F
ix. c
x. b
Fill in the Blanks
i. rational
v. market period
ix. multiple
ii. involuntary
vi. factor
x. TC n–1
iii. efficiency
vii. factual
iv. rationality
viii. short run
Pick the Correct Option
i. d
ii. d
iii. d
iv. a
v. a
vi. c
vii. b
viii. b
Caselet 1
The ‘Retail Dahi’
As consumer trends in health and nutrition are undergoing drastic changes in recent times, DuPont
Nutrition & Health has also tried to address this concern with its recent initiative - YO-MIX Curd
Cultures for reliable production of dahi, lassi and buttermilk with desired texture and traditional taste.
This new range caters to the diverse needs of Indian market in fresh fermented dairy products. It is a
strong indicator of how companies have recognised India as an emergent market with diverse needs that
these companies are diversifying into new areas to meet the growing demand of Indian consumers who
nowadays have a strong demand for fresh ideas, indulgent recipes and innovative products. The YOMIX Curd Cultures Series range has been developed by DuPont to enable curd manufacturers meet the
key challenges in producing retail dahi on an industrial scale in the face of fast growing market demand
for dahi and other dairy-based products, and enabling manufacturers in not only improving production
efficiency, but also maintaining consistency in product quality.
Sources:
http://www.dupont.com/industries/food-and-beverage/enhanced-food-texture-and-taste/pressreleases/cultures-indian-market.html; accessed on 15/05/2017.
22
Managerial Economics
DuPont announces new products, The Economic Times, Jamshedpur-Ranchi, Tuesday, 24/01/2017,
p. 15.
http://www.danisco.com/product-range/dairy-cultures/yo-mixr-t-yogurt-cultures/ accessed on
15/05/2017.
Case Question
1. Discuss ‘What to produce’ decision in light of the above case.
Caselet 2
Baby Steps for Baby Food
The market for infant food in India has been showing signs of healthy growth, with an estimated
figure of 125–150 million children under the age of four years. Demand for infant food has been
increasing with rising number of working women and growing awareness about the importance of
nutritious food for children. These factors have been pushing dairies like Prabhat, Danone India
and Schreiber Dynamix to foray into growing infant food products. Some of them have already
established dedicated production facilities for this segment.
Sources:
Kulshrestha, A. Dairies take baby steps into growing infant food products, The Economic Times,
Jamshedpur-Ranchi, Monday, 20/02/2017, p. 6.
https://www.kenresearch.com/blog/2016/07/baby-food-market-in-india-research-report/ accessed on
15/05/2017.
Case Question
1. Discuss the ‘For whom to produce’ decision in light of the above case.
Appendix 1.1
Basic Mathematics for Economic Analysis
Functions
When one thing depends on another, it is called “function” of the other. For example the area of a circle is a function
of its radius, demand for a commodity is a function of its price, and cost of production is a function of the volume
of production. In mathematics, if there are two variables x and y such that for each value of x there exists one and
only one y value, then y is said to be a function of x. This is denoted as:
y = f (x)
(A.1)
In the function y = f (x), x is referred to as the argument of the function and y is the value of the function. Here x is
the independent variable and y is the dependent variable. Thus, we can say that a function is an expression of the
relationship between dependent and independent variables.
Basic Concepts and Principles
Consider the following function:
D = f (P)
23
(A.2)
This functional relationship represented in (A.2) is read as ‘demand is a function of price of that commodity’.
Here demand of the commodity (D) is the dependent variable (the value of which we are interested to ascertain) and
price of the commodity (P) is the independent variable (given from outside). The value of an independent variable
is determined exogenously and is independent of its relation with the dependent variable.
A specific functional relationship between variables can be represented in the form of an equation. An equation
is a mathematical representation of a functional relationship among variables. Hence, we can rewrite (A.2) as
follows:
D = a + bP
(A.3)
Here you must know that since demand and price are negatively related, the demand function is written as D =
a – bP. (You will learn about the reason behind the negative relationship between price and demand in Chapter 3).
Different values of D and P which would hold good for an equation can be represented in the form of a table,
which is the sequential arrangement of values of one variable or number of variables in rows and columns. The
intersection of a row and a column is known as a cell. Economic data are widely presented in tables. Table A.1
gives hypothetical values of price (P) of a cup of coffee and its respective quantity demanded (D).
Table A.1
Demand Schedule for Coffee
Price (` per cup)
Demand (’000 cups)
15
50
20
40
25
30
30
15
35
10
Note that functional relations can be linear as well as non-linear and hence, corresponding equations will be
linear as well as non-linear. We would discuss such relations in details in the following section on different types
of functions.
typeS
of
functIonS
1. Constant Function: A constant function is one whose range consists of only one element. Let us explain
with an example. Suppose we have a function of y = f (x) = 10. Note here that the value of the function would
remain 10, regardless of the value x.
2. Polynomial Function: The word “poly” means many. A polynomial function is one in which each term
contains a coefficient as well as an integer power of the independent variable. A polynomial of a single variable x can be represented as:
y = a 0 + a1x + a2 x 2 +…+ an x n
(A.4)
In equation (A.4), each term contains a coefficient as well as a non-negative integer power of the variable
x. You must be wondering about the very first term in this equation, which does not have any component of
the variable x. But it actually has. This is because x0 (read as x raised to the power of 0) is equal to 1.
24
Managerial Economics
Note the integer n in equation (A.4): it specifies the highest power of x in the polynomial function. Thus,
we have the following types of polynomial functions:
Constant function:
Linear function:
Quadratic function:
Cubic function:
for n
for n
for n
for n
= 0, y = a0
= 1, y = a0 + a1x
= 2, y = a0 + a1 x + a2x2
= 3, y = a0 + a1x + a2 x2 + a3 x3 and so on.
The highest value of n, i.e., the highest power in any polynomial is known as the degree of that function.
Thus, a quadratic function has the highest value of n as 2, and hence will be known as a polynomial of degree
2. Similarly, a cubic function will be a polynomial of degree 3.
Let us take another function from economic concepts to make this more lucid:
C = f (Q)
(A.5)
where C is cost and Q is level of output. Equation (A.5) is read as “cost is a function of level of output”.
Now this functional relationship can take the following forms:
C = a + bQ
(A.6)
C = a + bQ + cQ 2
(A.7)
(A.8)
C = a + bQ + cQ2 + dQ3
As we have explained earlier, the degree of a polynomial is given by the highest power of the independent
variable appearing in the function. Thus, equation (A.7) has 2 as its highest degree and is regarded as a
quadratic function; equation (A.8) has 3 as its highest degree and is known as a cubic function.
THINK OUT
OF
BOX
What is the degree of the equation D = a – bP?
Before we move on to the next category of functions, we would discuss one of the most commonly used functions
in economics, namely the linear function in details.
A linear relationship between variables x and y can be expressed as:
y = a + bx
(A.9)
Here “a” and “b” are the parameters of the equation. The parameters signify the extent of relationships among
the variables in an equation.
If we denote f as the function that assigns y to x, then equation (A.9) can be rewritten as:
f (x) = a + bx
(A.10)
f(x) is called a linear function. In this equation “b” is the slope of the function and also of the line obtained by
plotting the function on graph; “a” is the intercept of the line on the y axis. If the value of the slope is positive,
the line would slant upward to the right; if slope is negative, then the line would slant downwards to the right. We
would discuss graphs of a linear function in the very next section. The concept of slope has been taken up in a
subsequent section.
3. Rational Function: A rational function is a function which is expressed as the ratio of two polynomials in
a variable. Following is an example of a rational function:
y=
x+2
x 2 + 3x + 6
(A.11)
Basic Concepts and Principles
25
4. Algebraic Function: Any function expressed in terms of polynomial and/or roots of a polynomial is an
algebraic function. Following is an example of an algebraic function:
f (x) = x 2 – 2x + 10
(A.12)
5. Non-algebraic Function: A non-algebraic function is one in which the independent variable appears in the
exponent. Thus, the following is an example of a non-algebraic function:
y = ab x
(A.13)
Here the independent variable x is in the exponent. Consider another example:
y = log x
(A.14)
This is another non-algebraic function known as a logarithm function.
6. Bi-variate and Multi-variate Functions: In all the above examples you have seen a function of a single
variable; they are known as uni-variate functions. However, in real world it is very difficult to explain any
behaviour or phenomenon as a function of only one variable. Economics being a social science is no exception! You would come across several variables (like demand and supply), which are functions of more
than one variable. As is evident from the name itself, a function of more than one variable is known as a
multivariate function. The simplest case of a multi-variate function is a bi-variate function, in which a variable is dependent on two or more variables. If we consider z as the dependent variable (like y in uni-variate
functions) and x and y as the independent variables (like x in uni-variate functions), then a bi-variate function
can be represented as:
z = f (x, y)
graphS
and
(A.15)
dIagramS
“A picture says a thousand words.” Diagrams are a powerful tool used extensively in economics to represent a
multitude of concepts. A set of data can be presented in the form of a table as you have seen in the previous section;
it can also be presented graphically. A diagram may be drawn to scale by plotting the values of the dependent and
independent variables on a graph or may be drawn freely to give a broad idea of the relationship between dependent
and independent variables.
The graph of a function can be defined to be the set of all points (x, f (x)), where x belongs to the domain of f.
Table A.2 shows the values of x (dependent variable) and y (independent variable). When we plot the two variables
along the scale we get a set of points, on joining which, we get the graphical representation of the functional
relationship between x and y. the same can be drawn to scale as in Graph A.1 or drawn freely as in Figure A.1. The
two variables x and y bear a positive relationship; therefore when y is increasing x is also increasing. Hence, we get
an upward moving curve (Graph A.1).
Table A.2
Relationship between x and y
x
y
20
15
25
20
30
25
40
30
50
35
26
Managerial Economics
Graph A.1
Linear Curve
On the other hand, we may have a function where x and y bear a negative relationship; in such case the curve
will be downward sloping. So you understand that a positive relation between the two variables x and y signifies an
upward sloping line, as shown in Figure A.1, while a negative relation would be signified by a downward sloping
line, as in Figure A.2. Further, both these figures represent a roughly drawn sketch, as it may not always be desirable
to draw the relation between two variables to the scale. You can see that the lines in both these figures are not drawn
to scale; yet they give a fair idea of the nature of relationship between the variables.
Fig. A.1 Upward Sloping Linear
Function
Fig. A.2
Downward Sloping Linear
Function
Note here that we have shown a linear relation between x and y but the curve may be non-linear too, as is shown
in Figure A.3.
Fig. A.3
Curvilinear Function
Basic Concepts and Principles
27
Such a curvilinear function can be explained with the help of a quadratic function. The most common form of
a quadratic function is:
f(x) = ax 2 + bx + c
(A.16)
where a π 0
If the value of a quadratic function is set equal to zero, then we get a quadratic equation, and the solutions
obtained are known as the roots of the equation. The graph for this equation will be obtained by computing the
pairs of values of x and f (x) on a graph and then drawing a smooth curve through the points. This graph is in the
shape of a parabola, as shown in Figure A.4. This would be the case when a < 0 in equation (A.16). You can notice
that this curve has a single wiggle.
Fig. A.4 Quadratic Function
Fig. A.5
Cubic Function
Let us see the graph of a cubic function with the following example of a cubic function:
f (x) = ax 3 + bx 2 + cx + d
(A.17)
The graph of such a cubic function will usually have two wiggles, as shown in Figure A.5.
Slope
In mathematics, the slope or gradient of a line describes its steepness; it also indicates the incline of a line (Fig. A.6).
A higher slope indicates a steeper incline of a line. It is usually denoted as “m”. Consider a straight line; given any
two points with coordinates (x1, y1) and (x2 , y2) respectively, the slope m of the line is given as:
m=
y2 - y1
x2 - x1
(A.18)
If we denote x2 – x1 as Dx and y2 – y1 as Dy, then the slope of this line can be represented as:
m = Dy
Dx
(A.19)
Let us give you a quick input here. What would be the shape of a line when its slope is 0? The line would be
horizontal! The line would be vertical when its slope is undefined.
28
Managerial Economics
Fig. A.6
Slope of a Line
tIme SerIeS
As is evident from the name itself, time series represents values of variable(s) against time. Thus, the independent
variable in case of such data is time. Time series data have a single observation on each variable for each time
period and they actually depict the changes of a variable over time. Often it becomes essential to study the past
behaviour of a variable to determine its future behaviour. You can estimate the trend of the variable by studying this
behavioural pattern of the variable over time. Time series can be made with different intervals of time, say daily,
weekly, monthly, quarterly, annually, etc. depending on the nature of study. Time series finds special relevance in
business as it helps in planning for the future on areas like production, sales, pricing, etc.
Time series data is arranged in tabular form, showing sequential changes in the variable across different time
periods. Table A.3 shows the time series data on expenditure by three leading pharmaceutical companies in India
on Research and Development (R&D) expenditure.
Table A.3
R&D Expenditure of Pharmaceutical Companies in India
2002
2003
2004
Cadila Healthcare Ltd.
Name of the firm
3355
4155
8820
Lupin Ltd.
4421
7093
4599
Ranbaxy Laboratories Ltd.
7480
21723
27612
Such data may also be plotted on a graph with time on the horizontal axis and values of the variable (R&D
expenditure in this case) on the vertical axis. Graph A.2 shows the time series data on R&D expenditure by three
leading pharmaceutical companies in India. You can easily follow from the graph that each point corresponds to the
value of such expenditure in that particular period of time. The advantage of using graphical method in Time Series
Analysis is that it depicts an overall view of the trend, that is, whether it is increasing, or decreasing, or constant,
or fluctuating.
Basic Concepts and Principles
29
`
`
Graph A.2
R&D Expenditure of Pharmaceutical Companies in India
croSS SectIonal data
What if time is held constant? Data on different observations made at the same point of time are regarded as cross
sectional data. As such they are often regarded as parallel data. Table A.4 shows different variables of the Indian IT
industry from 1996-97 to 2000-01. Suppose we consider the year 1996-97: it shows different values of the variables
like share in GDP of the Indian IT market, size of the Indian IT market, etc. Thus, if we move row-wise, we get
cross sectional data; if we move column-wise with time, we get time series data.
Table A.4
Indian IT Industry: 1996-97 to 2000-01
Year
A
%
B
%
C
%
D
%
E*
%
1996-97
—
—
—
—
3,900
—
6,594
—
9,438
—
1997-98
1.22
—
18,641
—
6,530
67.43
10,899
65.28
12,055
27.72
1998-99
1.45
18.85
25,307
35.75
10,940
67.53
16,879
54.86
14,227
18.01
1999-00
1.87
28.96
36,179
42.96
17,150
56.76
23,980
42.07
18,837
32.4
2000-01
2.71
44.91
56,592
56.42
28,350
65.30
37,840
57.79
28,330
50.39
Source: NASSCOM *
A: share in GDP of the Indian IT market, B: size of the Indian IT market (in ` crore), C: software and services exports (in ` crore), D: size of
software and services (in ` crore), E: size of the domestic market (in ` Crore), %: Percentage growth
real
and
nomInal ValueS
Nominal values of a variable are the money values of the variable, whereas real values are shown in terms of goods
and services. For example, nominal income of a person is the money received in a month, whereas real income is the
purchasing power of that money. Let us consider national income, if estimated at the prevailing prices, it is called
nominal national income. Thus, the statement ‘GDP of India at current prices in 2005-06 is `3,250,932 crores’
30
Managerial Economics
(Source: Reserve Bank of India) implies that GDP has been measured on the basis of prices prevailing in 2005-06.
Needless to say, we do not take into account inflation while calculating nominal value.
Real values, on the contrary, are money values of a variable, by factoring the element of inflation (i.e., increase
in the level of price of itself). In other words, real values are corrected or adjusted for inflationary effects. Let
us make this clear with an illustration. If national income is measured on the basis of some fixed price, say
price prevailing at a particular point of time, or by taking a base year, it is known as real national income. Thus
the statement ‘GDP of India for the year 2005-06 is ` 2,604,532 crores at 1999-2000 prices’ (Source: Reserve
Bank of India) implies that GDP for the year 2005-06 has been measured on the basis of prices prevailing in
1999-2000.
You would be learning more of these two concepts in the chapter on National Income.
concept
of
derIVatIVe
The concept of derivative bears close relation with the concept of margin discussed in this chapter. Marginal value
of a dependent variable is a change in the variable associated with a unit change in an independent variable. Let
us explain with the help of the function (A.1). You know that y is the dependent variable and x is the independent
variable. We normally use the symbol D to denote change in a variable. Then Dx would represent a change in the
value of x and Dy would represent change in the value of y. Following the concept of marginality, the marginal
value of y can be expressed as:
Marginal Y =
Dy
Dx
(A.20)
What about very small changes in the value of x? By this, we are referring to a situation in which Dx becomes
so small that it tends to reach zero, but never reaches zero. How to determine the marginal value in such cases?
Yes, by differential calculus. The measure of a marginal change in the dependent variable due to an infinitesimal
change (approaching zero) in the independent variable is determined under differential calculus through a tool
known as “derivative”. If we continue with our previous example of y = f(x), the derivative of y in terms of x can
be expressed as:
Dy
dy
= lim
Dx
D
x
Æ
0
dx
(A.21)
What does equation (A.21) mean? It can be read as: “the derivative of y with respect to x is equal to the limit of
the ratio
Dy
, as Dx approaches zero.” Expressing a derivative as the limit of a ratio is precisely equivalent to the
Dx
slope of a curve at any point.
You may refer to any standard text book on differential calculus for the standard rules of differentiation.
partIal derIVatIVe
We have so long considered bivariate functions, in which the dependent variable is a function of a single independent
variable. However, you would often come across multi-variate functions in economic theory, which have more than
one independent variable. The function (A.2) is uni-variate, in which demand depends only on one variable, namely
price. You would see eventually in the course of this book that (A.2) is a simplified version of a demand function,
Basic Concepts and Principles
31
in which all the other variables like price of the commodity, income of the consumer, price of other commodities,
etc. are assumed to be constant at that point of time. The demand function may be represented as:
D = f (Px , Y, Po, T, A, E f , N, etc.)
(A.22)
where Px is price of the commodity X, Y is income of the consumer, Po is price of other commodities (substitutes
or complements), T is tastes and preference of the consumer, A is advertising, E f is future expectations about price,
and N is population and economic growth.
You can, thus, infer from equation (A.22) that demand for a commodity depends on a number of factors.
How do we isolate the effect of a change in any one of these independent variables on the dependent variable in
a multivariate function like demand? Here the concept of partial differentiation is applied. A partial derivative
expresses the change in the dependent variable due to a change in any one of the independent variables, keeping
the other variables constant. Note here that we apply the standard rules of differentiation in partial differentiation
as well. Thus with respect to the demand function in (A.22), the partial derivative
dD
would express change in
dP
dD
would express change in demand
dY
dD
with respect to change in income, keeping all other variables constant; and
would express change in demand
d Po
demand with respect to change in price, keeping all other variables constant;
with respect to change in prices of other goods, keeping all other variables constant, and so on.
optImISatIon
wIth
calculuS
Managerial economics is concerned with the ways in which managers make decisions in order to maximise the
performance of a business organisation. You have already read about rational behaviour on the part of producers
and consumers alike. While consumers aim at maximising utility out of consumption, producers aim at maximising
profit or revenue, or minimising costs of production. Such rational optimisation by both producers and consumers
would be discussed thoroughly in the subsequent chapters. Let us understand how calculus can be useful in such
optimisation decisions.
Optimisation or mathematical programming refers to choosing the best from a set of available alternatives. In its
simplest form optimisation would require finding either the maximum or the minimum value of a function. For a
function to be either maximum or minimum, its slope (or its marginal value) must be equal to zero at the maximum
or minimum value. In other words:
dy
=0
dx
(A.23)
However, if this relation is valid for both maximisation and minimisation, then how can we distinguish between
a maximum and a minimum? For this we need the second derivative of the function. This second derivative is
nothing but the derivative of the derivative of the function. For the function y = f (x) we can express it as:
d2y
dy
= d ÊÁ ˆ˜
dx Ë dx ¯
dx 2
(A.24)
You have seen that the first order derivative is the slope of a function. So what does the second order derivative
indicate? Yes, you got it right: the second order derivative signifies the change in the slope of the function. It is,
hence, instrumental in finding the maximum or minimum value of a function. If the value of the second order
derivative is positive, we have a minimum; if its value is negative, we have a maximum.
32
Managerial Economics
You can rightly infer that the condition that ‘first order derivative equal to zero’ holds for both maxima and
minima; and it is the condition of sign of the second order derivative that would identify maxima or minima. You
may also refer to the condition of equality of the first order derivative with zero as the necessary condition and the
positivity or negativity of the second derivative as the sufficient condition for optimisation.
Before we end this discussion on optimisation, it is necessary to throw light on the role of constraints. In realbusiness scenario, all businesses run with many constraints, like availability of raw materials, etc. Since such
constraints affect a firm’s actions, the optimisation technique that a firm adopts under such constraints is known
as ‘constrained optimisation technique’. Constraints can be only one in the simplest form, to many. Generally, we
include a Lagrange multiplier when the constraints are many or complex by nature. However, such constrained
optimisation is beyond the scope of this book.
You would learn more on optimisation with respect to business decisions in subsequent chapters.
Chapter
2
Theory of firm
2. Discuss the role of public sector in economy.
3. Understand various objectives of a firm and develop a critical appraisal of the
various theories of objectives of a firm.
4. Comprehend the nuances of concepts like principal agent problem and asymmetric
information in an organisational context.
Chapter Objectives
1. Identify the various types of organisations on the basis of ownership pattern and
highlight the advantages and limitations of each type.
IntroductIon
You would recall from our discussion in Chapter 1 that Managerial A firm is an entity that draws various
Economics as a subject is applicable to all types of organisations, types of factors of production in different
though it finds special application in business firms. This brings forth amounts from the economy, and converts
some pertinent questions like: what is a firm; who identifies the factors them into desirable output(s), through
of production; who collects the factors and puts them to productive a process with the help of suitable
technology.
use; and so on. A firm is an entity that draws various types of factors
of production in different amounts from the economy, and converts them into desirable output(s),
through a process with the help of suitable technology. Economists have identified five factors of
production, namely land, labour, capital, enterprise and organisation, of which, enterprise and organisation
are relatively new entrants. It is obvious that factors of production cannot produce unless they are given
proper direction and a system to operate in. The process of identifying
the potential sources of the factors such as land, labour and capital, There are five factors of production, namely
land, labour, capital, enterprise and
collecting them in required quantities and assigning them specific organisation.
tasks as per their skills is the subject matter of organisation. Using
these factors of production for economic activities, without any certainty of returns is the function of
34
Managerial Economics
enterprise, or the entrepreneur. Hence, we can say that an entrepreneur is a person (or group of persons)
who decide(s) to undertake the responsibility of the inherent risks in starting a business.
Needless to say, the firm and its activities would be the focal point of this book. As such, we need
to develop an understanding of what can be the different types of organisations from the point of view
of ownership, how do they operate, and what are the underlying objectives of any business firm. In
this chapter we would be discussing the different forms of ownership of business firms, before we deal
elaborately with different perspectives on the objectives of firms. We would also throw light on some of
the relevant concepts like asymmetric information and the principal agent problem.
ForMS
oF
oWnErSHIP
The success of every business depends largely on its organisation; and the form of ownership is a significant aspect of any organisation. Businesses may be organised in various forms, depending on their size,
nature and need for resources. Legal framework of the economy also plays a significant role in choice of
form of ownership. Figure 2.1 illustrates the major forms of ownership. Let us explain at the very outset
that “ownership” is always measured from the point of view of investors (entrepreneurs). Based on this
concept, we may divide business organisations into three broad categories: (a) private sector (wholly
owned by people, individually, or as a group), (b) public sector (owned, managed and controlled by
government), and (c) joint sector (owned and managed jointly by individuals and government).
Ownership is always measured from the point of view of investors (entrepreneurs).
Forms of Ownership
Private Sector
Individual
Collective
Joint Sector
Company
Public Sector
Corporation
Proprietorship
Partnership
Company
Cooperative
Fig. 2.1 Forms of Ownership
Department
Theory of Firm
35
Private sector represents all the major forms of ownership, whereas under public sector proprietorship
and partnership do not exist. Joint sector consists of only joint stock
companies. We would discuss these forms in details under private There are three broad categories of business
sector, because that is where most of the theories of business apply. organisations:
● Public sector
However, some space will also be given to public sector due to its ● Private sector
special role in an economy’s growth. Joint sector will not be discussed ● Joint sector
separately because it is just a combination of private and public sector.
A. Private Sector
In any economy it is the private sector that dominates the business frontier. Let us first explain the
meaning of private sector. When ownership is in the hands of individuals, whether independently, or
as a small group, or in a large number, without any investment from the government, then the setup is
referred to as private sector.
In the early years of organised economic activities only the private sector existed, while other sectors
came at a very later stage. Proponents of private sector believe that businesses should always be in the
hands of individuals. The reason cited has been that the root of all economic activities is profit making,
and that governments cannot run organisations with profit motive. Supporters of the public sector argued
that private investors would invest only in those areas in which returns are high and also gestation period
is small; hence governments should step into economic activities in order to ensure equal distribution of
economic resources and balanced growth of the economy.
Let us explain the various types of business organisations that may exist under private sector in the
following sections, and also highlight the advantages and limitations of each type.
i. Sole Proprietorship
Sole proprietorship is the most ancient form of ownership; its roots
Sole proprietorship firm is one in which
can be tracked back to the development of civilised living, private an individual invests own (or borrowed)
ownership of resources and advent of the benefits of exchange. capital, uses own skills in management,
Primitive societies were created on the basis of sharing of resources, and is solely responsible for the results of
whether natural, or manmade. This sense of sharing resulted in the operations.
advent of exchange, which emerged as the mother of all economic
activities. Then money was invented for convenience, and can undoubtedly be termed as one of the
most wonderful inventions by mankind. Thus, began the process of private ownership of resources,
accumulation of wealth and capital formation.
You may find numerous proprietorship firms existing all around you; retail outlets, restaurants,
hotels, small/cottage industries are only few examples of such sole proprietorship. In fact, many of the
modern big business houses were started as ownership firms, and were eventually converted into limited
companies.
We may, thus, define sole proprietorship, or single owner, or proprietary firm as one in which an
individual invests own (or borrowed) capital, uses own skills in management, and is solely responsible
for the results of operations. The profits or losses are not shared with any one.
36
Managerial Economics
Advantages of Sole Proprietorship
The advantages of sole proprietorship are as follows:
a. Simple and easy to start or exit There are no legal formalities in starting a sole proprietorship and
hence its formation is easy. Anyone willing to be self employed, and willing and capable to take the risks
involved, may begin one’s own business. The only conditions necessary to be satisfied are willingness
and capability to take the risk due to uncertainty of returns. At the same time, exit from the business is
easy, because decision-making lies in single hands.
b. Undivided profits In proprietorship form of business all the profit earned accrues to the owner. This
works as a strong motivator, since all the hard work put in is directly rewarded, and the returns emerging
from the business are not to be shared with any one.
c. Secrets of trade Single ownership ensures that secrets of the trade are not leaked out. This sometimes
may have important implications, especially in case of knowledge (such as handicrafts) in the family
descending through generations.
d. Prompt decision-making Another big advantage of sole proprietorship is that any decision
regarding the business can be taken with great speed, and in certain cases, timeliness of decision-making
may be very crucial.
e. Personal touch to business Single ownership keeps the business small, but the owner can keep
personal touch with employees, as well as customers. This way the owner can have first hand information
on employee performance and customer satisfaction. Sole proprietorship firms can thus conform to the
foremost secret of business success, i.e., to keep the internal as well as the external customers satisfied.
Limitations of Sole Proprietorship
The limitations of sole proprietorship are as follows:
a. No separate entity of firm The biggest limitation of this kind of ownership is that the firm does not
have an entity separate from the owner. In other words, the owner and the firm are one and the same. Any
legal matter is settled in the name of the owner, and not the firm. Any credit taken from outside sources
like banks, or market, or friends, would be in the name of the owner.
b. Unlimited liability This limitation is an offshoot of the fact that the firm does not have a separate
entity. The liability of the owner is not limited to the extent of capital invested in the business but it is
extended to the personal assets of the owner. In the event of owner’s inability to repay the loan, creditors
have right to claim the same from owner’s personal assets. As a corollary to unlimited liability, a sole
proprietorship involves greater financial risk, as the proprietor is personally liable for all obligations.
c. Limited availability of funds Availability of funds is totally dependent upon the owner’s
creditworthiness. Hence, the owner is left with only two options: either use own savings, or borrow
money on personal guarantee. This obviously limits the financial strength of the firm and thus limits the
scope of expansion of the business.
Theory of Firm
37
d. Uncertain life of business The life of single ownership business depends upon the will and life of
the owner. Maximum life of the business is till the life of the owner; if the proprietor dies, the business
also terminates, though assets of the business may continue to exist. Hence, suppliers, creditors and the
customers may not plan for a long-term relationship with a sole proprietory business.
If you give a deep look at these limitations, you would realise that all of them emerge from the fact
that there is a single owner of the business and that the business is not separate from the owner. In fact,
due to these limitations of sole proprietorship firms, people have invented other forms of ownership.
THINK OUT
OF
BOX
What happens to the assets of a sole proprietory business if the owner
dies?
ii. Partnership
Due to the inherent limitations of a single owner organisation, investors In partnership, two or more individuals
invented another form of organisation, which solved many of the (individually partners and collectively a
problems of proprietorship and still could retain all its advantages. firm) decide to start a common business.
This form is known as partnership, in which two or more individuals
decide to start a common business. As per Section 4 of Indian Partnership Act 1932, a partnership is
“relation between persons who have agreed to share the profits of a business carried on by all or any of
them acting for all”. Persons who have entered into partnership are individually regarded as ‘partners’
and collectively as a ‘firm’. Here it is important to understand that the term “firm” is only a commercial
notion, and has no legal personality apart from the partners, except for purposes of assessment of income
tax. A partnership firm cannot become a member of another firm, though its partners can join another
firm as partners.
Limited Liability Partnership (LLP) The Limited Liability Partnership Act of India 2008, has changed
the face of partnership to promote entrepreneurship and innovation in the country. The rules of Act of
1932 are not applicable to the firms established under this Act. It is a legal entity with an existence
separate from its owners. It has perpetual existence. Any change in the partners shall have no impact on
the existence, rights or liabilities of the LLP firm.
Characteristics of Partnership As per the Act of 1932, partnership must simultaneously satisfy all of
the following aspects, also regarded as the essential conditions of partnership:
1. Association of two or more persons A partnership cannot exist unless at least two persons join
hands. At the same time, there is an upper limit to the number of members. A partnership cannot have
more than 20 partners.
2. Agreement to voluntarily form partnership Partnership arises
from a contract that all the partners agree to form a firm. The agreement
is to share the profits emerging from the business, which also implies
In partnership agreement, to share losses is
not essential.
38
Managerial Economics
sharing the losses; however, agreement to share losses is not essential. This contract may be explicit or
implied, and would take either of the following forms:
a. it may be for a certain specified period and a specific purpose, or
b. it may be for a certain specified period and any purpose, or
c. it may be for an uncertain period and a specific purpose, or
d. it may be for an uncertain period and any purpose.
An heir of a partner does not automatically become a partner, unless other members agree to induct
the heir(s) as partners.
3. Business carried out by all or any one acting for all Partners are mutual agents for each other and
principal for themselves. All of them may actively manage the business, or any one of them may conduct
the business under implied authority to do so by all other partners. All the partners are bound by an act
or decision taken by any one of them in normal course of business.
4. Partnership deed Partnership is created as an agreement. It is not necessary to prepare this
agreement in writing, though it is strongly desired that the agreement is prepared in writing, in order to
avoid any dispute arising in future. The document, thus, created is called a Partnership Deed. A typical
partnership deed normally consists of following information:
a. Name and location of firm, and nature of business
b. Name of partners, their respective shares, powers, obligations and duties
c. Date of commencement of partnership
d. Duration of firm
e. Capital employed by different partners
f. Manner in which profits (losses) are to be shared among partners
g. Salaries (if any) payable to partners
h. Rules regarding operation of bank accounts
i. Interest on partners’ capital, loans, drawings, etc.
j. Provision for admission, retirement or expulsion of partners
k. Settlements on dissolution of the firm
Advantages of Partnership
The advantages of partnership are as follows:
a. Easy formation It easy to establish a partnership firm, though not as easy as sole proprietorship.
This is because of the fact that a partnership would necessitate that two like minded people need to come
together to start a business. With liberalisation of the Indian economy, formation of partnership firms has
become easier, because most of the businesses do not need licensing.
b. Strong credit position Since availability of funds is largely dependent on the creditworthiness of
owners, a partnership firm, unlike sole proprietorship, has greater credit, and hence greater availability
of funds.
Theory of Firm
39
c. Shared risk By the very nature of partnership, risk is divided among all the partners. This is a great
advantage, especially to all the entrepreneurs who want to start on a small scale. Sole proprietorship
form of business, however, does not provide this benefit to the owners.
d. Shared wisdom and resources Like risk, knowledge, skill and wisdom can also be shared in this
type of business. Diversified skills provide an additional advantage to the business.
Limitations of Partnership
The limitations of sole proprietorship are as follows:
a. Uncertain life of firm The biggest limitation of the partnership form is that the firm’s life is very
uncertain. Because the partners have contractual relationship, the partnership can be broken at any point
of time, for any cause of dispute or disagreement among the partners. Another important aspect is that,
such a firm needs to be dissolved and reconstituted, if any one of the partners dies, or leaves, or resigns,
or if a new partner joins. Hence, just like ownership, a partnership firm’s life is solely dependent upon
the life of partners.
b. Unlimited liability Similar to single owner, the liability of the partners is not limited to the extent
of capital invested by them in the business in form of assets, but extends even to the personal assets of
the partners. In the event of any partner’s inability to repay the loan, creditors have the right to claim
the same from the partner’s personal assets. However, the Limited Liability Partnership Act 2008 has
allowed limited liabilities to the partners. However, the membership cannot fall below two at any points
of time.
c. Dissents and distrust Whenever misunderstandings arise between partners, leading to distrust, it
is the business that suffers significantly. Surprisingly, such situations cannot be avoided, as there is no
legal framework for defining the roles of partners. The biggest disadvantage of this is that the defecting
partners may carry trade secrets with them and emerge as rivals.
d. Insufficient funds A partnership has generally insufficient resources for undertaking any business
activity on a large scale. The reason, similar to sole proprietorship, is that availability of funds is directly
related to the creditworthiness of partners.
THINK OUT
OF
BOX
What is the biggest limitation of partnership as against company?
iii. Joint Stock Company or Company
The most important type of business organisation today is the joint
stock company, commonly called “company”. A joint stock company
gets this name from its characteristic that it is a business entity in
which stocks can be bought and owned by the shareholders. Each
A joint stock company in India is
established under Companies Act 1956,
amended in 2013.
40
Managerial Economics
shareholder owns company stock in proportion as per their shares (certificates of ownership). This
results in unequal ownership among the shareholders. Shareholders may sell their stock or transfer them
without affecting the existence of the entity. In India a Joint Stock Company is established under the
Companies Act 1956, which was amended in 2013. The details of functions and scope of the company
are governed by Memorandum of Association signed among members. The Memorandum contains the
name of the company, the location of the head office, its aims and objectives, the amount of share capital,
the kind(s) and value(s) of shares and a declaration that the liability is limited. Articles of Association,
containing the rules and regulation of the company are also drafted. These two documents are submitted
to the Registrar of Joint Stock Company. The company comes into existence only after the Registrar of
Companies issues a certificate of incorporation.
The owners’ capital in a joint stock company is invested in the form of shares; hence the owners are
regarded as shareholders and there may be various categories of shareholders with the two major ones
being common shareholders and preference shareholders. These categories are on basis of the claim on
dividend. The profit earned is divided in the form of dividends on the basis of shares. Besides raising
capital by shares, the company may also raise funds by bonds and debentures, which have a priority in
the claim for repayment, irrespective of profits or losses. Owners of bonds and debentures are the
creditors of the company.
The liability of each shareholder is limited to the proportion of
A joint stock company is a legal entity and
shares
held by him/her; therefore a joint stock company is also known
has perpetual existence.
as a limited company. In the event of inability of a company to repay
loan or interest amount the creditors can raise their claim on assets of the company and not on the
personal belongings of shareholders. This is the biggest advantage of a limited company over all other
forms of business. The overall governance of a company is in the hands of a Board of Directors, which
is a body elected by the shareholders.
A joint stock company is a legal entity and its existence is independent of its members. It has a name,
a seal and an authorised signatory; it has the right to own, buy, sell and transfer property; it can sue and
can be sued in its own name. For all practical purposes, a joint stock company is like a person, but it
exists only in contemplation of law, and is strictly governed by the clauses laid in the Memorandum
of Association.
A joint stock company has two basic forms, namely, Private Limited Company and Public Limited
Company. Let us explain each in details.
Private Limited Company The maximum number of
shareholders in such a company is limited to 50. The shares of the
company are transferable only among the members. This type of
company is free from the necessity of submitting certain returns to the Registrar. But a private limited
company has to operate under certain restrictions: it can neither issue a prospectus, nor can it raise
capital by selling its shares to outside public other than the members.
The maximum number of shareholders in a
private limited company is limited to 50.
There is no limit on the maximum number
of members in a public limited company,
though the minimum number of members
is 7.
Public Limited Company The joint stock company may take
the form of a public limited company, in which there is no limit on
the maximum number of members, though the minimum number of
members is seven. Such a company has to submit certain statements
Theory of Firm
41
and its balance sheet to the Registrar of joint stock companies on an annual basis. It can invite the public
to buy shares by issuing a prospectus. One feature of a public limited company is that, its business cannot
be started unless the minimum capital laid down as per law has been subscribed.
Advantages of Public Limited Company
The advantages of public limited company are as follows:
a. Limited liability Liability of a joint stock company is limited, Liability of a joint stock company is limited.
unlike unlimited liability in the case of partnership or proprietorship.
A partner can be called upon to pay the entire debt of the business; even his/her private property can be
attached. Unlike this, the liability of a shareholder in a company is limited to his/her share capital only.
b. Perpetual existence A company has perpetual existence. Any number of shareholders may join or
leave, but the company continues. Unlike sole proprietorship, the retirement or death of a shareholder,
or a director, cannot bring about the dissolution of company. This facilitates a company to plan on a
long-term basis and enhances its capacity to take bigger risks.
c. Separate entity The company is legal person; in that capacity, it can own property and enter into
business contracts. Personal relationship is of no importance in a company; management of a company
is in the hands of professional Board of Directors. Ownership is, thus, separated from control.
d. Large funds The financial resources of a joint stock company are much larger than ownership
firm or partnership. In case of public limited company, there is no dearth of capital as long as investors
are sure of its potential to earn profits. Even financial institutions and banks are more willing to grant
finances to companies than to individuals.
e. Economies of large scale The large financial resources of a company enable it to undertake business
on a scale large enough to realise internal and external economies. These economies are in the form of
use of modern machinery, division of labour, economies in buying and selling, lower overhead charges
relating to distribution, publicity and administration, research and experiments, etc. You will learn more
about economies of scale in the chapter on production.
Limitations of Public Limited Company
The limitations of public limited company are as follows:
a. Indifference of shareholders Common shareholders are only interested in the profits of the
company and do not have any loyalty to any particular company. They keep on selling and buying shares
of different companies. Small shareholders have no influence on the decisions of the company. Directors
may decide on policies and rules which may not be in the interests of either shareholders or employees
and may promote their own interests at the expense of the company.
b. Complexity in formation Since a company is a creation of law, it is not easy to form a joint stock
company. There are many legal formalities which must be fulfilled, therefore other forms are more
popular among small investors and company is formed only when the business has to be expanded to a
large size.
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Managerial Economics
One Person Company The Company Act 2013 has introduced many changes to encourage and
facilitate economic activities. One major reform is creation of One Person Company (OPC). This has
removed the necessity to search for like-minded people to create a company.
iv. Cooperative
A cooperative is a non-profit, non-political, non-religious, voluntary
organisation, formed with an economic objective. The main principles
of cooperation are:
i. It is based on mutual help and self reliance. This can be neatly summed up as “each for all and all
for each”.
ii. Dealings are confined to members only.
iii. Its objective is not earning profits but to encourage mutuality and cooperation.
The principle of cooperation has been given a much extended application. Cooperative societies have
been formed for a number of purposes. Primarily cooperation may be divided in two broad categories:
producers’ cooperation and consumer’s cooperation. Let us explain both in details.
A cooperative is a non-profit, non-political,
non-religious, voluntary organisation,
formed with an economic objective.
Producers’ Cooperative In this form of cooperation, workers are their own masters i.e., the
business is owned by them. Surpluses (Profits), if any, are divided among all the members. Thus, profits
go to the actual workers instead of enriching a few individuals. Nothing could be more attractive and
fairer than this. You must have, by now, conceptualised a producers’ cooperation to be the idealised form
of company? Let us sound a warning bell here, as the claims of fair division of profits are all theory;
reality may be strikingly different! Unless all the members of cooperative work in tandem with loyalty
and beyond individual interests, a producers’ cooperative may not work efficiently. For example, Indian
Fertilisers and Farmers Cooperative (IFFCO) has proved to be great success.
eality
ites
Cooperating to Glory!
Indian Farmers Fertiliser Cooperative (IFFCO) is the world’s largest fertiliser cooperative, and also the
largest producer of chemical fertilisers in India. It was established in 1967 as a collective initiative of the
farmers. By 2007, IFFCO boasts of annual sales of over ` 9,700 crore, and markets its products through
a whopping 37,300 Cooperative Societies and 165 Farmers’ Service Centres across the length and
breadth of the nation. IFFCO’s mission is “to enable Indian farmers to prosper through timely supply of
reliable, high quality agricultural inputs and services in an environmentally sustainable manner and to
undertake other activities to improve their welfare”.
To achieve its mission, IFFCO as a cooperative society, undertakes several activities covering a broad
spectrum of areas to promote welfare of member cooperatives and farmers. The objective of IFFCO is
to promote the economic interest of its members by conducting its affairs in professional, democratic
and autonomous manner through self help and mutual cooperation. It manufactures various types of
fertilisers, and allied products/by-products, farm and forestry products, agriculture machinery and other
agricultural inputs/outputs. It is also involved with the conversion, storage, transportation and marketing
of such products.
Sources: www.iffco.nic.in, http://dqindia.ciol.com/content/cio_handbook07/ITLandscape/2007/107022809.asp,
accessed on 18/01/2008.
Theory of Firm
43
Consumers’ Cooperative Persons living in a particular place, or working in an establishment, may
combine together to open different types of cooperative societies. Typical examples are multi purpose
stores, credit societies and housing societies. This form of cooperation has been very successful. You
can find around you many such types of consumers’ cooperatives; may be the house you live in is part
of such cooperative effort!
Advantages of Cooperatives
The advantages of cooperatives are as follows:
a. Dual benefits The fundamental advantage of cooperatives is that
it combines the benefits of capitalism with socialism. Main objective
of cooperative is to work for the benefits of its members, and not to
generate profit; however, if in due course of time surplus is generated,
it is distributed among the members.
Main objective of cooperative is to work
for the benefits of its members and not to
generate profit.
b. Promotes societal values A cooperative is basically formed as a social movement where social
values, concern for others and mutual benefits are prominent, and not the sentiments of competition and
profiteering. In a country where economic resources are scarcely available, cooperatives provide a very
useful form of business.
Limitations of Cooperatives
The limitations of cooperatives are as follows:
a. Fraudulent activities Often unscrupulous executives of cooperative societies deceive the members
by fraudulent acts. Such frauds are very common in housing and credit societies.
b. Uncertain life Cooperatives suffer with the problem of uncertainty of life as due to differences
among members cooperatives die out before being able to serve the purpose they were aimed at.
eality
ites
Coexistence of Private Sector and Public Sector
Automobile Industry
Tata Motors, established in 1945, is India’s largest automobile company, with revenues of ` 32,426
crores (USD 7.2 billion) in 2006-07. It is the leader by far in commercial vehicles in each segment, and
the second largest in the passenger vehicles market with winning products in the compact, midsize car
and utility vehicle segments. The company is the world’s fifth largest medium and heavy commercial
vehicle manufacturer, and the world’s second largest medium and heavy bus manufacturer.
Maruti Suzuki India Limited (MSIL): Erstwhile Maruti Udyog Limited (MUL) was established in
February 1981 through an Act of Parliament, as a Government company with Suzuki Motor Corporation
of Japan as a joint venture partner holding 26 percent stake. In 1992 Suzuki increased its stake in Maruti
to 50 percent. On 24th July 2007 the Board of Directors decided to rename the company as Maruti
Suzuki India Limited. The company has been entrusted with the task of achieving the modernisation
of the Indian automobile industry, production of vehicles in large volumes and production of fuel efficient
vehicles and Maruti cars have truly emerged as market leaders.
(Contd.)
44
Managerial Economics
Steel Industry
Established in 1907, Tata Steel is Asia’s first and India’s largest private sector steel company. Tata
Steel is among the lowest cost producers of steel in the world and one of the few select steel companies
in the world that is EVA+.
Steel Authority of India Limited (SAIL) is a fully integrated iron and steel maker. The Government
of India owns about 86% of SAIL’s equity and retains voting control of the Company. Ranked amongst
the top ten public sector companies in India in terms of turnover, SAIL manufactures and sells a broad
range of steel products.
B. Public Sector
Public sector is that segment of economy where government is the investor and the owner of a business.
The public sector came into existence as an outcome of two major revolutions: Communism and Great
Depression. Although deliberation on these two issues is out of scope of this book, still we shall briefly
touch them one by one. Karl Marx propounded the theory of public ownership of all resources and gave
the logic that the entire society is a community and all resources, whether natural or manmade, should be
owned by the community as a whole and not by any individual. This is regarded as communism. Many
countries were deeply influenced by the Marxist theory and adopted Communism as national economic
philosophy. Another major event that had drawn the attention of economists and thinkers alike was the
Great Depression. Another great economist, John Maynard Keynes recommended that in order to break
the impasse, the government should enter into business activities, because only government can invest in
the areas where profits are not certain. As a result, governments of nations, the world over, forayed into
business activities, giving rise to another sector in the economy, regarded as the public sector. In many
countries, including India, the two sectors continue to coexist even today.
As we have discussed the various types of business organisations under private sector, we shall
hereafter learn about forms of organisations under public sector.
i. Corporate (or Company) Just like private sector when
government invests in production activities and enters the market,
such firms are called Public Sector Units (PSUs) or Public Sector
Enterprise (PSEs). These PSUs (or PSEs) have to operate on the same
ground as any other joint stock company, with the single exception that there are no shareholders, as the
government owns the entire or controlling amount of invested capital. These units play very significant
role in many respects like: employment generation; development of products where private sector does
not want to enter; balanced economic development and equitable distribution of national wealth. In
India, SAIL, ONGC, NTPC, GAIL, BSNL are some of the examples of PSUs.
When government invests in production
activities and enter the market, such firms
are called (PSUs) or Public Sector Enterprise
(PSEs).
ii. Corporation or Board Another structure of organisation is in the form of a corporation or a
board. The corporation or the board normally controls some of the economic activities, especially where
the government feels that government intervention is necessary for equal distribution of economic
resources. Such a corporation does not aim at revenue generation; it rather aims at optimum utilisation
of national resources and welfare maximisation of groups of small economic units like household and
Theory of Firm
45
cottage industries. In India, typical examples are Khadi and Village Industries Corporation (KVIC), Coir
Board, Food Corporation of India and Railway Board.
iii. Department A Department is run for a specific purpose related to social utility, such as education,
health, civil administration, etc. These Departments normally function under the directives of relevant
ministries, either at the appropriate level. For example, in India, police, excise and education (up to
secondary) are the responsibility of State Governments, whereas telecommunication, post and telegraph,
customs, etc., are under the Central Government. These Departments help the government in smooth
delivery of welfare measures, maintenance of law and order and equality of opportunities. Though these
are not part of economic activities, yet Departments facilitate economic activities by providing a safe
and constructive environment.
Advantages of Public Sector
The advantages of public sector are as follows:
a. Balanced economic growth Private sector would not venture in areas in which profit is delayed
or uncertain; but the government can afford to wait for an enterprise to yield profit. Therefore, heavy
industries like iron and steel, natural gas, petroleum, or construction of dams and power projects are
mostly undertaken as PSEs. Because private players either may not like to enter in these areas or if they
do come, they may charge very high price for using these services, which may not be in the interest of
larger section of the society.
b. Employment generation A major objective of public sector has been to generate employment
opportunities by way of developing large industries.
c. Profits for public welfare Profits earned by the public sector go to the government, and are utilised
for the benefit of the society at large. Utilities like education and public health can be liberally financed
from the increased resources.
Limitations of Public Sector
The limitations of public sector are as follows:
a. Evils of bureaucracy Public sector suffers from all the ills of bureaucracy, such as delayed
decision-making, corruption, centralised power, etc. This has put a serious question mark on the very
existence of public sector and the justification for huge amount of national resources involved therein.
b. Absence of profit incentive Success of business lies in profit motive, but this is missing in the
public sector, since the government cannot aim for profits. At the same time, the objective of social
justice has created, as an appendage, the element of job security and has divorced performance and
remuneration. Hence, the employees of PSEs do not have the same incentive to perform as they have
in private service.
c. Extravagance and inefficiency There is little check on extravagance and inefficiency in the public
sector. There are no shareholders to question the directors in the annual meeting. Overheads are very
large resulting in high cost of production.
46
Managerial Economics
PuBLIc SEctor
In
IndIA
Public sector in India was established as per the First Industrial Policy
enunciated in 1948 and restated in 1956. Economic planners had
decided that for overall economic development of the nation all the
economic activities cannot be left in the hands of private initiatives.
The State Enterprises in India are run under
Development of infrastructure and public utility services like
three broad categories:
communication, gas, electricity, water supply, air and rail transport,
i. Public Sector Units
etc. were kept under public sector. These areas were where government
ii. Corporations and Boards and
had a monopoly to avoid profiteering by the private sector and to
iii. Departments
provide these services at affordable price to all the sections of the
society. A number of industries were exclusively reserved for the public sector, including basic and
heavy industries. However, with the era of liberalisation all this has changed and public investment has
been allowed in all of these areas. The State Enterprises in India are run under three broad categories:
(i) Public Sector Units (e.g., SAIL, BHEL, ONGC and IOC), (ii) Corporations and Boards (e.g., Coir
Board, Railway Board, and Food Corporation of India); and (iii) Departments (e.g., Telephone and
Telegraph, Education, and Health).
Public Sector in India was established as
per the First Industrial Policy enunciated in
1948 and restated in 1956.
For long, the public sector in India has played important role in the development of economy of
the country. However, disadvantages subsequently overweighed the advantages, resulting in mounting
deficits, inefficiency and sluggish growth. Hence, as an outcome of economic reforms, the role of public
sector in India has changed significantly over time. However, detail discussion on this issue is not
desirable here as it is out of scope of this book.
oBJEctIVES
oF
FIrM
Once we understand the various organisational structures and ownership forms, there is need to understand another important dimension of business, i.e., why do people do business? What motivates the
owners/investors/promoters to take so much of risk and conduct their own businesses, rather than going
for a secured employment? Is it only maximisation of profits that drives businesses? Or is it something
beyond? These questions have been puzzling scholars for a long time. The complication has been
Theory of Firm
47
multiplied by the evolution of different types of firm structures. Consider single ownership firms; it
would be reasonable to accept that single owners would aim at maximum profits. But what about other
forms of business? Do they also run on the same objective? From our earlier discussion in this chapter,
we have see that sole proprietorship forms had given way to partnership and joint stock structures, which
implies that businesses no longer remained restricted in the hands of a “single owner”. In other words,
emergence of other firm structures led to the evolution of “managers”, and owners and managers became
two distinct groups. Thus, profit making was conceived to be the sole objective of a business for quite a
long time, until scholars came up with alternate objectives of sales maximisation, and thereafter, growth
maximisation. These objectives further gave way to more advanced thought on “satisficing” as the
objective of an organisation and the perspective of separation of management from ownership.
Whatever be the form of ownership, one thing is definite, that every business has some objective,
which provides the framework for all the functions, strategies and managerial decisions of that business.
It determines both short-term and long-term perspective of the firm. We would deal with various
prominent thoughts on objectives of firm in the following sections.
1. Profit Maximisation Theory
Business is for profit; so the golden rule of business is that, one who According to profit maximisation theory,
takes risks will reap profits. This seems logical, doesn’t it? This is objective of business is generation of the
the most conventional thought, and also the most widely accepted largest amount of profit.
objective of a firm. Traditionally economists assumed that generation
of the largest amount of absolute profit over a period of time is the single most important objective of
a business organisation. This thought is based on the belief that an individual would risk one’s capital
and time for uncertain returns, only with the expectation of generating profits. Thus, traditionally the
efficiency of a firm is measured in terms of its profit generating capacity; profit is the only internal source
of funds; even the market value of a firm is largely dependent upon profits earned. Another argument
in favour of this objective is that, profit is must for long-term survival of any business. Normally profit
may be stated as following:
Profit = Total Revenue – Total Cost
…(1)
Nobel Laureate Milton Friedman supported profit maximisation on the ground that its validity cannot
be judged by opinions of some executives; rather its ultimate test of validity is that it has greater ability
to predict future business trends and practices. Others argue that whatever may be stated as the objective
of firm, the bottom line of balance sheet will always be important, that is the profit earned.
However, certain pertinent questions arise in accepting profit maximisation as the objective of the
firm. First of all, which measure of profit to consider among gross profit, net profit, net profit after
tax, and net profit before tax? The list would go on. Another question is which period of time to take
into account among current year, next year, next five years, and next 10 years? When we talk of future
profit then concept of time value of money comes in. Often managers have reported that the pressure to
focus on short-term profit has led them to take such decisions which ultimately have adversely affected
the long-term growth of the company. At the same time, validity of profit maximisation may also be
questioned in competitive markets, because it may be simply impossible to maximise profits in modern
times of high customer awareness and highly competitive markets.
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Managerial Economics
As is clear from the above discussion, accepting maximisation of profit as the objective of the firm
leaves various questions unanswered, and may even lead to a situation that answers to all of these
questions would vary from firm to firm.
All these, and similar questions gave rise to another objective of firm, namely maximisation of sales
revenue. This objective finds particular relevance in firms which face tough competition and in which
ownership is segregated from managers.
2. Baumol’s Theory of Sales Revenue Maximisation
Baumol raised serious questions on the validity of profit maximisation as an objective of the firm. He
stressed that in competitive markets, firms would rather aim at maximising revenue, through maximisation
of sales. According to him, sales volumes, and not profit volumes, determine market leadership in
competition. He further stressed that in large organisations, management is separate from owners.
Hence, there would always be a dichotomy of managers’ goals and owners’ goals. Manager’s salary and
other benefits are largely linked with sales volumes, rather than profits.
Baumol hypothesised that managers often attach their personal
Sales maximisation theory assets that
prestige to the company’s revenue or sales; therefore they would
managers attempt to maximise the firm’s
rather attempt to maximise the firm’s total revenue, instead of profits.
total revenue, instead of profits.
Moreover, sales volumes are better indicator of firm’s position in
the market, and growing sales strengthen the competitive spirit of the firm. Since operations of the
firm are in the hands of managers, and managers’ performance is measured in terms of achieving sales
targets, therefore it follows that management is more interested in maximising sales, with a constraint
of minimum profit. Hence, the objective is not to maximise profit, but to maximise sales revenue,
along with which, firms need to maintain a minimum level of profit to keep shareholder satisfied. This
minimum level of profit is regarded as the profit constraint.
However, empirical evidence to support above arguments of Baumol is not sufficient to draw any
definite conclusion. Whatever research has been done is based on inadequate data; hence the results
are inconclusive.
eality
ites
PSU Eyeing Bigger Bite of the Pie
Established in 1984, GAIL (India) Limited is listed by Forbes as one of the world’s 2,000 largest public
companies in 2007. The company aims to expand its core business of Natural Gas Transmission &
Marketing, to capture larger share of the growing market. The company wishes to move upstream to
secure gas supplies for the core transmission business. Further, the company is exploring and investing
in international opportunities with a strategic rationale of gaining international presence.
Sources: www.gailonline.com, accessed on 20/01/2008.
http://www.companieshistory.com/gail-india/ accessed on 15/05/2017.
Theory of Firm
49
3. Marris’ Hypothesis of Maximisation of Growth Rate
Working on the principle of segregation of managers from owners, According to growth maximisation theory,
Marris proposed that owners (shareholders) aim at profits and market owners (shareholders) aim at profits and
share, whereas managers aim at better salary, job security and growth. market share, whereas managers aim at
These two sets of goals can be achieved by maximising balanced better salary, job security and growth.
growth of the firm (G), which is dependent on the growth rate of
demand for the firm’s products (GD) and growth rate of capital supply to the firm (GC). Hence, growth
rate of the firm is balanced when the demand for its product and the capital supply to the firm grow at
the same rate.
Marris further said that firms face two constraints in the objective of maximisation of balanced
growth, which are as follows:
(i) Managerial Constraint Among managerial constraints, Marris stressed on the importance of
the role of human resource in achieving organisational objectives. According to him, skills, expertise,
efficiency and sincerity of team managers are vital to the growth of the firm. Non availability of
managerial skill sets in required size creates constraints for growth; organisations on their high levels
of growth may face constraint of skill ceiling among the existing employees. New recruitments may be
used to increase the size of the managerial pool with desired skills; however new recruits lack experience
to make quick decisions, which may pose as another constraint.
(ii) Financial Constraint This relates to the prudence needed in managing financial resources. Marris
suggested that a prudent financial policy will be based on at least three financial ratios, which in turn set
the limit for the growth of the firm. In order to prove their discretion managers will normally create a
trade off and prefer a moderate debt equity ratio (r1), moderate liquidity ratio (r2) and moderate retained
profit ratio (r3). (Let us mention here that the ratios used in the financial constraint are dealt with in detail
in any standard textbook on Financial Management and are beyond the scope of this book). However, a
brief description is given hereunder:
(a) Debt equity ratio (r1) This is the ratio between borrowed capital and owners’ capital. High
value of debt equity ratio may cause insolvency; hence, a low value of this ratio is usually preferred by
managers to avoid insolvency. However, a low value of r1 may create a constraint to the growth of the
firm in terms of dependence on high cost capital, i.e., equity.
Debt is a low cost source of capital as compared to equity.
(b) Liquidity ratio (r2) This is the ratio between current assets and current liabilities and is an
indicator of coverage provided by current assets to current liabilities. According to Marris, a manager
would try to operate in a region where there is sufficient liquidity and safety and hence would prefer a
high liquidity ratio. But a high r2 would imply low yielding assets, since liquid assets either do not earn
at all (like cash and inventory), or earn low returns (like short-term securities).
50
Managerial Economics
(c) Retention ratio (r3) This is the ratio between retained profits and total profits. In other words,
it is the inverse of dividend payout ratio, i.e., the retained profits are that portion of net profit which is
not distributed among shareholders. A high retention ratio is good for growth, as retained profits provide
internal source of funds. However, a higher r3 would imply greater volume retained profits, which may
antagonise the shareholders. Hence, managers cannot afford to keep a very high value of retention ratio.
Marris explained his hypothesis of Growth Maximisation with the help of set of functions which are
as follows:
G = G D = GC
…(2)
…(3)
GD = f(d, k)
…(4)
GC = f(r, p)
where is d is diversification; k is success rate; r is financial security ratio derived from weighted average of
three financial ratios and p is a constant rate at which profit increases).
The above proposition is subject the following constraints:
Um = f(salary, power, status, job security)
…(5)
where Um = Utility function of managers and
Uo = f(profit, market share, brand image)
where Uo = Utility function of shareholders
…(6)
The most interesting dimension in this model is that, although managers and owners (or shareholders)
have different utility functions, yet the two are highly correlated. Managers try to maximise their utility
function Um, but that is dependent upon growth of the company. Hence, managers must make efforts to
maximise GD and GC. On the other hand, Uo is maximised when G is maximised; hence for maximisation
of Um, managers must aim at maximisation of Uo. This results in forcing the managers to aim at keeping
all the above mentioned financial ratios at moderate levels.
Marris’ model, however, is not devoid of limitations. Though it gives a very simplistic solution to a
very complex problem and ignores the role of other constraints like government, social groups, elasticity
of demand, and phases of business cycle, which play a crucial role in determining the growth pattern of
the firm.
THINK OUT
OF
BOX
How long can a firm go without earning profits?
4. Williamson’s Model of Managerial Utility Function
As per Model of Managerial Utility
Function, managers apply their
discretionary power to maximise their
own utility function, with the constraint
of maintaining minimum profit to satisfy
shareholders.
Oliver Williamson’s model is a combination of the objectives of profit
maximisation and growth maximisation. Williamson emphasised
upon the fact that in modern businesses, ownership is separate from
management and modern managers have discretionary powers to set
the goals of firms. He further said that managers would apply their
Theory of Firm
51
discretionary power in such a way, as to maximise their own utility function, with the constraint of
maintaining minimum profit to satisfy shareholders. The utility function of managers, namely Um, is
dependent upon managers’ salary (measurable); job security, power, status, professional satisfaction
(all non measurable); and the power to influence firm’s objectives. To formalise the model, Williamson
took measurable proxy variables like perks of the manager, office facilities like company car, and slack
payments like a luxurious environment in the office, and expenditure that takes place at the discretion
of the manager, heading a large pool of workers, which is directly related to his power and status. Slack
payments are the ones whose removal may not make the manager leave the company, but their presence
not only ensures stable and better performance, but is also preferred by the manager, as these payments
are generally far less conspicuous than monetary benefits.
Williamson’s model can be written as following:
Um = f (S, M, ID)
…(7)
where Um is manger’s utility function; S is salary; M is managerial emoluments and ID is power of discretionary investment.
ID = pD
…(8)
where pD is discretionary profit
pD = Actual profit – Minimum profit – Tax
…(9)
Therefore, it can be said that:
Um = f (S, pD)
…(10)
S and are pD substitutable, i.e., an increase in S is only possible by decrease in pD and vice versa. It is
easy to understand that since S is represented in terms of salary and other benefits and is actually an item
of expenditure, it has negative relation with profit. Managers’ interest is in increasing their salary; hence
their goal is to maximise Um. At the same time, they are aware that they have to keep their shareholders
happy; therefore they try to find an optimum combination of S and pD.
eality
ites
Maximising Managerial Utility: The ITC Way
ITC envisions enhancing the wealth generating capability of the enterprise in a globalising environment,
delivering superior and sustainable stakeholder value. ITC’s core values are aimed at developing a
customer-focused, high-performance organisation which creates value for all its stakeholders. ITC’s
Corporate Governance initiative is based on two core principles:
i. Management must have the executive freedom to drive the enterprise forward without undue
restraints;
ii. This freedom of management should be exercised within a framework of effective accountability.
Source: www.itcportal.com, accessed on 20/12/2008.
52
Managerial Economics
5. Behavioural Theories
Behavioural theories of objectives of firms postulate that firms aim at
satisficing behaviour, rather than maximisation. Here we would discuss two of the most important of such models, namely Simon’s satisficing1 model and the model developed by Cyert and March.
Herbert Simon’s research focused on decision-making in
According to satisficing model firm has to
operate under “bounded rationality” and
organisations and his contribution to behavioural theories is renowned
can only aim at achieving a satisfactory
as “bounded rationality”. According to his Satisficing Model, the
level of profit, sales and growth.
biggest challenge before modern businesses is lack of full information
and uncertainty about future. Because of this, firms have to incur costs in acquiring information in the
present. In the face of both these aspects, the objective of maximising either profit, or sales, or growth
is not possible. In fact, they act as constraints to rational decision-making by any firm, because of which,
the firm has to operate under “bounded rationality” and can only aim at achieving a satisfactory level of
profit, sales and growth. Simon has suggested that managers would set an aspiration level and then aim
to achieve it. If their behaviour or performance exceeds the aspiration level, the target is increased; if it
fails to meet the aspired level, the target is brought down and a search behaviour is adopted simultaneously
to find the deviation in the behaviour pattern from the aspiration level.
The model developed by Cyert and March is a step ahead of
According to the model by Cyert and March,
Simon’s theory. It added that apart from dealing with inadequate
firms need to have multi goal and multi
information and uncertainty, businesses also have to satisfy a variety
decision-making orientation.
of stakeholders, who have different and oft-conflicting goals. Such
stakeholders would include shareholders, employees, customers, financiers, government, and other
social interest groups. All of these groups have their own goals; hence a firm cannot have a single
objective, and has to aim at a multi-dimensional goal. In other words, firms need to have multi goal
and multi decision-making orientation. However, in order to achieve such multiplicity of goals and
decisions, firms have to face many conflicts and have to develop means to resolve them. Thus, according
Cyert and March, a firm’s behaviour is ‘satisficing behaviour’, i.e., it aims at satisfying all stakeholders.
To meet this objective, managers form an aspiration level on basis of their past experience, past
performance of the firm, performance of other similar firms, and future expectations. These aspiration
levels are revised and modified on the basis of achievements and changes in business environment. Cyert
and March further suggest that the excess profit that firms accumulate during an industrial boom is used
to monetarily resolve conflicting demands by the following means:
i. Making cash payments in the form of bonuses, dividends, etc.
ii. Side payments in the form of general expenditure, to improve the overall work atmosphere.
iii. Slack payments that bring in a sense of happiness and satisfaction to the stakeholders.
However, the Cyert March hypothesis has been criticised on the same lines as Simon’s model,
that it lacks objectivity and cannot be used to predict a firm’s future direction. It fails to recognise
interdependence of firms, and it may not even work under dynamic business environments.
Behavioural theories propose that firms
aim at satisficing behaviour, rather than
maximisation.
1.
The term “satisfice” is a cross between satisfying and sufficing, used by Simon (1957).
Theory of Firm
53
PrIncIPAL AGEnt ProBLEM
From our previous discussions, we have seen that there is conflict Conflict of interests between the owners
of interests between the owners and the managers of a firm. As per and the managers of a firm is a principal
Williamson’s model, managers are more interested in maximisation of agent problem.
their own benefits, instead of maximising corporate profits. This is one
example of a principal agent problem, which arises in the context of firms and is an offspring of the
Agency Theory that had emerged during the 1970s. You would be wondering as to who the principal is
and who is the agent here? Let us explain with an example. Suppose you are planning to go for a pleasure
trip to Europe the next summer. You can either make all arrangements by yourself, or hire a travel agent
to plan your trip. Similarly, if you want to have LPG connection, you would contact your nearest LPG
agent. What are we hinting at, with such examples? You guessed it right: a principal agent relation. In
both these examples, you, the consumer, are the principal, and the service provider is the agent. In an
organisational setup, the owners are the principal while managers are the agents.
In an organisational setup, the owners are the principal while managers are the agents.
Why would you hire an agent to execute a particular task? A major reason is better knowledge of that
particular task with the agent. A travel agent you may hire to plan your trip to Europe would surely be
having better knowledge than you about the different places of interest, the tariffs of different hotels, and
so on! That way it is more convenient to let the agent plan the trip, isn’t it? In an organisational setup
the owners (principals) hire managers (agents) who work on a well
defined task, as the latter have better knowledge of the market and are Difference in information between two
parties in any transaction is termed as a
expected to steer the business. Now this difference in information state of asymmetric information.
between two parties in any transaction (typically in principal agent
problems cited here) is termed as information asymmetry, or a state of asymmetric information2.
Because of such asymmetry, the principal cannot directly observe the activities of the agent; the agent
may also know some aspect of the situation, which may be unknown to the principal. Let us explain this
with another example. Suppose a car manufacturing unit plans to launch a newly designed model. The
managers would have better knowledge of the market mood and competition position, in order to fix a
schedule for this launch as compared to the shareholders (the owners). This is due to asymmetric
information. Hence, owners (principal) will have to depend upon the wisdom of managers (agents) for
the purpose.
2
George Akerlof, Michael Spence and Joseph Stiglitz had jointly received the Nobel Prize in Economics for 2001 for their
contribution on asymmetric information.
54
Managerial Economics
What can be the possible consequences of asymmetric information? It can actually lead to two
main problems:
a. Adverse selection This refers to immoral behaviour that takes
advantage of asymmetric information before a transaction. The best
example is of medical insurance; a person who is not in perfect health
conditions may be more inclined to go for a life insurance policy than
someone who is fine in health. Akerlof had shown that hypothetically information asymmetry in the
market can either cause the entire market to collapse, or contract it into an adverse selection of low
quality products.
Adverse selection is immoral behaviour that
takes advantage of asymmetric information
before a transaction.
b. Moral hazard This refers to immoral behaviour that takes
advantage of asymmetric information after a transaction. For example,
if someone joins a job that offers health insurance, he/she may be more
likely to undergo medical treatment after joining the job, to reap the
benefits of the insurance.
In the organisational framework of asymmetric information, what are the possible solutions available
to the owners, to make their managers work in the interest of the organisation? There are several
solutions. The first and perhaps the easiest solution would be to minimise the information gap between the
principal and the agent. Another solution is to tie the managers’ rewards to organisation’s performance;
this would act as an incentive to managers, to act in the interest of the owners. Yet another way out is to
pass on some ownership to managers, as in case of stock options to employees.
To summarise it can be said that in modern business paradigm the ownership will normally be
separated from managers and growth of the organisation will largely depend upon decisions taken by
the managers; therefore it is necessary that a medium is evolved which serves the interest of both parties
in a “win-win” way.
Moral hazard is immoral behaviour that
takes advantage of asymmetric information
after a transaction.
Summary
◆
◆
◆
◆
We may divide business organisations into three broad categories: (i) private sector (wholly
owned by individuals, independently, or as a group), (ii) public sector (owned, managed and
controlled by government), and (iii) joint sector (owned and managed jointly by individuals and
government).
A sole proprietorship firm is one in which an individual invests own (or borrowed) capital and is
solely responsible for the results of operations.
A partnership is that form of ownership in which two or more individuals decide to start a common
business. Persons who have entered into partnership are individually regarded as ‘partners’ and
collectively as a ‘firm’.
A joint stock company (or “company”) is a legal entity, limited liability and has perpetual
existence.
Theory of Firm
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
55
A joint stock company may be a ‘private limited’ or ‘public limited’. A private limited company
cannot transfer shares to non-members, whereas public limited company can offer equity shares
to any one.
A cooperative is a non-profit, non-political, non-religious, voluntary organisation, formed with an
economic objective.
Public Sector in India has played important role in the development of economy of the country.
However, disadvantages subsequently overweighed the advantages, resulting in mounting deficits,
inefficiency and sluggish growth.
Every business has some objective, which provides the framework for all the functions, strategies
and managerial decisions of that business.
Many economists including Milton Friedman support profit maximisation as the objective of firm.
Baumol stressed that in competitive markets, firms would aim at maximising revenue, through
maximisation of sales. According to him, sales volumes, and not profit volumes, determine market
leadership in competition.
According to Marris, owners (shareholders) aim at profits and market share, whereas managers aim
at better salary, job security and growth. These two sets of goals can be achieved by maximising
balanced growth of the firm.
Oliver Williamson’s model is a combination of the objectives of profit maximisation and growth
maximisation, which proposes that managers would apply their discretionary power in such a
way, as to maximise their own utility function, with the constraint of maintaining minimum profit
to satisfy shareholders.
Herbert Simon’s Satisficing Model says that a firm has to operate under “bounded rationality” and
can only aim at achieving a satisfactory level of profit, sales and growth.
Cyert and March propose that businesses have to satisfy a variety of stakeholders, who have different and oft conflicting goals; hence a firm has to aim at a multi dimensional goal and exhibit a
‘satisficing behaviour’.
The conflict of interests between the owners (principal) and the managers (agent) of a firm is
known as principal agent problem.
Difference in information between two parties in any transaction is termed as information
asymmetry, or a state of asymmetric information.
In the organisational framework of asymmetric information, owners can make managers work
in the interest of the organisation by minimising the information gap in between; or by tying the
managers’ rewards to organisation’s performance.
Key ConCeptS
Sole proprietorship
Private and public sector
Profit maximisation
Growth maximisation
Partnership
Company
Sales maximisation
Principal agent problem
56
Managerial Economics
referenCeS
and
further reading
1. Akerlof, G. (1970). The Market for Lemons: Quality uncertainty and the market mechanism,
Quarterly Journal of Economics, Vol. 89, pp. 488–500.
2. Arrow, Kenneth J. (1963). Uncertainty and the Welfare Economics of Medical Care, American
Economic Review, Volume 53, No. 5, pp. 941–973.
3. Baumol, W.J. (1985). Economic Theory and Operational Analysis, Prentice-Hall of India.
4. Cyert, R.M. and March J. (1963). A Behavioural Theory of Firm, Prentice-Hall, New York.
5. Simon, H. A. (1957). Models of Man: Social and Rational, New York: Wiley.
6. Williamson, O.E. (1967). The Economics of Discretionary Behaviour: Managerial Objectives,
The Theory of Firm, Markhamm, Chicago.
QueStionS
Objective Type
I. State True or False
i. Profit is necessary to keep shareholders happy.
ii. Satisficing of a variable would imply maximising its value.
iii. The biggest disadvantage of PSUs is that they created the element of job security.
iv. In consumers’ cooperative, profits are divided among all the members.
v. Shareholders of a company elect its Board of Directors.
vi. Owners have better knowledge about the market than managers.
vii. Increase in profit is possible through increase in discretionary profit.
viii. Partners are mutual agents as well as principal.
ix. A sole proprietor firm has a distinct entity separate from its owner.
x. Moral hazard takes advantage of asymmetric information before a transaction.
II. Fill in the Blanks
i. A person who has health insurance would have _______ tendency to take risks.
ii. _________are generally far less conspicuous than monetary benefits.
iii. A manager would prefer a high ________ ratio.
iv. The profit earned in a joint stock company is divided in the form of _______on basis of shares.
v. In case of sole proprietorship any legal matter is settled in the name of the ______.
vi. Growth rate of demand for a firm’s product depends on success rate and
.
vii. Owners of debentures are
of the company.
viii. According to Simon, managers operate under
rationality.
Theory of Firm
57
ix. Availability of funds in a partnership firm is dependent on
of the partners.
x. Ownership of capital investment lies with the
in case of a PSU.
III. Pick the Correct Option
i. Advantages of sole proprietorship include all of the following except:
a. Speedy decision-making
b. Transcending trade secrets
c. Shared fruits of business
d. Easy inception
ii. Balanced growth of the firm is dependent on:
a. Growth rate of demand for the firm’s products
b. Success rate of business
c. Brand image of the firm
d. Utility function of managers
iii. Public sector suffers from all the following evils except:
a. Delayed decision-making
b. Corruption
c. Decentralised power
d. Lack of incentive to perform
iv. A cooperative is:
a. A non-profit organisation
b. A political organisation
c. A religious organisation
d. A proprietory organisation
v. Find the odd one out:
a. There is no limit on the maximum number of members in a public limited company.
b. A joint stock company is a legal entity and its existence is independent of its members.
c. Risk is divided in case of a partnership firm.
d. A private limited company can raise capital by selling its shares to outside public other than
the members.
vi. Retention ratio is the ratio between:
a. Borrowed capital and owners’ capital
b. Retained profits and total profits
c. Current assets and current liabilities
d. Retained profits and net profits
vii. Which of the following only is true about a government department?
a. It aims for revenue generation.
b. It is a part of economic activities.
c. It is run for a social utility.
d. It looks after small economic units.
viii. Which of the following ways is NOT adopted by a firm to make good of excess profits?
a. Cash payments
b. Debt payments
c. Slack payments
d. Side payments
ix. A partnership deed would have which of the following information?
a. Details of dependants of the partners
b. Other sources of income of the partners
c. Interest on a partner’s capital
d. Investment record of a partner in other businesses
58
Managerial Economics
x. Manager’s utility is a function of all except which of the following?
a. Salary of a manager
b. Actual profit
c. Discretionary profit
d. Discretionary investment
Analytical Corner
1. “Segregation of ownership from management works against the objective of profit maximisation”.
Do you agree with this statement? Why? Or why not?
2. “It is more advisable to form a company than a partnership”. Do you agree with this statement?
Give justification for your answer.
3. “A cooperative is the most ideal form of business still it is not very popular”. What are the reasons
for this in your opinion?
4. Why is a formally documented partnership deed in the interest of all the partners? Explain with
suitable example.
5. Search for a public sector unit and another in the private sector in the same industry, and discuss
the difference in their performances.
6. Discuss the advantages and limitations of forming a joint stock company.
7. Relate the principal agent problem with Williamson’s theory of Maximisation of Managerial
Utility function.
8. Discuss the three constraints discussed in Marris’ theory and their role in achieving growth
maximisation.
9. On a critical note, which one among the theories on objectives of a firm do you think is the most
relevant in present business scenario in India?
10. Consider the Public Sector in India. Project all the theories on objectives of a firm on any PSE.
Which one fits the best? Why? Which is the most unfit? Why?
11. We have discussed some solutions to the principal agent problem in an organisational set up.
Which one among these, according to you, bears the maximum amount of risk? Why?
12. How can managers (agents) be better off than owners (principals) by having more knowledge than
the latter?
13. You have been recently promoted as general manager sales of a multinational company producing
various consumer goods. As part of your responsibilities you have been given a target of increasing
market share. But the board of directors wants high profits. Whereas looking at competition you
know that price reduction is necessary to increase demand. What will you do?
14. Consider the following examples and comment on them:
i. Five persons want to start a software company. What is the most suitable form of organisation
for them and why?
ii. A person who owned a small retail store died in road accident. He had taken loan from bank
for the purchase of this store. What will happen to the store?
iii. Board of directors of a company were holding annual general meeting when a fire broke out
and all of them died in that fire. What happens to the company?
Theory of Firm
59
Check Your Answers
State True or False
i. T
ii. F
iii. T
iv. F
v. T
vi. F
vii. F
viii. T
ix. F
x. T
viii. b
ix. c
x. b
Fill in the Blanks
i.
iv.
vii.
x.
more
dividends
creditors
government
ii. Slack payments
v. owner
viii. bounded
iii. liquidity
vi. diversification
ix. creditworthiness
Pick the Correct Option
i. c
ii. a
iii c
iv. a
v. d
vi. b
vii. c
Caselet 1
The Utterly, Butterly Cooperative
Headquartered at Anand, Gujarat, the Kaira District Co-operative Milk Producers’ Union had
introduced the brand Amul (derived from Sanskrit word ‘Amulya’ meaning ‘priceless’ or precious’)
in 1950s for marketing its product range. The ‘Anand Pattern’ represents an economic organisational
pattern to benefit small producers who join hands forming an integrated approach in order to gain
economies of a large scale business. The National Dairy Development Board (NDDB), established
at Anand in 1965, had incepted the dairy development programme for India popularly known
as “Operation Flood” or “White Revolution” in 1969–70, which stands to be the largest dairy
development programme ever drawn in the world. The man behind this revolutionary upliftment in
the socio-economic conditions of milk producers is Mr. Verghese Kurien.
At present, there are a total of 17 District Co-operative Milk Producers’ Unions federated to
Gujarat Co-operative Milk Marketing Federation Ltd. (GCMMF), Anand. GCMMF was recently in
news for its announcement to launch camel milk in 2017.
Source:
https://www.amuldairy.com/index.php/about-us/history, accessed on 15/05/2017.
Case Question
1. What are the factors which led to the success of Amul model while many other cooperatives
failed?
60
Managerial Economics
Caselet 2
Asymmetric Information in Healthcare
India’s record in improving health outcomes has been dismal despite years of rapid economic growth.
Poor health in the country is largely a result of poor policy and low public investments. Though
insurance seems to be an attractive market solution, but the market for medical insurance suffers
from two well-identified market failures, namely, adverse selection and moral hazard. The problem
of adverse selection emerges when insurance premium increases because only a few high-risk buyers
are chosen for insurance, driving other willing buyers out of the market. The problem of moral hazard
occurs when people who choose insurance have little or no incentive to keep their bills low. Since
these bills are reimbursable and hospitals want to minimise their costs, people who require high-cost
healthcare are driven out of the market.
Sources:
http://www.livemint.com/Opinion/riNdqyWpnMc2RUWfLq00nL/The-economic-case-for-universalhealthcare.html, accessed on 15/05/2017.
http://www.oecd-ilibrary.org/economics/improving-health-outcomes-and-health-care-inindia_5js7t9ptcr26-en, accessed on 15/05/2017.
Case Questions
1. Describe the problem of information asymmetry in insurance.
2. How can insurance companies reduce the risk of adverse selection and moral hazard?
Case 1
Vistara: Scaling New Heights in the Skies
Vistara, a full-service airline, is a joint venture between Tata Sons Ltd. and Singapore Airlines (SIA),
with Tata Sons holding the majority stake of 51 percent and SIA holding the remaining 49 percent. The
company has drawn its name from the Sanskrit word Vistaar, which means limitless expanse, thus aiming for limitless possibilities. The name also contains the word tara, a star, depicted in the company’s
logo, the Vistara Star.
The core purpose of Tata group is to improve the quality of life of the communities it serves globally,
through long-term stakeholder value creation based on leadership with trust. Vistara believes in upholding the highest ethical standards in line with the Tata Group’s philosophy, with its business conduct
guided by the tenets of the Tata Code of Conduct. Employees and associates of Vistara are expected to
be aligned to the Code in letter and spirit.
With commitment to fleet modernisation, product and service innovation and market leadership,
Singapore Airlines operate a modern passenger fleet of more than 100 aircrafts and its network covers a
total of 109 destinations in 40 countries. Vistara brings together the legendary hospitality and renowned
Theory of Firm
61
service excellence of Tata and SIA, to create memorable and personalised flying experiences for its
customers. Core values of brand Vistara include excellence that surpasses customer expectations,
thoughtfulness that demonstrates empathy and understanding, trust that upholds integrity, fairness
and transparency, innovation to deliver operational excellence and cost leadership, and teamwork by
building collaboration and diversity. Obsessed with quality, the company aims to set new standards in
the aviation industry in India, with international best practices and state-of-the-art technology in the
Indian air transport sector. The brand personality of Vistara exudes an elegant and refined spiritedness,
reflecting a service experience that will be tech savvy, meticulous and authentic.
Source:
https://www.airvistara.com/trip/press-releases, accessed on 5/05/2017.
Posers
1. What could be the possible objectives of the Tata Group to launch Vistara?
2. Which of the theories of firms, according to you, is adopted by Vistara?
Case 2
Dabur India Limited: Growing Big and Global
Dabur is among the top five FMCG companies in India and is positioned successfully on the specialist
herbal platform. Dabur has proven its expertise in the fields of health care, personal care, Homecare
and Foods.
The company was founded by Dr. S. K. Burman in 1884 as a small pharmacy in Calcutta (now Kolkata), India and is now led by his great grandson Vivek C. Burman, who is the Chairman of Dabur India
Limited and the senior most representative of the Burman family in the company. The company headquarters are in Ghaziabad, India, near the Indian capital New Delhi, where it is registered. The company
has over 12 manufacturing units in India and abroad. The international facilities are located in Nepal,
Dubai, Bangladesh, Egypt and Nigeria.
The company faces stiff competition from many multinational and domestic companies. In the
Branded and Packaged Food and Beverages segment major companies that are active include Hindustan
Lever, Nestle, Cadbury and Dabur. In case of Ayurvedic medicines and products, the major competitors
are Baidyanath, Vicco, Jhandu, Himani and other pharmaceutical companies.
Vision, Mission and Objectives
Vision statement of Dabur says that the company is “Dedicated to the health and well being of every
household”. The objective is to “significantly accelerate profitable growth by providing comfort to
others”.
62
Managerial Economics
Leading Brands
More than 300 diverse products in the FMCG, Healthcare and Ayurveda segments are in the product line
of Dabur. List of products of the company include very successful brands like Vatika, Anmol, Hajmola,
Dabur Amla Chyawanprash and Lal Dant Manjan with turnover of `100 crore each.
Strategic positioning of Dabur Honey as food product, lead to market leadership with over 40%
market share in branded honey market; Dabur Chyawanprash is the largest selling Ayurvedic medicine
with over 65% market share. Dabur is a leader in herbal digestives with 90% market share. Hajmola
tablets are in command with 75% market share of digestive tablets category. Dabur Lal Tail tops baby
massage oil market with 35% of total share.
CHD (Consumer Health Division), dealing with classical Ayurvedic medicines has more than 250
products sold through prescriptions as well as over the counter. Proprietary Ayurvedic medicines
developed by Dabur include Nature Care lsabgol, Madhuvaani and Trifgol.
However, some of the subsidiary units of Dabur have proved to be low margin business; like Dabur
Finance Limited. The international units are also operating on low profit margin. The company also
produces several “me-too” products. At the same time the company is very popular in the rural segment.
Sources:
http//www.daburindia.com, accessed on 15/05/2017.
http//en.wikipedia.org/wiki/Dabur, accessed on 15/05/2017.
Posers
1. What is the objective of Dabur? Is it profit maximisation or growth maximisation? Discuss.
2. Do you think the growth of Dabur from a small pharmacy to a large multinational company is an
indicator of the advantages of Joint Stock Company against proprietorship form?
Part
2
Consumer Behaviour,
Demand and Supply
Demand is the basis of all economic activities. Don’t they say that necessity is the mother of invention?
This may also be read as ‘demand is the mother of production’. Before we tell you about production,
pricing and related aspects, it is necessary that you learn everything about demand. Part 2 deals with
consumer preferences and choice, demand and supply analysis, elasticities and demand forecasting.
Everything and anything that one may like to know about demand theory is included in the four
chapters in this part; and sufficient care has been taken to draw a connecting path to the next part
where you will learn about production and cost.
Chapters
3.
4.
5.
6.
Consumer Preferences and Choice
Demand and Supply Analysis
Elasticities of Demand and Supply
Demand Forecasting
Chapter
3
Consumer PreferenCes
and ChoiCe
2. Explain the nuances of utility analysis, marginal utility, total utility and law of
diminishing marginal utility.
3. Find the difference between cardinal and ordinal utility analyses of consumer
behaviour.
4. Discuss how consumer equilibrium is attained subject to budget constraint.
5. Illustrate the concept of consumer surplus and its application in decision-making.
Chapter Objectives
1. Introduce the crux of consumer behaviour, choices and preferences.
IntroductIon
You have learnt that as a consumer you have to satisfy your unlimited wants with limited resources.
Therefore, you are expected to prioritise your wants on the basis of urgency and intensity of such wants
and your paying capacity, i.e., income. Recall the last time when you bought a shirt, you had so many
options, which brand, which colour, striped or checked, and what price range? Or when you bought a
television, or a watch, or a textbook of managerial economics, your purchase manifested your choice
and preference. At times, you might have found it very easy to take a decision of purchasing a particular
commodity, especially when you have a clear picture of your preference in mind. For example, you
would never miss the first show of a Shah Rukh Khan movie; on the other hand, while buying salt, any
brand will be acceptable to you. In real life, you do not buy a single commodity at a time; you may be
consuming many commodities, like a burger with a soft drink; tea with snacks; and so on. You can see
these are complementary goods. Similarly, you may have bought a pair of leather shoes and sneakers;
they satisfy the same want, but would differ in utility. Interestingly, producers (or sellers) are also keen to
know consumers’ preference and choices. An insight into consumers’ buying behaviour and perception
helps firms in identifying new marketing variables such as product offering, pricing strategy, promotion,
transportation and communication, and a host of other pertinent variables. The basis of consumer’s
buying behaviour is the concept of utility.
66
Managerial Economics
In this chapter, we would talk about dimensions of consumer choice and preferences through two
schools of thought, namely cardinal utility and ordinal utility analysis.
eality
ites
Bottled Water: A New Social Phenomenon
Bottled water is the most dynamic sector of the food and beverage industry across the world. In pre
liberalised India, the bottled water market was miniscule, catering to only the upper strata of society,
travellers and conference meetings in five star hotels. But over the last 10 years, it has witnessed
tremendous growth. The change is very much evident. From a mere 60 towns in the year 1997, it is
predicted that mineral water is today available in more than 1000 towns and cities across India. With
a compounded annual growth rate of close to 30% over the last decade, the mineral water market has
witnessed a large growth in terms of volume.
However, in comparison to the global scenario, the Indian market is a very small one; the per
capita consumption of mineral water in India is a mere 0.5 litres compared to 111 litres in Europe and
45 litres in USA. This is in spite of the fact that the consumers in industrialised countries have access
to cheap good quality tap water. Bottled water has come out of merely a matter of fashion among elite
to common persons.
Sources: Catherine Ferrier, Discussion Paper on Bottled Water: Understanding a Social Phenomenon, Report
commissioned by WWF, April 2001.
www. exampleessays.com/viewpaper/51194.htm, accessed on 26/1/2008.
consumer cHoIce
Demand for a commodity is determined by various factors, including income and tastes of the consumer
and price of the commodity. Given the prices of different commodities, consumers need to decide on
the quantities of these commodities according to their paying capacity and tastes and preferences. You
would agree that the most difficult task is to identify an individual’s taste and preferences because
these in turn depend upon several other factors like age, education, socioeconomic background and
even religious beliefs. Still sellers have to take various important production decisions on the basis of
consumers’ tastes and preferences. Therefore, economists have tried to explain consumers’ choice and
behaviour in terms of utility.
Underlying Assumptions
The explanation of consumers’ choices, tastes and preferences rests on the assumptions discussed in
this section.
Completeness
It is assumed that a consumer would be able to state own preference or indifference between two
distinct baskets of goods. There is, thus, no room for ambiguity or confusion. Let us explain this with
Consumer Preferences and Choice
67
the example of a consumer who is faced with two commodities, say pizza and burger. The assumption
of completeness necessitates either of the following:
a. pizza is preferred to burger; or
b. burger is preferred to pizza; or
c. the consumer is indifferent between pizza and burger.
Transitivity
This assumption implies that an individual consumer’s preferences are always consistent. If you have
preferred pizza to burger, and burger to pasta, then it can be deduced that you would prefer pizza over
pasta too. Or if you were indifferent between pizza and burger and also indifferent between burger and
pasta, you would be indifferent between pizza and burger.
Here we introduce the third assumption, without which consumer’s choice may not remain consistent.
Non-satiation
A consumer is never satiated permanently. More is always wanted; if “some” is good, “more” of the good
is better. A bigger pizza is preferred to a smaller one; two burgers are preferred to one pizza and two
pizzas to one burger. A package of one pizza and two burgers is preferred to the bundle of only one pizza
and one burger. However, non-satiation is not a fundamental condition, because rational consumers get
satiated after a certain limit.
These assumptions are meant to create the foundation of consumer satisfaction and behaviour in your
mind, and help develop an understanding of utility analysis.
Utility Analysis
We make our consumption decisions on the basis of utility (or Utility is the attribute of a commodity to
satisfy or satiate a consumer’s wants.
usefulness) of different commodities. Commodities are desired
because of their utility, i.e., their ability to satiate wants. The notion of utility owes its origin to Jeremy
Bentham (1748–1832). So what is utility?
Utility is the satisfaction a consumer derives out of consumption of a commodity. It may also be
defined to be an attribute of a commodity to satisfy or satiate a consumer’s wants. You would agree that
the concept of utility is somewhat abstract; yet utility analysis is one of the corner stones of consumer
behaviour, because consumption as an act itself is driven by utility.
Mathematically, we can express utility as the function of the quantities of different commodities
consumed. If an individual consumes quantity m1 of a commodity M, quantity n1 of N, and r1 of R, then
the utility function U of the consumer can be expressed as:
U = f(m1, n1, r1)
…(1)
68
Managerial Economics
As you proceed in this chapter, you would see that a rational consumer would aim at maximising his
utility from consumption of different commodities, subject to budget constraint. Now, in order to
maximise utility, we need to ascertain how much value is associated with the utility function of each
consumer. This has been an issue of concern to economists for long, and they have come up with
different views on such optimisation behaviour of consumers.
A rational consumer aims at maximising
Primarily, these can be divided into cardinal utility analysis and ordinal
his/her utility from consumption of
utility analysis. The cardinal school believes that utility is quantifiable
different commodities, subject to budget
in units, whereas the ordinal school posits that utility cannot be
constraint.
measured, rather can be only shown as higher than or less than ranks.
eality
ites
Consumer Perceptions: Virtual Security
In a country, like India, there is need for providing better and cost efficient banking services to the
masses. Customers look for ease in performing banking transactions, along with more and updated
information, when they adopt Internet banking. Internet banking users weigh excellent services the
most, followed by brand name.
There is a greater concern for security among the non-users of internet banking and there is a need to
introduce such security measures which are valued more by the customers; these include high security
password on mobile, tips on the website, automatic lock out on multiple incorrect password entries, etc.
It is important for the banks to study not only the perception of the people who are coming to the bank
as customers but also of those who are using the Internet for various purposes other than banking.
Source: Geetika, Nandan, T., Upadhyay A. (2008). Issues And Prospects of Internet Banking in India: A Customer
Perspective, ICFAI Journal of Bank Management, Vol. II, May 2008.
Cardinal Utility
Earlier economists like Marshall and Jevons opined that utility is
measurable like any other physical commodity and proposed “utils” as
its unit. According to them, utility is a cardinal concept, and we can
assign number of utils to any commodity. Moreover, according to the
cardinalists, utility is additive, i.e., we can add the utility of
Total utility refers to the sum total of utility
commodities. Say for a particular consumer a banana can have 2 utils,
levels out of each unit of a commodity
while a mango may have 3 utils. If an individual consumes a mango
consumed within a given period of time.
and a banana, then, following the same example, total utility derived
by the consumer is equal to 2 + 3 = 5 utils. In this way, the total utils of a consumption basket for any
consumer may be calculated and comparison can be made across individual consumers on the basis of
utils over their baskets. Now we shall understand the concepts of total and marginal utility.
According to cardinalists, utility is a cardinal
concept, and we can assign number of utils
to any commodity.
69
Consumer Preferences and Choice
Total and Marginal Utility
Total utility (TU) refers to the sum total of utility levels out of each
Marginal utility is the total utility of
unit of a commodity consumed within a given period of time, or in the additional unit consumed of the
other words, total satisfaction from consumption. Thus, if a consumer commodity.
has three apples, his total utility will be the sum of the utility derived
out of each apple. Marginal utility (MU) is the change in total utility due to a unit change in the
commodity consumed within a given period of time. In other words, marginal utility is the total utility
of the additional (or nth) unit consumed of the commodity. In other words:
…(2)
MU = TUn – TUn–1
Using calculus, we may express marginal utility as:
MU =
THINK OUT
OF
∂TU
∂Q
…(3)
BOX
Why is time of consumption vital in measuring utility?
As a consumer continues to have more and more units of a commodity, his total utility increases, but his
marginal utility diminishes.
Law of Diminishing Marginal Utility
As per the law of diminishing marginal
As you consume more and more units of a commodity, total utility
utility, marginal utility for successive units
would go on increasing, but only up to a certain point, beyond which, consumed goes on decreasing.
if you continue to consume any subsequent unit, the total utility will
start decreasing. This can be explained with the help of the law of diminishing marginal utility. Let us
explain the law with a simple example. Suppose Saumil has strong liking for sandwiches; his utility
function for consumption of sandwiches is summarised in Table 3.1.
Table 3.1
Total and Marginal Utility
Units of Consumption
TU
MU
0
0
—
1
20
20
2
36
16
3
46
10
4
52
6
5
55
3
6
55
0
7
50
–5
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Managerial Economics
Till Saumil had not consumed any sandwich, his satisfaction level was nil; hence his total utility
derived was zero. The very first sandwich gives him maximum satisfaction, i.e., 20 units, because he had
strong desire to have one. You would see that total utility is increasing with each successive sandwich,
but marginal utility is declining. The sixth sandwich gives him no additional satisfaction and MU for the
sixth sandwich is zero; thus, total utility derived from the fifth and sixth units is same. Any consumption
beyond this point will lead to a fall in total utility to 50 units, because marginal utility from the seventh
unit of sandwich is minus five, which implies disutility or dissatisfaction out of excess consumption. No
rational consumer would continue consumption till this level.
Graph 3.1 illustrates the table through Total Utility Curve (TU Curve) and Marginal Utility Curve
(MU Curve).
Total and Marginal Utility
TU, MU of Sandwich
60
50
40
30
TU
MU
20
10
0
–10
1
2
3
4
5
Quantity of Sandwich
6
7
Graph 3.1 Total and Marginal Utility Curves
In Graph 3.1, you can see that when MU is zero (at the sixth unit), TU is at its maximum and is
constant at the previous level. As explained, no rational consumer would continue consumption beyond
the sixth unit. This will be the point of saturation or satiety of Saumil’s desire to consume sandwich
for the particular time. The downward trend of the MU curve is the outcome of the law of diminishing
marginal utility.
The TU and MU curves have also been explained through Figures 3.1 and 3.2, where X indicates the
commodity being consumed.
Fig. 3.1 Total Utility
Fig. 3.2
Marginal Utility
Consumer Preferences and Choice
71
Assumptions
The law of diminishing marginal utility is based on certain assumptions, absence of which may create
exceptions to the law. Such assumptions are as follows:
(i) The Unit of Consumption must be a Standard One
Too large or too small units would not
validate the law. Thus, in the above example, if Saumil was given a small bite every time, the law
would not hold good.
(ii) Consumption must be Continuous
Gap between consumption of two successive units will
invalidate the law. As in our example, if every next sandwich is taken at an interval of two hours,
the utility will not diminish with successive units of consumption because the need for hunger
will remerge.
(iii) Multiple Units of the Commodity should be Consumed
In other words, demand for the
commodity should be of a recurring nature. The law normally does not apply to durable consumer
goods like house, cars, etc.
Let us change our example to understand this assumption. Suppose Saumil wants to buy a
luxury car. At any point of time, he will not buy two luxury cars; he may buy a car today and
will only like to replace it after substantial number of years of use. Hence, the law of diminishing
marginal utility cannot be explained in case of durable goods.
(iv) The Tastes and Preferences of the Consumer should Remain Unchanged during the Course
of Consumption You can see that we started our example with the statement that Saumil has
strong liking for sandwiches. If after three sandwiches he is offered cold coffee which he likes a
lot, he may not continue consumption beyond the third unit. Because it is possible that utility from
the first glass of cold coffee for Saumil is equal to nine; thus he maintains his total utility at 55.
(v) The Good should be Normal and Not Addictive in Nature
Many goods like cigarettes,
alcohol etc., are consumed due to addictions, in such cases it is likely that the law does not set in.
Such consumption is governed by compulsive behaviour and does not follow the rule of rationality.
Rational consumer would always try to maximise total utility.
Law of Equimarginal Utility
So far we have explained utility with a single commodity. But in real As per the law of equimarginal utility,
marginal utilities of all commodities should
life a consumer buys multiple commodities at the same time to satisfy be equal.
diverse wants. As Saumil may like to consume sandwiches with cold
coffee, he may also like to buy a luxury car, send his children to good schools and take membership
of a health club and all at the same time, say in the same month! How would he know what amount
of his income to spend on each of these commodities? The law of equimarginal utility explains how a
consumer would spend his income on different commodities.
72
Managerial Economics
Utility from the last unit consumed is the marginal utility.
We begin with the assumption that the consumer has a fixed income and determines purchase decision
on the basis of prices of different commodities to be consumed. According to the law of equimarginal
utility, a consumer will maximise utility when the marginal utility of the last unit of money (say, Rupee)
spent on each commodity is equal to the marginal utility of the last Rupee spent on any other commodity.
The consumer, thus, has to distribute his/her income in purchasing different commodities in such a
manner that the utility derived from the last unit of each commodity is equal for all commodities in the
consumption basket. Thus, as per this law, marginal utilities of all commodities should be equal. The
underlying logic is simple. If the utility from a commodity M is more than that from another commodity
N, then the consumer would reduce consumption of N and increase consumption of M. The common
marginal utility per Rupee spent on all commodities is referred to as the marginal utility of income. The
law of equimarginal utility can be expresed as:
MU M MU N
=
= º = MU I
PM
PN
…(4)
where MUI is the marginal utility of income.
Marginal Utility and Demand Curve
From the previous discussion you surely understand that a consumer would continue to consume
subsequent units of a commodity till the marginal utility of the commodity is equal to its own price. In
the next chapter you would get to see that a normal demand curve slopes downward; this can be further
explained with the help of diminishing marginal utility. You can see that in Figure 3.3, the MU curve
coincides with the DD curve.
In Figure 3.3, the marginal utility curve of commodity
MU is downward sloping. For any given amount of income
when price of the commodity is PC , the consumer would
consume QC quantity of the commodity. This corresponds
to point C on the MU curve, where MU = PC. When price
MU
increases to PB, the ratio
would fall below MUI in
P
equation (4). The consumer, thus, has to readjust consumption
to ensure restoring of the equality. Thus, the consumer would
reduce the consumption of the good; this will increase the
MU
is
marginal utility of the commodity until the new
P
again equal to MUI (as per equation (4)). This corresponds to
Fig. 3.3
Marginal Utility and Demand
Curve
point B on the MU curve. Similarly, when price increases further to PA, the consumer would consume
a further lower amount QA. This would correspond to the point A. The bottomline is thus clear, as price
goes on increasing, the desired consumption of the commodity for the consumer goes on diminishing.
This would lead us to the individual demand curve of the commodity. Points A, B, C, and so on, would
lie on the demand curve of the consumer for commodity M.
Consumer Preferences and Choice
73
eality
B ites
“The Coke Side of Life”
“The beverages in our portfolio must offer an appropriate level of sweetness and functional benefit. And
not just taste but right packaging and communication,” opined Mr. Marc Mathieu, Senior Vice President,
Global Marketing and Creative Excellence (The Coca Cola Company). He further says that there are
moments where consumers want to be more focused on nutritional values, and there are moments
when one requires mental change. Sometimes one wants vitality and energy boost; youth wants to live
life with utmost joy and optimism. Therefore, he insists that it is company’s responsibility to ensure that
it caters to different needs of its consumers.
Source: Mukherjee and Dobhal, Economic Times, 9/01/2008.
consumer preFerences
Ordinal Utility
The ordinal utility theory is a major departure from the cardinal Under ordinal utility, it is the ranking of
school, as it negates the physical measurement of utility. The most utility that is important, not its magnitude.
prominent propounders of this school were Edgeworth and Fisher.
According to ordinal utility theory, utility cannot be measured in physical units rather the consumer can
only rank utility derived from various commodities. Thus, according to the ordinal approach, utility is
not additive. However, it is possible that the consumer may find two different bundles of goods equal
in terms of utility. Saumil may like to consume either (a) three sandwiches and one glass of cold coffee
or (b) two sandwiches and two glasses of cold coffee; thus he is indifferent between (a) and (b). Or he
may prefer three sandwiches and two glasses of cold coffee to two sandwiches and two glasses of cold
coffee. When these combinations of two goods are shown on a graph, they represent a curve which is
called indifference curve.
Indifference Curve Analysis
The realms of consumer behaviour were expanded to new horizons
with the introduction of indifference curve analysis by J.R. Hicks According to ordinal school, a consumer
is able to rank different combinations of
and R.G.D. Allen. The crux of this analysis is that utility is ordinally the commodities in order of preference or
measurable. From the above discussion on ordinal approach, you can indifference.
promptly infer that given two commodities M and N, a consumer is
able to rank different combinations of the commodities in order of preference or indifference. If we
plot the quantities of the two commodities on the two axes, then we can draw a set of points that would
represent alternative combinations of M and N, between which the consumer would be indifferent. The
curve formed by joining such points is known as an indifference curve.
Indifference between two bundles of goods implies equal preference.
74
Managerial Economics
maycurvedefine
An We
indifference
is the locusan
of points
which show the different combinations of
two commodities a consumer is indifferent
about.
indifference curve as the locus of points which show the different
combinations of two commodities a consumer is indifferent about.
Since all these points render equal utility to the consumer, an
indifference curve is also known as an isoutility (“iso” meaning equal)
curve. The tabular representation of such combinations is referred to
as the indifference schedule.
Table 3.2 gives the indifference schedule between two
commodities, say sandwich and cold coffee, consumed per unit
of time. All the different combinations render the same level
of total utility, namely U. The first column of the table shows
the corresponding points when plotted on graph. On joining
all such points, we get what is known as an indifference curve,
shown as I in Figure 3.4. Graph 3.2 shows the indifference
curve drawn to scale from the figures given in Table 3.2. Let us
Fig. 3.4 Indifference Curve
explain the various aspects of such a curve now.
Table 3.2
Indifference Schedule
Combination
Sandwich (M)
Cold coffee (N)
TU
A
1
6
U
B
3
3
U
C
4
2
U
D
7
1
U
Cold coffee (glass)
per unit of time
Indifference Curve
7
6
5
4
3
2
1
0
1
3
4
Sandwiches per unit of time
7
Graph 3.2 Indifference Curve
Each point on an indifference curve represents a consumption basket, having a combination of the
two goods consumed. Thus, point A on the curve shows a combination of 1 sandwich and 6 glasses
of cold coffee, which would give the consumer the same level of satisfaction as 3 sandwich and 3
glasses of cold coffee, shown by point B, or 5 sandwich and 2 glasses of cold coffee, shown by point
C, or 7 sandwich and 1 glasses of cold coffee, shown by point D. You may, thus, infer that the level of
satisfaction remains the same at all points on the same indifference curve and the consumer would as
such be indifferent between all such combinations of the two goods consumed.
Consumer Preferences and Choice
75
The consumer can make many more combinations of the two goods, with less of any one, or both
of the goods. Points below an indifference curve will have lesser utility than any point on the curve. In
Panel “a” of Figure 3.5, an indifference curve (say, I0) can be drawn through points below I1; each point
on such a curve would give lesser satisfaction than points on I1. Similarly, an indifference curve (say,
I2) can be drawn through points above I1; each point on such a curve would render greater satisfaction
than those on I1. In fact, it is possible to draw numerous such curves like I0, I2 and I3, each representing
a unique level of utility and none intersecting any other. The family of such indifference curves, shown
in Panel “a”, is referred to as the indifference map.
Assumptions
You know that the basic premise is that the consumer is rational; besides the indifference curves analysis
is based on certain other assumptions:
i. At any given point of time, the consumer has only two goods in his/her consumption basket.
ii. It is not possible to quantify the utility availed from the consumption rather the consumer is able
to rank his/her preferences on a scale.
iii. The consumer is never completely satisfied; this is in accordance to the assumption on nonsatiation you have read earlier in this chapter. In other words, more is always wanted.
iv. The consumer is consistent in his choices. This implies that if a consumer is indifferent
between butter and ghee, and between ghee and cheese, he would be indifferent between butter
and cheese as well. Yes, you got it right: this is the same as the assumption of transitivity discussed
earlier.
v. The two goods under consideration are perfectly divisible in small units. This implies that
indifference curves would be continuous in nature.
Properties of Indifference Curves
(i) Downward Sloping Indifference curves are downward sloping. This is because of the assumption
of non-satiation. You know that an indifference curve shows various such combinations of two goods
which give same utility to the consumer. As per assumption of non-satiation, more is better; this will be
negated on an upward sloping indifference curve. You will see this in case of “bads” later in the chapter.
THINK OUT
OF
BOX
What can be the implications of a positively sloping indifference curve?
(ii) Higher Indifference Curve Represents Higher Utility An indifference curve placed higher
will represent higher level of utility. Let us explain how. Observe the curves in Panel “a” of Figure 3.5.
If we consider point A on the curve I1 and point C on I2, then you can follow from the figure that C has
more of both M and N. However, a point on a higher indifference curve may not necessarily have greater
amounts of both the goods; but it will have greater quantity of at least one of the two commodities and
a greater quantity of any one of the two commodities will render a higher level of utility.
76
Managerial Economics
Fig. 3.5 Indifference Curves and Indifference Map
(iii) Indifference Curves can Never Intersect Indifference curves cannot intersect. This follows
from the assumptions of transitivity and higher utility at a higher indifference curve.
Let us start with the assumption that indifference curves do intersect; we would check the feasibility of
this assumption to prove that indifference curves do not intersect. Suppose I1 and I2 are two indifference
curves that intersect at point C in Panel “b” of Figure 3.5. Points A and C lie on I2 and points B and
C lie on I1; I2 is higher than I1. You can readily infer from the assumption of transitivity that since A
and C give same utility and B and C give same utility, therefore A and B also give same utility to the
consumer. Now since a higher indifference curve represents higher utility, then following the properties
of indifference curves, A must be preferred to B. This is nothing but a contradiction. Hence, indifference
curves can never intersect.
THINK OUT
OF
BOX
Can indifference curves be tangent to each other?
(iv) Convex to the Origin Indifference curves are convex to the origin, i.e., they are bowed out
towards the origin. This is because two goods cannot be perfect substitutes of each other. Therefore,
as you have more of one commodity, you would like to sacrifice less of the other commodity for an
additional unit of the first commodity. The explanation of this property needs an elaboration on another
concept, namely that of marginal rate of substitution.
Diminishing Marginal Rate of Substitution
Let us first understand the concept of Marginal Rate of Substitution
(MRS). You have seen that in order to be on the same satisfaction
level, a consumer must have less of one commodity to have more
of the other commodity. MRS is the proportion of one good that the
consumer would be willing to give up for more of another. Thus, marginal rate of substitution of M
for N (MRSMN) would be the amount of commodity N that the consumer would be willing to give up
for an additional unit of M; marginal rate of substitution of N for M (MRSNM) would be the amount of
MRS is the proportion of one good that the
consumer would be willing to give up for
more of another.
Consumer Preferences and Choice
77
commodity M that the consumer would be willing to give up for an additional unit of N. Consider the
indifference curve I1 in Figure 3.5; MRSMN would measure the downward vertical distance (representing
the amount of N that the consumer is willing to sacrifice) per unit of the horizontal distance (representing
additional units of M sought). In other words, MRS is expressed as the ratio between rates of change in
M and N, down the indifference curve. Thus,
MRSMN = -
DN
DM
…(5)
You must be wondering as to why MRS has a negative sign. The answer is simple: to increase
consumption of M, the consumer has to reduce consumption of N and hence, the negative sign. MRSMN
goes on diminishing as we move down the indifference curve. Why? Let us explain. Consider the same
two goods M and N. As the consumer moves further down the indifference curve for M and N, he/she
will be having more and more units of M and less of N. As this substitution continues, each remaining
unit of N would become more and more valuable because of its scarcity! Thus, the consumer would be
less interested to give up further units of N to get each additional unit of M, which he/she now has in
abundance. This contributes to the negative sign of MRS and convexity of indifference curves. However,
we may take the absolute value of MRS to ignore the minus sign.
Table 3.3
Marginal Rate of Substitution
Combination
M
N
MRS
A
1
6
—
B
3
3
1.5
C
4
2
1.0
D
7
1
0.3
Indifference Curves and Utility Analysis
Let us now take you through an interesting exercise by superimposing utility analysis on indifference
curves. From the above discussion, it would be clear to you that in order to stay on the same indifference
curve, the consumer must give up units of one commodity to have more units of the other. Thus, there
is a trade off for the consumer, the gain in utility due to consumption of more units of one commodity
must be equal to the loss in utility due to consumption of less units of the other commodity. So how
much is the gain in utility due to increased consumption of M? Yes you got it right, it would be equal
to the product of the marginal utility of M (MUM) and the increase in consumption of M (DM), i.e.,
(DM◊MUM). Following the same logic, loss in utility due to lowered consumption of N would be equal
to the product of the marginal utility of N (MUN) and the decrease in consumption of N (–DN), i.e.,
(–DN◊MUN). Thus,
(DM◊MUM) = (–DN◊MUN)
…(6)
78
Managerial Economics
We can modify equation (6) as:
MU M
DN
MU N = DM
…(7)
Notice the right hand side of equation (7); it is nothing but MRSMN. We can, thus, conclusively
say that:
MU M
=
…(8)
MU N MRSMN
Use calculus to prove that MRSMN is equal to the ratio of marginal utilities of M and N.
Solution: Consider a utility function U = U(M, N). We know that utility remains the same across
the same indifference curve. This is to say that U = U on an indifference curve. Also in the utility
∂U
and marginal utility of N is MUN =
function U = U(M, N) marginal utility of M is MUM =
∂M
∂U
. Differentiating totally the utility function, we get:
∂N
dU =
∂U
∂U
dM +
dN . Since utility is constant, dU = 0. Transposing we get
∂M
∂N
∂U
∂U
dM +
dN = 0
∂M
∂N
∂U
fi
fi
∂U
∂M = dN
dM
∂N
MU M
= MRSMN
MU N
Special Types of Indifference Curves
The most common type of indifference curves is the one shown in the
previous figures; they are downward sloping and convex to the origin.
However, there may be other shapes of such curves as well.
In Figure 3.6, various possible shapes of indifference curves are
shown; these are of very special nature and rarely found in real life.
Panel “a” shows negatively sloping linear indifference curves, which
means that M and N are perfect substitutes. You would understand that MRSMN for such curves is
constant, i.e., the consumer is willing to give up the same amount of one good for an additional unit
of the other. Panel “b” shows indifference curves that are in the form of right angle, i.e., M and N
are perfect complements; these are the goods which cannot be substituted at all. Panel “c” shows
concave indifference curves; in this case the consumer is willing to give up more and more units of
Shape of indifference curves:
● For perfect substitutes: linear,
downward sloping
● For perfect complements: right angled
● For “bads”: positively sloping
Consumer Preferences and Choice
79
Fig. 3.6 Different Shapes of Indifference Curves
one commodity for additional units of the other. Assuming the consumer to be rational, this is most
unlikely to happen. Panel “d” in Figure 3.6 shows positively sloping indifference curves. This refers to
a commodity which is a “bad ” (not a “good ”), such as pollution, health hazards, unemployment, etc.
You can understand this phenomenon with the help of the environmentalists’ struggle with creation of
dams, local villagers’ struggle against SEZs, etc. Stated in simple terms, creation of dam is necessary
for growth and development, but it inflicts serious environmental problems!
If you choose construction of dams, you have to accept environmental hazards, and if you vote for
environment protection, you will have to suffer with poor infrastructure and low growth, among other
problems. Such cases make choice a very difficult task, and hence are referred as “bad” and not “goods”.
As a result, the indifference curve is upward sloping, showing that more you consume one of these more
you dislike the other.
consumer’s Income
So long we have discussed about consumer preferences as one aspect of
Budget constraint includes income of the
consumer behaviour. Let us now take you to the second very important consumer and prices of the commodities in
aspect, namely constraints to the consumer in satisfying his/her wants. the consumption basket.
Such constraint includes income of the consumer and prices of the
commodities in the consumption basket. We refer to this as the budget constraint to the consumer, as
he has to accept his/her income and prices of the commodities as given. A brief idea about this budget
constraint has already been given while discussing the concept of opportunity cost in Chapter 1.
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Managerial Economics
We start with the assumption that the consumer spends all of his/her income on the two commodities,
say M and N. If the price per unit of M is PM and that of N is PN, and the income of the consumer is I,
then we can express the budget constraint of the consumer in the form of a budget equation as:
PM ◊QM + PN◊QN = I
…(9)
where QM and QN are the quantities purchased of M and N. In other words, consumer’s income equals
the amount spent by the consumer on purchasing commodities M and N.
We can also deduce the quantities of the commodities purchased from the budget equation by
algebraic treatment, as following:
P
I
- N ¥ QN
…(10)
QM =
PM PM
QN =
I
P
- M ¥ QM
PN PN
…(11)
Figure 3.7 shows the budget line of a consumer, derived from
equations (10) and (11); it consists of all possible combinations of
the two commodities that the consumer can purchase with a limited
budget. You can figure out that the intercept on the X axis is equal to
I
I
and that on the Y axis is equal to
. Given I, PM and PN, you
PM
PN
can easily calculate the values of QM and QN.
Now recall your knowledge of production possibility frontier in
Chapter 1; any point to the right of the line AB, say R, is not attainFig. 3.7 Budget Line
able, as it represents a combination of commodities beyond the individual’s income. The region beyond the budget line towards its right is regarded as the infeasible area.
The area bound by the budget line, namely OAB is referred to as the feasible set. But any point to the
left (or below) the line AB, say S, is not desirable; because at this point consumer can still buy more of
both commodities.
Let us return to Saumil to understand budget constraint with the help of a simple example. Assume
Saumil’s income to be spent on M and N is `1000 a month. Price per unit of M is `10 and of N is `20.
Table 3.4 shows few possible combinations of these two commodities with budget constraint of ` 1000.
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Consumer Preferences and Choice
Table 3.4
Budget Constraint
Combination
Quantity of M
Quantity of N
A
0
50
C
20
40
D
40
30
E
60
20
F
80
10
B
100
0
Slope of the Budget Line
I
PM
Given the equation of the budget line as PM ◊QM + PN◊QN = I, if QN = 0, then QM =
If
QM = 0, then QN =
I
PN
…(12)
…(13)
-I
(
P )
, which can be
Movement from the vertical to the horizontal intercept can be interpreted as
N
I
rewritten as:
(- I P ) = - P
N
I
PM
M
PM
…(14)
PN
Given the equation of budget line in equation (11), we can conclusively say from equation (15) that
P
Slope of the budget line = - M
…(15)
PN
Shifts in Budget Line
Any change in income of the consumer or price of the
commodity(s) would lead to a shift in the budget line.
Such a shift can be of three types: upwards, downwards
and swivelling. Let us see how.
We start with AB as the initial budget line in Figure
3.8. Consider a situation in which there is an increase
in the consumer’s income, prices of M and N remaining
constant. This would lead to a shift in the budget line
towards the right, to say A1B1, because with increased
income consumers can buy more of both commodities,
their prices remaining same. If, on the other hand, the
income of the consumer goes down, the budget line would
shift to left, say A2B2.
Fig. 3.8
Shifts in Budget Line
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Managerial Economics
Consider another situation in which the price of M falls, while price of N and income of consumer
remain same. Now the budget line would swivel from the point A towards the right, to say AB¢, because
now the consumer can buy more of M. What would be outcome if the price of N falls, without any change
in price of M and income of consumer? The budget line would swivel from the point B towards the right,
to say A¢B, because now the consumer can buy more of N.
Consumer’s Equilibrium
Now the most important question is how the consumer would reach equilibrium point, i.e., where satisfaction is highest given all constraints. You know
that maximum utility will be attained by the consumer at the highest indifference curve he/she can
reach. However, in this upward movement for a
higher indifference curve, the consumer is limited by
budget constraint. Consumer’s equilibrium can be
understood by combining Figure 3.5 (Panel a) and
Figure 3.7. The consumer is able to maximise utility
at a point where the budget line is tangent to an indifference curve; this is the highest possible curve atFig. 3.9 Consumer’s Equilibrium
tainable by the consumer, subject to budget constraint. Figure 3.9 illustrates consumer’s equilibrium in a two goods case.
From Figure 3.7, it is clear that feasible set is the area OAB, and
beyond line AB is infeasible area; therefore IC4 is beyond reach of the
consumer. You also know that more distant is an indifference curve
from origin higher is the utility level. Thus, equilibrium is attained
at point E where the budget line AB is tangent to curve IC3 which
is highest attainable indifference curve. The equilibrium quantities of commodities M and N are QM and
QN.
The following are the conditions for consumer’s equilibrium:
(i) The consumer spends all income in buying the two commodities; hence the point of equilibrium
Consumer’s equilibrium is at the point
where the budget line is tangent to the
highest attainable indifference curve by the
consumer, subject to budget constraint.
Consumer Preferences and Choice
83
will always lie on the budget line.
(ii) The point of equilibrium will always be on the highest possible indifference curve the consumer
can reach with the given budget line. Any other combination of the two goods below the budget
line AB would provide less utility.
(iii) At the optimum bundle, slope of the indifference curve should be equal to the slope of the budget
line. In other words:
MU M PM
…(16)
=
PN
MU N
reVeAled preFerence tHeorY
The indifference curve analysis provides a basic outline for understanding consumer behaviour. However,
it has limitations in terms of its highly theoretical structure and simplifying assumptions.
Samuelson came up with a more realistic approach to assessing consumer behaviour and introduced
the term ‘revealed preference’. Revealed Preference Theory neither makes any reference to utility as the
neo classical economists (Marshall and others) did, nor does it make use of indifference curves. Both of
these approaches were subjective, whereas according to Revealed Preference Theory, demand for a
commodity by a consumer can be ascertained by observing the actual behaviour of the consumer in the
market in various price and income situations. The basic hypothesis of the theory is ‘choice reveals
preference’. Here it must be kept in mind that the assumptions regarding consumer behaviour discussed
in the beginning of the chapter apply to this theory as well.
Are you confused? Let us explain how this theory works. The
Revealed Preference Theory
theory of revealed preferences gives us an idea of demand curve posits that choice reveal
for an individual consumer on the basis of observed behaviour. Let preference.
us understand with the help of Figure 3.7, where AB is the
budget line. By now you can easily decipher that OAB is
the feasible set; hence all the points on AB and below AB
are attainable to the consumer, given the price and income
constraints. The same is redrawn here in Figure 3.10, to
further elaborate the Revealed Preference Theory. Supposing
out of all the possible combinations of two goods M and N,
the consumer chooses C; it may then be deduced that the
consumer has revealed his preference for C over all other
possible combinations (say D, L, R as shown in Figure 3.10).
Samuelson further extended his theory to explain the
inverse relationship between price of the commodity and Fig. 3.10 Demand Curve by Revealed
quantity demanded. He posited that as demand for any good
Preference
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Managerial Economics
(or basket of goods) is known to always increase when money income alone rises hence, it must shrink
when price alone rises. Let us see how. You know that when price of M falls, money income and price
of N remaining unchanged, the new budget line will be AB¢. This also means that real income of the
consumer in terms of M has increased. Now let us deprive the consumer of some amount of money
income, so that his real income is only sufficient to buy combination C of M and N. Thus, a new budget
line A1B1 parallel to AB¢ is drawn, which would show the same price income situation as in AB¢.
Do an exercise here: will the consumer buy the same combination C, or will choose some other
combination? Consider the point D, will the consumer choose it? You guessed it right: No! The consumer
has already revealed preference for C, negating all possible baskets of these two goods including D. And
you know that we have assumed that the consumer’s choices are always consistent. So the consumer
will not consider any combination falling in the region OAB. The only feasible set in new situation is the
triangle BCB1, and the consumer will either remain at C, or will be on any combination falling on CB1.
Hence, you can see that with a fall in price of M, either the same amount, or more of M will be consumed
even when money income is reduced. The reverse will be true if price of a commodity had increased,
other things remaining the same. Thus, Samuelson proved that positive income elasticity implies
negative price elasticity, and reinstated Marshall’s law of demand without involving the controversy of
cardinal or ordinal measurement of utility.
consumer surplus
When you go to market for purchasing some commodities, you
normally carry a value impression of prices of these goods. Quite
often either you have to pay more than what you had expected, or
less than your expected price. When you pay less, you find a special
kind of satisfaction. This is known as consumer’s surplus. Hence, the difference between the price
consumers are willing to pay and what they actually pay is called consumer surplus. For example,
Rakesh wanted to buy a formal shirt and had decided to pay a maximum amount of `1800 for it,
but he got a shirt of choice for `1650; the difference `1800 – 1650 = `150 is his consumer surplus.
A graphical illustration of consumer surplus is
given in Figure 3.11. Suppose that the equilibrium
D
market price and quantity is determined at (P*, Q*),
A
where market demand equals market supply. Let us
P1
Consumer Surplus
B
assume that there is a customer who is willing to pay
P2
S
as high as P1 but actually pays only P*. The difference
E
between the two prices (P1 – P*) represents the
P*
surplus of the first consumer. Again, suppose a second
D
S
consumer willing to pay P2 and actually paying P*
gains a surplus of (P2 – P*). Continuing in this way,
O
Q1 Q2
Q* Quantity
it can be understood that the total consumer surplus
in the economy is given by the triangular area P*DE.
Fig. 3.11 Consumer Surplus
Thus, individual consumer surplus measures the
gain that a consumer makes by purchasing a product at a price lower than what he had expected to pay.
Price
Consumer surplus is the difference between
the price consumers are willing to pay and
what they actually pay.
Consumer Preferences and Choice
85
In a market, the total consumer surplus measures the gain to the society due to the existence of a market
transaction. You would learn more about consumer surplus when we will discuss price discrimination
and allocative efficiency of different types of markets.
Summary
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
Utility is the measure of satisfaction a consumer derives out of consumption of a commodity; it
is an attribute of a commodity to satisfy or satiate a consumer’s needs.
A rational consumer aims to maximise utility from consumption of different commodities, subject
to budget constraint.
Earlier economists like Marshall and Jevons opined that utility is a cardinal concept and is
measurable like any other physical commodity.
Total utility is the sum total of utility levels out of each unit of a commodity consumed within
a given period of time. Marginal utility is the change in total utility due to a unit change in the
commodity consumed within a given period of time.
According to law of diminishing marginal utility, as you consume more and more units of a
commodity, total utility would go on increasing, but at a diminishing rate.
According to law of equimarginal utility, a consumer will maximise utility when the marginal
utility of the last unit of money spent on each commodity is equal to the marginal utility of the
last unit of money spent on any other commodity.
Individual demand curve for a commodity is the same as the marginal utility curve for that
commodity for an individual, measured in monetary terms.
According to ordinal school, utility cannot be measured in physical units; it is possible to rank
utility derived from various commodities.
If we plot the quantities of commodities consumed on the two axes, we get an indifference curve
as the locus of points which show the different combinations of these commodities a consumer is
indifferent about.
Indifference curves are downward sloping and convex to the origin; a higher indifference curve
would represent higher utility and two indifference curves do not intersect each other.
Marginal Rate of Substitution (MRS) shows the amount of a good that a consumer would
be willing to give up for an additional unit of another commodity. Thus, marginal rate of substitution
of M for N (MRSMN) would be the amount of commodity N that the consumer would be willing to
give up for an additional unit of M; MRSMN is equal to the ratio of marginal utilities of M and N.
Budget constraint to the consumer includes income of the consumer and prices of the commodities
in the consumption basket. A change in any of these constraints would lead to a shift in the budget
line. Such a shift can be of three types: upwards, downwards and swivelling.
The consumer will be at equilibrium at a point where the budget line is tangent to the highest
attainable indifference curve.
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◆
Managerial Economics
According to the theory of revealed preferences, demand for a commodity by a consumer can be
ascertained by observing the buying pattern of the consumer.
Consumer surplus is equal to the difference between the price a consumer is willing to pay and
the price he actually pays for a commodity.
Key ConCeptS
Utility
Cardinal utility
Diminishing marginal utility
Ordinal utility
Indifference curves
Marginal rate of substitution
Revealed preference
Budget constraint
Consumer equilibrium
Consumer surplus
QueStionS
Objective Type
I. State True or False
i.
ii.
iii.
iv.
v.
vi.
vii.
viii.
ix.
x.
Positive income elasticity implies positive price elasticity.
Slope of indifference curve bears relation with diminishing marginal utility.
For concave indifference curves, marginal rate of substitution decreases along the curve.
Any consumption bundle would be preferred or indifferent to its ownself.
A feasible purchase of commodity bundle can never lie under the budget line.
If a consumer prefers butter to cheese and is indifferent between cheese and margarine, then he
would be indifferent between butter and margarine.
The law of diminishing marginal utility holds good for items of addiction.
If the utility from a commodity A is more than that from another commodity B, the consumer
would increase consumption of B and reduce consumption of A.
Convexity implies that a curve is bowed away from the origin.
A higher indifference curve implies more quantities of both the goods.
II. Fill in the Blanks
i. The assumption of _______ implies that an individual consumer’s preferences are always
consistent.
ii. The theory of revealed preference proposes that _______ reveals preference.
iii. The law of diminishing marginal utility mandates that demand for the commodity should
be _______.
Consumer Preferences and Choice
87
iv. _______ goods have L-shaped indifference curves.
v. At the optimum bundle, slope of the indifference curve should be equal to the slope of _______.
vi. Given the equation of the budget line, if the quantity consumed of one good is nil, then quantity
consumed of the other good would be the ratio of _______ and price of the other good.
vii. Ordinal school proposes that utility cannot be measured in _______ units.
viii. Cardinalists propose that utility is _______.
ix. Slope of the indifference curve is equal to the slope of the budget line at the _______ bundle.
x. The point at which marginal utility is zero is the point of _______.
III. Pick the Correct Option
i. Indifference curves do not intersect because of:
a. Transitivity
b. Higher utility on a higher indifference curve
c. Both a and b
d. None of the above
ii. Continuity of consumption is a prerequisite for:
a. Law of diminishing marginal utility
b. Revealed preference
c. Indifference curve analysis
d. Marginal rate of substitution
iii. The difference between the price consumers are willing to pay and they actually pay is called:
a. Cost plus pricing
b. Consumer surplus
c. Feasible set
d. Marginal utility
iv. All the following facts hold good for consumer’s equilibrium EXCEPT:
a. Utility is maximised at the tangency of budget line to an indifference curve
b. The indifference curve is the highest possible curve attainable by the consumer.
c. At the optimum bundle, slope of the indifference curve is equal to the slope of the
budget line.
d. The point of equilibrium may lie within the feasible area.
v. In order to stay on the same convex indifference curve, the consumer must:
a. Reveal preference for any one of the commodities.
b. Have equal units of both commodities.
c. Have more units of one commodity to have more units of the other commodity.
d. Give up units of one commodity to have more units of the other commodity.
vi. Which of the following is valid for linear indifference curves?
a. The goods are perfect complements.
b. The goods are perfect substitutes.
c. MRS for such curves is an decreasing ratio.
d. MRS for such curves is an increasing ratio.
vii. A consumer had to pay off his debt from his income. Assuming no change in price of goods he
consumes, which of the following would happen?
a. A shift in the budget line towards the right.
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Managerial Economics
b. A swivel in the budget line towards the right.
c. A shift in the budget line towards the left.
d. A swivel in the budget line towards the left.
viii. Gain in utility due to increased consumption of a good is equal to which of the following?
a. Marginal utility/Increase in consumption
b. Marginal utility ¥ Increase in consumption
c. Marginal utility + Increase in consumption
d. Marginal utility – Increase in consumption
ix. All of the following are valid for ordinal school of consumer preferences EXCEPT:
a. Consumer preferences can be plotted on an indifference curve.
b. Ranking of utility is important.
c. Magnitude of utility is important.
d. Utility is not additive.
x. Which of the following can be derived from law of equimarginal utilities?
a. Marginal utility of the cheapest commodity should be equal to marginal utility of income.
b. Marginal utility of the most expensive commodity should be equal to marginal utility of
income.
c. Marginal utility of the first commodity purchased should be equal to marginal utility
of income.
d. Marginal utilities of all commodities should be equal to each other.
Analytical Corner
1. Which one between cardinal and ordinal theories of utility seems to be more realistic to you? Why?
2. Would you consider theory of revealed preferences to be superior to cardinal and ordinal theories
of utility? Defend your answer with logic.
3. Suppose you are a purely vegetarian consumer. Can you draw your indifference curve for a nonvegetarian food item? Explain.
4. ‘Choice reveals preference!’ Do you agree with this statement? Illustrate your arguments with
help of an example and suitable diagrams.
5. Is it possible to explain consumer’s behaviour without taking help of the assumptions of
completeness, transitivity and non-satiation?
6. How can you decide on distribution of your income on various goods that you wish to purchase
in a month?
(Hint: use equimarginal utility principle)
7. Explain that in a two goods combination a consumer would sacrifice successively less of one
commodity for getting more of another commodity.
8. With the help of suitable diagrams, explain all the features of indifference curves.
9. “A budget line is nothing but demand curve of the consumer expressed in terms of two goods
given the money income and prices of these two commodities”. Explain.
Consumer Preferences and Choice
89
10. Consider the following utility functions with commodities x1 and x2 and determine the absolute
value of MRS of each:
i. U(x1, x2) = x1x22
ii. U(x1, x2) = a2logx1 + b2logx2
11. Assume a consumer’s income is `5000; she has to buy pens at `5 each and pencils at `1 each.
i. Formulate the equation of budget line for this consumer that would indicate the amount of
income spent on pens and pencils.
ii. Find the intercept on each axis and the slope of the budget line.
iii. Plot the budget line.
Check Your Answers
State True or False
i. T
ii. T
iii. F
iv. T
v. F
vi. F
vii. F
viii. F
ix. F
x. F
ix. c
x. d
Fill in the Blanks
i. transitivity
v. budget line
ix. optimum
ii. choice
vi. income
x. satiety
iii. recurring
vii. physical
iv. complementary
viii. additive
Pick the Correct Option
i. c
ii. a
iii. b
iv. d
v. d
vi. b
vii. c
viii. b
Analytical Corner
2
10. i. x 2 x , ii.
1
a 2 x2
b 2 x1
11. i. 5Qx + Qy = 5000
ii. –5
Caselet 1
The Androids-Windows Battle
The face of mobile phone industry had changed way back in 2007 with the launch of Android, a free
and open-source operating system. Smartphones, thus, got transformed from an expensive rarity to
dramatically low priced devices. Since then, Androids have been engulfing the market, attracting
youngsters, hipsters and mobile user demographic. However, Nokia decided to go with Microsoft
Windows Phone, and this was met with market failure.
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Managerial Economics
While Nokia itself offers a collection of great games, many of the top quality games available on
other platforms take long to get to Nokia. Windows Phone has a collection of apps that are perceived
to be inferior to their counterparts in other operating systems. As a consequence, while Nokia was
stuck into making Windows OS mobiles, consumers quietly shifted to Android phones of competitor
brands like Samsung, Micromax and Lava. As sales of smartphones continue to grow, Android has
been the preferred operating system with the lion’s share of internet users, accounting for more than
90 percent of smartphones.
Sources:
https://www.blog.google/topics/google-europe/android-choice-competition-response-europe/
accessed on 15/05/2017.
https://techcrunch.com/2017/04/03/statcounter-android-windows/ accessed on 15/05/2017.
Case Question
1. Explain the concept of revealed preference in context of popularity of Android.
Caselet 2
From Economy to First Class
Ria was studying at a reputed Business School in Mumbai. Economics teacher was her favourite
because of her teaching style, linking theory with real life and engaging the class with active
participation. Still a science graduate, Ria found Economics interesting, yet intriguing. For winter
vacation, she had planned to go home (Varanasi) by flight to save time. She booked Air India because
it was the first flight in morning from Mumbai to Varanasi. Also luckily she had got her favourite
window seat in the sixth row. She reached the airport at 6 a.m., checked in and started the endless wait.
Due to bad weather conditions and low visibility at Varanasi airport, the flight was delayed. She
was irritated, tired, and hungry; after all reaching Domestic airport at 6 am from Colaba was not an
easy task. Finally at 11 a.m., they announced boarding. Then happened something unexpected; the
official at scanning counter scanned her boarding pass and said…. “Ma’am! Your ticket has been
upgraded to first class. Would you accept it, please?” What could she say? For a middle class girl, air
travel was a luxury and ‘first class’ was beyond her dreams. She somehow murmured “yes”.
And when she sat on her new upgraded seat, she felt like it’s a dream come true. The airhostess
came and offered a warm wet towel, a glass of juice…. and….suddenly like lightening it struck her…
is this what Economics teacher meant when she taught consumer surplus?
Case Questions
1. Why did Ria relate seat upgradation with consumer surplus? Discuss.
2. Would diminishing marginal utility occur if it happens to her next time as well? Why or
why not?
Consumer Preferences and Choice
91
Caselet 3
Retail Sector: Riding the Changing Waves of Consumerism
Modern retail has entered India as seen in multi-storeyed malls and huge complexes offering shopping,
entertainment and food under one roof. The Indian retailing sector is at an inflexion point where the
growth of organised retailing and growth in the consumption by the Indian population is about to take
a higher growth trajectory.
A large young working population with median age of 24 years, nuclear families in urban areas,
increase in disposable income levels, consumer awareness and propensity to spend, along with
increasing working-women population and emerging opportunities in the services sector are going to
be the key growth drivers of the organised retail sector in India.
The modern consumers prefer the convenience of centrally located stores with ample parking
space, variety of brands and a good ambience. They now want to minimise time spent and maximise
the pleasures derived. And retail is encashing on all these factors to its own advantage.
Source:
Retail Mania, Investment Monitor, December 2006, pp. 40-42; Bagga, D. S. (2007). Home is Where
the Market is, Capital Market, Jan 15-28, 2007, pp. 5-8; Aggarwala, A. (2007). On a Roll, But…,
Investors India, November 2007, pp. 38-42.
Case Questions
1. Discuss the role of non-price determinants in affecting consumer preferences.
2. Discuss the phrase “consumer is sovereign” in the background of the above caselet.
Case 1
Maggi Noodles: Trouble in Oodles
The branded packaged food market in India accounts for around 20 percent of the annual `3.2 trillion
packaged consumer products market, which is projected to grow at around 12-15 percent annually till
2019, according to a September 2015 report by FICCI and KPMG. Nestlé, world’s largest food and
beverages company, has sold Maggi in India for more than 30 years. In 2014, Indians had consumed
more than 400,000 tonnes of Maggi instant noodles available in 10 varieties from Thrillin’ Curry to
Cuppa Mania Masala Yo!, and Maggi accounted for roughly a quarter of the company’s $1.6 billion in
revenue in the country. These products of Nestle India are urban-centric and have always been relevant
to a particular lifestyle and income group. The same year Maggi was named one of India’s five most
trusted brands.
5 June 2015 was a red letter day for Nestlé India, as Maggi faced a nationwide ban by Food Safety
and Standards Authority of India (FSSAI) for a period of six months on the basis of allegations by Food
Safety and Drug Administration of Uttar Pradesh that it contained monosodium glutamate (MSG), a
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Managerial Economics
flavour enhancer, and lead in excess of prescribed limits. MSG is a controversial ingredient that is legal
in India,though it requires disclosure and a warning that the product is not recommended for children
under 12 months age. In fact, MSG has even been blamed for everything from bad dreams to cancer.
Once the allegation was spread wide by media, enraged consumers wasted no time venting their
anger. In some cities, protesters in the street smashed and set fire to packs of noodles and photos of
Bollywood stars who were endorsing Maggi. As a consequence, Nestlé had to recall around 38,000
tonnes of Maggi noodles between 5 June and 1 September 2015, from across the country. The recalled
packets had to be destroyed, and the company had to jump to action to tackle regulating authorities and
other government authorities to establish the safety of Maggi.
Maggi was re-launched on 9 November 2015, Monday, five months after the government ban. Nestlé
had to get official clearance from the Bombay High Court in October. Though its re-launch has been
somewhat successful, recovery is unlikely to be smooth. The instant noodles category has been impacted
adversely after the ban, with several consumers having switched over to Yippie noodles (by ITC) and
Wai Wai noodles from Nepal’s CG Foods. Incidentally, the growing popularity of Patanjali Ayurveda
products has also led several of erstwhile Maggi loyalists to start consuming its atta noodles. According to a report by Nomura Financial Advisory and Securities (India) Pvt. Ltd., published in May 2015,
Maggi commanded 80.2 percent of the instant noodles market in the quarter of March 2015; probably
the loss of faith consumers had in Maggi led to a downfall in the net profit of Nestlé by 52 percent to
`563.27 crore for the 12 months ended 31 December 2015.
Sources:
http://www.livemint.com/Companies/xyFCHn7hGJm1zUkesEVy5L/How-Nestle- is-rebuildingin-India18-months- after-the-Maggi.html?li_source=LI&amp;li_medium=news_rec accessed on
15/05/2017.
http://fortune.com/nestle-maggi-noodle-crisis/ accessed on 15/05/2017.
http://www.business-standard.com/article/markets/maggi-relaunch-no-instant-relief-for-nestleindia-115111700805_1.html, accessed on 15/05/2017.
http://www.livemint.com/Companies/15oYqmpVIztCUpWKwrs4kI/Maggi-noodles-now-has-50-marketshare-says-Nestle-India.html, accessed on 15/05/2017.
Posers
1. What aspects of consumer behaviour are reflected in the case of Maggi noodles? How can
companies operating in FMCG sector, especially in packaged food, use this information?
2. Discuss the role of media in influencing consumer preference with respect to Maggi.
Case 2
Making Magic: The Multiplex Way
The middle class of India, from a virtual non-existent entity on Independence, has gradually become
more sensible, educated and demanding. The overall growth of the economy has given a tremendous
Consumer Preferences and Choice
93
thrust to the middle class. The middle class on the whole is expected to grow by 5 to 10 percent annually.
It has grown over 57 million by 2001-02 and is expected to cross 153 million by 2009-10.
The average household income in urban India has grown at a CAGR of 5 percent over the last decade.
Not only is this, but the age profile of the Indian spenders also undergoing a sea of changes. NCAER has
identified five categories of households on basis of income which is summarised in Table 1.
Table 1
Classification of Indian Households on the Basis of Income
Number of Households (in millions)
1994-95
1999-2000
2006-07
Very rich
1
3
6
Consuming
29
55
91
Climbers
48
66
74
Aspirants
48
32
15
Destitute
35
24
13
(Source: NCAER)
Table 1 reveals the paradigm shift in Indian households over the last decade. The number of effective
consumers is expected to exceed 600 million by 2010. This big bang in consumerism in India is being
seen as the driving force in the emergence of various new businesses, which aim at riding the high
consumer tide. Availability of easy financing schemes is another aspect of the story: owning a house,
or buying a car, or going abroad on a pleasure trip is no more a distant dream to the average Indian
consumer! With the consumers’ composition gradually getting skewed towards the young, there is a
greater tendency towards increased spending on consumption. A very interesting piece of information is
that average Indian household has increased its spending on movies and theatres from 1 to 4.6 percent
of its disposable income. This amazing spurt in spending on entertainment has affected the quality
and delivery of films as an industry. The single screen theatres with poor maintenance and inadequate
infrastructure are gradually paving way for high tech multiplexes with 3 to as many as 11 screens,
digitalised films and Dolby surround audio system. The industry is undergoing a swing, driven by
consumer behaviour.
Reports indicate that multiplexes account for 0.6 percent of the total cinemas, 2.3 percent of the total
screens and have a total capacity of more than two lakh seats. The average gross collection per multiplex
is around `5.72 crore fetching about 29 to 35 percent of the revenue for the film industry.
India’s multiplex bandwagon has spread its tentacles beyond the metros to redefine entertainment in
B and C class towns. While the first phase of the growth of multiplexes was in metros, now this growth
is spreading to Tier 2 and 3 cities like Lucknow, Indore, Nasik, Aurangabad and Kanpur. Top multiplex
players like PVR, Adlabs Films, Inox Leisures, Shringar Cinemas (Fame multiplexes), Fun Multiplex
and Cinemax India are venturing to small towns across the country and redefining entertainment to the
vast Indian masses.
The multiplex business has rightly tapped the growth of consumerism in India as it has understood
the pulse of the Indian consumer’s preference towards superior ambience, comfortable seating, airconditioning and good quality snacks, even at the cost of paying a higher price. The average price of
94
Managerial Economics
ticket in a conventional theatre is `15–35, while a multiplex charges on an average price of `75–350
and consumer is willing to dish out this extra amount to enjoy the “complete” movie experience, which
most of the traditional theatres could not render and are, thus, facing the fate of near extinction. It,
thus, promises to take the moviegoers’ experience to a whole new level and giving a new dimension to
watching movies at theatres.
Sources:
Singh, H. (2007), Going the Multi(plex) Way, Indian Management, January 2007, pp. 41–46.
Suja, S. (2007), Facets of Retail Industry in India, Global Management Review, Vol. 2, Issue 1,
pp. 33–38.
Menon, P. (2007), The Multiplex Boom Sweeps India, Outlook Business, 24 January 2007,
www.indiaonestop.com.
http://www.rediff.com/money/2007/jan/24spec.htm, accessed on 15/05/2017.
http://www.dailyexcelsior.com/web1/07nov12/busi.htm#5, accessed on 15/05/2017.
http://www.indianretailer.com/indianretailer0807/marketplace.php, accessed on 15/05/2017.
Posers
1. What lessons can you draw from the above case regarding consumer behaviour?
2. Do you think change in consumer perception in middle class has been instrumental in emergence
of multiplexes? What can be the other reasons?
3. Observe Table 1. Which of the groups, according to you, would have demand for multiplexes?
4. Would law of diminishing marginal utility apply to movie watching? Will this affect the growth
rate of multiplexes? Or can it be seen as a cause for establishment of multiplexes? Give argument
in support of your contention.
5. Can multiplexes use the concept of consumer surplus for attracting more consumers? How?
Chapter
4
2. Explain the law of demand and exceptions to the law.
3. Analyse the different determinants of demand and supply and their effects on demand
and supply curves.
4. Develop an understanding of demand and supply functions in determining market
equilibrium.
5. Introduce the concepts of market equilibrium and disequilibrium.
Chapter Objectives
1. Introduce the basics of demand and supply and their relevance in economic
decision-making.
INTRODUCTION
“If you can’t pay for a thing, don’t buy it. If you can’t get paid for it, don’t sell it.”
Benjamin Franklin
Very often you come across news items like, ‘the growth rate of over 25 percent in IT/ITES sector of
demand
and supply
of
demand and
supply,
Market refers to the interaction between
sellers and buyers of a good (or service) at a
mutually agreed price.
96
Managerial Economics
DEMAND
understood
unlimited and means to achieve them are limited, people have to prioritise their wants according to the
you may have an intense desire
Demand is the quantity of a commodity
which consumers are willing to buy at a
given price for a particular unit of time.
Demand is defined as that want, need or
desire which is backed by willingness and
ability to buy a particular commodity, in a
given period of time.
one, you are willing
want, need or desire which is backed by willingness
and ability to buy a particular commodity, at a given point of time.
effective desire
quantity
given price for a particular unit of time
Types of Demand
Direct and Derived Demand
When a commodity is demanded for its
own sake by the final consumer it is known
as consumer good and its demand is
direct demand.
a consumer good
direct
demand Direct demand is also known as autonomous demand
97
Demand and Supply Analysis
when a commodity is demanded for using it either as a raw material or as an
intermediary for value addition in any other good, or in the same good, it is known as a capital good;
and its demand is derived demand
with radio, internet and camera, the machinery required to produce
A capital good is demanded for using
it either as a raw material or as an
intermediary and its demand is derived
demand.
Recurring and Replacement Demand
have
take tea and snacks three to four times a day, read newspaper everyday, have soft drinks as many times
have learnt that demand is per unit of time, therefore, producers (or
sellers) of such goods know that consumers make purchases on short-
Consumable goods have recurring demand;
durable consumer goods are purchased
to be used for a long time but they need
replacement.
how this knowledge helps in designing competitive pricing strategies
Complementary and Competing Demand
Obviously no
which create
Goods which create joint demand are
complementary goods.
Goods that compete with each other to
satisfy any particular want are called
substitutes.
close
substitutes
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Managerial Economics
Demand for Consumer Goods and Capital Goods
direct
demand and for capital goods as
Demand for Perishable Goods and Durable Goods
Individual and Market Demand
individual demand and the theory of
Demand for an individual consumer is
individual demand.
all
planning, even economic planners and governments are also interested
Industry demand is the demand for the
product produced by all the firms in the
industry.
Determinants of Demand
Demand and Supply Analysis
99
Price of the Product
The single most important determinant of demand is the
Normally, price has a negative
effect on demand.
of demand remaining unchanged, if the price of the product falls, its
law of demand
Income of the Consumer
Another equally important determinant of demand for a commodity is the income of the consumer, as it
Normally, income bears a positive
relationship with demand.
income
into normal goods and inferior goods Normal goods
Inferior goods
with an increase in income, consumers add fruits and other nutritious
whereas people with less income stay in homes in vacations, and
Normal goods have a positive relation
between their demand and income; inferior
goods have a negative relation between
their demand and income.
higher quality food items, higher class of travel in train and air, demand for tourism, hotels and other
eality
B ites
Price Does Matter!
In the early 1970s, when Nirma washing powder was introduced in India, it was the lowest priced
branded washing powder available. It caught the fancy of the low income and middle class Indian
consumers, who responded by opting for Nirma rather than the high priced Surf detergent powder from
Hindustan Lever Ltd. (HLL). However, the brand did not remain restricted to this segment only; Nirma
was also used by the upper middle income and higher income Indian families for washing inexpensive
clothes.
Source: http://www.citeman.com/segmenting-and-targeting-the-market, accessed on 27/09/2007.
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Managerial Economics
Price of Related Goods
Thus, an increase in the price of a commodity
increases the demand for its substitute and reduces the demand for its complement. In other words, price
Tastes and Preferences
Tastes and preference have such
effect that in spite of a fall in price, demand may not increase if the good has gone out of fashion and in
Advertising
mithai, with the slogan ‘Kuch meetha ho jai’. Similarly, life
styling has emerged as an upcoming industry,
Demand and Supply Analysis
101
eality
ites
What Determines Demand?
73% of the respondents feel that promotion has no or moderate effect on buying various products,
which included detergent powder, bathing soap, shampoo, hair oil, watches, tea, edible oil and bicycle.
However, in case of edible oil and soft drinks the importance of promotion is acknowledged by 54%
and 75% consumers respectively. Watches and bicycles did not show any impact of advertisement. On
and motivator for most of the purchases. Thus, that there is a need to design special strategies for rural
consumers, especially in social economic climate of India.
Source: Agrawal, P. R., Geetika, Singh, T. (2006). Consumer’s Buying Pattern in Indian Villages: Survey of a SubInstitute of Technology, Bangkok, Thailand, 18-19/11/2006, pp 940–947.
Consumer’s Expectation of Future Income and Price
Population
Size of the
Growth of Economy
102
Managerial Economics
Consumer Credit
Demand Function
its determinants mathematically, the relationship is known as
demand for a product X (Dx
X (Px)
(ii) Income of the consumer (Y)
Po)
(iv) Tastes and preferences of the consumer (T)
(v) Advertising (A)
Ef)
N)
Dx = f(Px, Y, Po, T, A, Ef, N)
Dx = a + b1P + b2Y + b3Po + b4T + b5A
In the equation (2), ‘a
…(1)
…(2)
b1, b2, b3, b4 and b5
eality
ites
Milestones on the Road to Theory of Demand and Supply
theory could not gain popularity as it was in pure mathematical terms with which the then students
“the curve of
consumption”
(Contd.)
Demand and Supply Analysis
103
refrained from using mathematics and even the diagrams which appeared only in the footnotes. He also
expressed that the theory of demand and supply provides a unifying analysis applicable to all aspects
of economics.
LAW
OF
DEMAND
Law of demand states that, ceteris
law of demand has paribus, demand for a product is inversely
other things remaining constant, (ceteris proportional to its price.
paribus) when the price of a commodity rises, the demand for that
commodity falls and when the price of a commodity falls, the demand for that commodity rises
Dx = f(Px)
…(3)
linear demand function can
Dx = a – bPx
a > 0, b > 0
where
…(4)
In this linear demand function the intercept a, a constant, represents the level of demand when price
b
instance, if b
D = aP–b
log D = a – b log P
where
a > 0, b
…(5)
…(6)
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Managerial Economics
price effect, substitution effect, income effect and law of diminishing marginal utility
Price effect:
cooking,
whereas if its price rises, people start using it only for most important purposes and use alternative
Price effect explains why a fall in price
results in rise in demand and vice versa.
Substitution Effect
Income Effect:
1
is `
is `
As per Law of Diminishing Marginal Utility,
the utility derived from every next unit
(marginal unit) of a commodity consumed
goes on falling.
`
`
Law of Diminishing Marginal Utility: According to this law, as the
consumer consumes successive units of a commodity, the utility
commodity, where the marginal utility of the commodity is equal to
D1
D2
D3
P
P
P
Demand and Supply Analysis
105
Solution:
Dm
Dm
20 =
Solving the equation, we get P = 20
P
P
P
P)
P
D1 = 5, D2 = 10, D3 = 5
Demand Schedule and Demand Curve
Demand schedule is the list or tabular
statement of the different combinations
of price and quantity demanded of a
commodity.
schedule and
is known as the demand schedule
price levels of a cup of coffee and their corresponding quantities of cups demanded every month, ceteris
`15 to `20 and so on), quantity demanded falls (say from
Table 4.1
Demand Schedule for Coffee
Price
(` per cup)
Demand
(’000 cups)
15
50
20
40
25
30
30
15
35
10
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Managerial Economics
The demand curve
The demand curve shows the relationship
between price of a good and the quantity
demanded by consumers, ceteris paribus.
curve (DD
Fig. 4.1 Demand Curve
`
`15, demand
d
a
Fig. 4.2 Individual and Market Demand Curves
Demand and Supply Analysis
107
A and B
price per unit of the commodity is `
consumer B
A
DADA for consumer A, showing
A at price `
curve D B DB for consumer B
B DD
A and B, at the
`
Shift in Demand Curve
Imagine a situation when price of coffee remained same, say `
a change in any other determinant of demand, price remaining unchanged, a new demand curve has to
Thus, movement along the same demand curve is known as a
contraction or expansion in quantity demanded, which occurs due to
curve due to a change in any of the factors other than price such as
income, tastes and preferences, or prices of other goods, is known as
change in demand.
earlier monthly income of consumers was `20,000 and now it has
increased to `
Shift of demand curve due to a change
in any of the factors other than price is a
change in demand.
Movement along the same demand curve
is contraction or expansion in quantity
demanded, due to rise or fall in the price of
the commodity.
108
Managerial Economics
Table 4.2
Demand Schedule for Coffee with Increased Income
Price
(` per cup)
Demand (’000 cups)
Demand (’000 cups)
`20,000)
`30,000)
15
50
60
20
40
50
25
30
40
30
15
25
35
10
15
`20,000 to `30,000, it increases their purchasing power
`
DD to D1D1
DD to D2D2
Fig. 4.3 Change in Demand
of the complement (milk) rises, the demand for the good under consideration (coffee) falls, and so the
demand for the good under consideration (coffee) will rise, causing the demand curve to shift to the
Demand curve shifts to the right if income
rises and shifts to the left if income falls,
ceteris paribus.
commodity at each price will cause the demand curve to shift to the
Demand and Supply Analysis
109
Exceptions to the Law of Demand
Giffen Goods
The case of
Giffen goods display direct price demand
relationship.
of the poor people and raised their marginal utility of money to such an extent that they were forced to
increased
Sir
happens that people in this case, with the rise of price of that good (say rice), are forced to reduce their
purchase of other expensive goods (say, chicken) and increase the purchase of that good (rice) in larger
Snob Appeal
value, for which the consumer measures the satisfaction derived from
This is an example of conspicuous consumption where the demand
known as
Veblen goods have snob value, for which
the consumer measures the satisfaction
derived not by their utility value, but by
social status.
110
Managerial Economics
Fig. 4.4
Demand Curve for Veblen Effect
eality
B ites
iPhone 7: The Gold Standard of Mobile Industry
Apple launched its latest smart phones iPhone 7 and iPhone 7 Plus in October 2016 at a starting price
of `60,000 for the 32GB model. The highly-anticipated latest models have advanced features such as
wireless headphones, stereo speakers, and water and dust resistance technology.
The iPhone 7 has a 4.7-inch display, costing US$ 649, while the 5.5 inch iPhone7 Plus is available
users perform different tasks by varying the pressure on the button.
Tim Cook, the CEO of Apple says that, “iPhone is the industry gold standard, the phone by which all
other smartphones are compared. The iPhone has become a truly cultural phenomenon.”
Sources: http://www.thehindubusinessline.com/info-tech/mobiles-tablets/apple-iphone-7-7-plus-india-launch-onoct-7-price-starts-rs-60000/article9085241.ece, accessed on 15/05/2017.
http://www.iphone7buzz.com/iphone-7-release-date-specs-price-and-other-news / accessed on 15/05/2017.
Demand and Supply Analysis
111
Demonstration Effect
activities, this is known as
Demonstration effect is the influence on
a person’s behaviour by observing the
behaviour of others.
Future Expectation of Prices
Panic buying is when people increase the
purchase of goods with the expectation
that prices will rise more in the future.
increase the purchase of these goods with the expectation that prices will rise more in the future, hence,
it is also termed as panic buying.
Goods with No Substitutes
112
Managerial Economics
SUPPLY
Supply refers to the quantities of a good or
service that the seller is willing and able to
provide at a price, at a given point of time,
ceteris paribus.
wide range of goods and render a vast variety of services for consumer
2
Supply indicates the quantities of a good or service that
the seller is willing and able to provide at a price, at a given point of
time, other things remaining the same.
Determinants of Supply
Price of the Commodity
Supply is positively related to price of the
commodity.
Cost of Production
Supply is reduced if the cost of production
rises.
State of Technology
and involves cost that includes prices of inputs (wages, rents, interest,
Demand and Supply Analysis
113
Number of Firms
Government Policies
eality
B ites
Pulsating Growth in Pulses
Agriculture is the backbone of Indian economy, with over half of the population depending on agriculture
directly or indirectly. Production of pulses has been upbeat since the past two years due to contributions of agricultural scientists and increase in minimum support price. Government policies have also
import.
Sources: https://www.researchgate.net/publication/281620011_Growth_and_Trends_of_Pulse_Production_in_
India,
.
http://www.thehindu.com/news/national/Growth-rate-of-pulses-production-encouraging/article14153044.ece,
.
years-radha-mohan-singh/articleshow/57194585.cms,
17/02/2017, p. 19.
Supply Function
product X (Sx
Px),
C),
114
Managerial Economics
(iii) State of technology (T),
G),
N
Sx = (Px, C, T, G, N)
Supply function represents the quantity of
the commodity that would be supplied at a
price, levels of technology, input prices and
all other factors.
…(7)
The supply function of a commodity represents the quantity of the
Sx) for a good X
S = f(P
where
c and d
Qs = c + d P
c > 0, d > 0
c
…(9)
slope d
LAW
OF
SUPPLY
The Law of Supply states that other things
remaining the same, the higher the price
of a commodity, the greater is the quantity
supplied.
The law of supply states that other things remaining the same, the
higher the price of a commodity the greater is the quantity supplied.
supply schedule and
Supply Schedule and Supply Curve
Supply schedule of a commodity is a list
or a tabular statement of the different
combinations of price and quantity
supplied of that commodity.
Supply curve represents the quantities
supplied of a commodity at different
price levels.
price increases (say from `15 to `
quantity supplied of a commodity is known as the supply schedule of
to the demand schedule, the only difference in case of supply schedule
showing different price levels of a cup of coffee and their corresponding
Demand and Supply Analysis
Table 4.3
115
Supply Schedule
Price
(` per cup)
Supply
(’000 cups per month)
15
10
20
15
25
30
30
45
35
60
Supply curve
quantity supplied is 10 thousand cups a month (point a
`15, the
`30,
d
Fig. 4.5
Supply Curve
Shift in Supply Curve
when change in supply is associated with change in factors like costs
Change in quantity supplied refers to
movements along the same supply
curve due to change in the price of the
commodity.
that earlier the seller was using an old machine and now has procured a new machine, which has
116
Managerial Economics
Fig. 4.6 Change in Supply
thus, supply curve will shift to the right from SS to S1S1
`
Change in supply is a shift in the supply
curve upwards or downwards due to non
price determinants of supply.
of `20, supply will fall to 10 thousand cups and the supply curve will
shift to the left from SS to S2S2
determinants of supply is known as change in supply
Table 4.4
Supply Schedule with New Machine
Price
(` per cup)
Supply
(’000 cups per month)
(old machine)
Supply
(’000 cups per month)
(new machine)
15
10
15
20
15
20
25
30
45
30
45
60
35
60
MARKET EQUILIBRIUM
Equilibrium refers to a state of balance that
can occur in a model showing a tendency of
no change.
After a detailed analysis of demand and supply, you are now in a
given
117
Demand and Supply Analysis
see that at `
Table 4.5
Market Equilibrium
Price
Supply
(’000 cups a month)
Demand
(’000 cups a month)
15
10
50
20
15
40
25
30
30
30
45
15
35
70
10
Price
Supply
(S)
E
25
of demand and supply will keep on changing till the point of
E
tendency of deviation from this position makes the system
return to the position E
`
Demand
(D)
O
30
Fig. 4.7
Quantity
Market Equilibrium
Qd(P) = Qs(P)
or lower than `
E
Excess Supply
If the price is `30, the consumers demand 15 thousand cups, given the demand curve DD
price the suppliers are willing to supply 45 thousand cups, given the supply curve SS
…(10)
Managerial Economics
Supply
(S)
30
Supply
(S)
Price
Price
118
E
E
15
O
15
Demand
(D)
45 Quantity
Fig. 4.8 Excess Supply in the Market
Demand
(D)
O
Fig. 4.9
10
50
Quantity
Excess Demand in the Market
ES = Qs – Qd
…(11)
eality
B ites
Raw Material Panic
The Indian Pulp and Paper Technical Association (IPPTA) has projected that the domestic paper
industry is expected to fall short of demand by 1.5 million tonnes by 2010-11 due to raw material
around 6.5 percent and is expected to further go up in future. Higher costs and supply constraints as
regards raw materials are being considered to be the biggest holdup in paper industry. The industry
now uses three sources of raw materials – recycled paper, wood and agro-based waste. Raw materials
occupy 40 percent of the production cost. Recycled paper, comparatively cheaper, comprises almost
are concerned with the cost of wood pulp besides its availability.
Source:http://www.paper360.org/paper360/articleDetail.jsp?id=443646,
Excess Demand
`15, quantity demanded is 50,
while quantity supplied is 10, given the supply curve SS
ED = Qd – Qs
DD,
…(12)
Price Adjustment Mechanism
If the quantity supplied is greater than the quantity demanded, there is excess supply at a price `30, as
`25, quantity 30)
Demand and Supply Analysis
119
`25, quantity
Qd = 1000 – P
Qs = 100 + 4P
Solution:
Qd) = quantity supplied (Qs)
So, 1000 – P = 100 + 4P
P
d
s
Q = 1000 – 500 = 500, Q = 100 + 4(500) = 2100
Therefore, excess supply = 2100 – 500 = 1600
Qd = 1000 – 100 = 900, Qs = 100 + 4(100) = 500
Therefore, excess demand = 900 – 500 = 400
Changes in Market Equilibrium
In the earlier sections, we have discussed how the demand curve or
supply curve shifts due to change in any of the determinants other than
Comparative statics is the process of
comparison between two equilibrium
situations.
comparative statics
Change in Demand
Let us assume that there is a change in demand due to a rise in income or shift in preference in favour
D1D1 and
initial supply curve S1S1
Q* and price at P
demand is manifested through the shift of the demand curve to the right (from D1D1 to D2D2
E to E1, where the new demand curve D2D2 intersects the supply curve S1S1
Q* to Q1
P* to P1
Change in Supply
D1D1 and S1S1 are the initial demand
E
P*, Q
120
Managerial Economics
supply curve to shift to the right from S1S1 to S2S2
price P2
Q2
E2
D2
E1
P1
D1
Price
Price
D1
S1
S1
E
S2
E
P*
P*
E2
P2
D2
S1
O
S1
D1
Q*
Q1
Quantity
Fig. 4.10 Change in Demand at Constant
Supply
D1
S2
O
Q*
Fig. 4.11
Q2
Quantity
Change in Supply at Constant
Demand
Change in Both Demand and Supply
in case demand rises due to the rise in income of consumers, while supply rises due to fall in the price
E1,
Comparative statics is the process of
comparison between two equilibrium
situations.
P1, Q1
right from D1D1 to D2D2 and the supply curve also shifts to the right
E2, where D2D2 and S2S2
P2, Q2
from S1S1 to S2S2
Price
D2
S1
D1
S2
E1
P1
E2
P2
S1
O
Fig 4.12
S2
Q1
D1
D2
Q2 Quantity
Increase in Both Supply and Demand
Demand and Supply Analysis
price will rise, or remain at the same level, or will fall, will depend on
the magnitude of shift and also on the shapes of the demand and
121
Increase in both supply and demand will
cause the sales to rise, but the effect on
price can be positive, negative or equal to
zero depending on the extent of the shifts
in the curves.
The quantity demanded of good X depends upon the price of X (Px), monthly income of
consumers (Y), and the price of a related good Y (PY
X (DX
DX = 1500 – 10PX + 4Y – 15PY
X in terms of the
price for X (PX), when Y is `500 and PY is `
X (SX) is given
SX
PX
Solution:
Y) and the price of the related good (PY), we can
DX = 1500 – 10PX + 4Y – 15PY = 1500 – 10PX + 4(500) – 15(60) = 2600 – 10PX
Given the supply function as SX
PX
DX = SX
Thus, 2600 – 10PX
PX fi PX = 150
DX = 2600 – 10PX = 2600 – 10(150) = 1100
eality
B ites
What The Indian Paradox of Supply and Demand
At the International AIDS Conference in Bangkok, the main issue discussed was getting inexpensive
generic drugs to tens of millions of people. The relatively small generic drug manufacturers in poor
countries were the focal point of discussion. One of the more aggressive of these generic drug
cocktail that costs less than 50 cents a day, thus making it not only easier to take, but also cheaper.
Triomune stands as the hope of treating millions of people in poor countries who have AIDS. The irony
is that Cipla sells Triomune mostly to other nations. Though the company has been trying for years to
sell more generic drugs in India, the Government was actually not coming to terms with Cipla’s until
recently. Activists consider this a profound paradox: A country known for manufacturing cheap AIDS
drugs has failed to put into action a plan for offering treatment to its 2 million citizens who are living
with AIDS.
Source: http://www.npr.org/templates/story/story.php?storyId=3339002,
.
122
Managerial Economics
SUMMARY
◆
◆
◆
◆
◆
X (Dx) is a function of price of the commodity X (Px), income of the consumer
(Y
Po), tastes and preferences of the
consumer (T), advertising (A), future expectations (Ef), and population and economic growth (N
A change in quantity demanded denotes movements along the demand curve due to a change in
price, while a change in demand denotes a rightwards or leftward shift of the demand curve due
◆
◆
◆
Supply of a product X (Sx) is a function of price of the product (Px), cost of production (C), state
of technology (T
G
N
◆
◆
◆
KEY CONCEPTS
Supply
Giffen goods
Demand and Supply Analysis
QUESTIONS
Objective Type
I. State True or False
II. Fill in the Blanks
and less when prices are low,
quantity of coffee will
III. Pick the Correct Option
123
124
Managerial Economics
Analytical Corner
Demand and Supply Analysis
d
125
s
is expected
d
d
s
s
S
S
dx
= 12,000 –
x,
sx
x
dx
x,
derive the new market
126
Managerial Economics
sx
x
Check Your Answers
State True or False
Fill in the Blanks
Pick the Correct Option
Analytical Corner
Caselet 1
Price Cut to Stay Alive
`
`67,000 crore,
Source:
Bailay, R. Marquee labels to come with smaller price tags, The Economic Times, JamshedpurRanchi, Tuesday, 14/02/2017, p. 5.
Demand and Supply Analysis
127
Case Question
Caselet 2
The Yoga of Advertising
Sources:
http://www.business-standard.com/article/companies/competition-from-patanjali-prompts-fmcgsto-hit-back-116011800008_1.html,
http://economictimes.indiatimes.com/industry/cons-products/fmcg/unilever-admits-to-newcompetition-in-patanjali/articleshow/54926013.cms,
Laghate, G. The year when Patanjali went on ad Blitzkrieg, The Economic Times, JamshedpurRanchi, Tuesday, 31/01/2017, p. 5.
Case Question
Caselet 3
The Demand and Supply of Mobile App Economy
131 percent in the past three years alone, which clearly reveals the rapid penetration of smartphones,
128
Managerial Economics
Sources:
http://www.digitalvidya.com/blog/mobile-app-market-india-4th-largest-app-economy/ accessed on
http://www.iamwire.com/2017/05/rise-app-economy-india/152340,
This is what makes India the next key player on app playground development, http://icoderzsolutions.
com/blog-detail/12/this-is-what-makes-india-the-next-key-player-on-app-playgrounddevelopment) accessed on 15/05/2017.
Case Questions
The Rough Ride from Feature Phones to Smartphones
Smartphone sales are, however, expected to grow to around 125 million in 2017 at a rate of
Demand and Supply Analysis
129
Sources:
http://www.gadgetsnow.com/tech-news/feature-phones-still-more-popular-than-smartphones-in-indiaread-how/articleshow/56792709.cms,
http://www.cxotoday.com/story/feature-phones-outsmart-smartphones-in-india-study/
https://www.androidheadlines.com/2016/12/indian-demand-smartphones-feature-phones-rising.html,
Khan, D., ‘Feature phones to dominate market in 2017’, The Economic times, Jamshedpur-Ranchi,
Thursday, February 9, 2107, p. 8; and ‘Local vendors face Chinese onslaught in handsets market,’
The Economic times, Jamshedpur-Ranchi, Tuesday, February 14, 2107, p. 5.
Posers
Power for All: Myth or Reality?
Pattern of Electricity Consumption (Utilities)
Year
Domestic
Commercial
Industry
Traction
Agriculture
3.9
1950-51
12.6
7.5
62.6
7.4
2000-01
23.9
7.1
34
2.6
35.6
2.5
2004-05
Others
4.0
5.6
22.9
6.1
Census
2001
th
130
Managerial Economics
(GOUP Policy 2003
`
to poor quality supply even to the remunerative consumers, resulting in these consumers moving away
Sources:
Pandey, N. and Geetika, ‘Uttar Pradesh Power Corporation Limited may Improve Performance by
better understanding of Organisational Dynamics published in Global Conference on Business and
Economics, pp 14-16, October 2006, Harvard University.
Electricity Bill 2003, Ministry of Power, Government of India.
GOUP Policy documents, 2004.
Posers
Chapter
5
2. List the degrees of responsiveness of demand.
3. Discuss various degrees of elasticities of demand and supply.
4. Learn how to measure elasticity by various methods.
5. Explain the relevance and application of elasticities of demand.
Chapter Objectives
1. Understand the meaning of responsiveness of demand to changes in determinants
of demand.
INTRODUCTION
Recall the law of demand, which shows the inverse relation between price of a commodity and its
quantity demanded. You know that when price of a commodity increases (or decreases), its quantity
demanded will fall (or rise). But this knowledge cannot answer a simple question that if price increases
by one unit, by what proportion will quantity demanded decrease. This is to say that the law of demand
gives only the direction of change of quantity demanded in response to a given change in the price of a
commodity, but not the magnitude of such a change. In order to ascertain this magnitude, you actually
need to know another concept, that of elasticity of demand.
responsiveness or sensitivity of demand for
the commodity it produces to changes in all the independent variables like income of consumer, price
we imply the proportion by which the quantity demanded of a commodity changes, in response to a
132
Managerial Economics
given
Responsiveness of a commodity is the
amount by which its quantity demanded
changes in response to a given change in
any of the determinants of demand.
the quantity demanded of a commodity either when the price of the
commodity is changed, or when it increases its advertising expenditure,
or when the consumer’s income increases as a result of reduced tax
rates, etc. Answers to all these questions can be found with the help of
the concept of elasticity. Knowledge of elasticity would obviously
basics of elasticity, its types, and the relation between elasticity and revenue.
Elasticity of Demand
Elasticity of demand measures the
degree of responsiveness of the quantity
demanded of a commodity to a given
change in any of the determinants
of demand.
Elasticity of demand measures the degree of responsiveness of the
quantity demanded of a commodity to a given change in any of the
Mathematically, it means the percentage change in quantity demanded
of a commodity to a percentage change in any of the (independent)
variables that determine demand for the commodity.
Let us now explain the different types of elasticity of demand. Note here that there can be as many
types of elasticities of demand, as the number of determinants of demand. However, we would restrict
ourselves to only four types of elasticity, namely price elasticity, income elasticity, cross elasticity and
advertising (or promotional) elasticity. As you know that demand is a function of multiple variables and
each of these variables independently affects demand in a different manner; therefore, in order to assess
the impact of one variable, we assume other variables as constant (ceteris paribus). Hence, in this chapter,
while talking of price elasticity, we shall assume income, price of other goods, advertisement, etc., as
given, and while measuring income elasticity we shall assume that price of the good, price of other
goods and all other variables are given. Therefore, if more than one variables are found to have changed
between any two periods, it will not be possible to assess the effect of any of these variables on the demand
for the commodity, and it will not be possible to measure the responsiveness (elasticity) of demand.
PRICE ELASTICITY
OF
DEMAND
Price is considered to be the most important among all the independent
variables that affect the demand for any commodity. That is why price
elasticity of demand (usually designated as “ep” or simply as “e”) is
considered to be the most important of all elasticities of demand. In
fact, most often when we refer to elasticity of demand, we actually imply price elasticity of demand.
Price elasticity of demand means the sensitivity of quantity demanded of a commodity to a given change
in its price.
Price elasticity of demand measures
the proportionate change in quantity
demanded of a commodity to a given
change in its price.
Elasticities of Demand and Supply
133
Degrees of Price Elasticity
of demand the same as slope of the demand curve? While discussing the measurement of elasticity you
will see that by principle of geometry, the same demand curve will show different degrees of elasticity
at its different points. However, for sake of simplicity it is conventional to depict relative degrees of
the higher is the elasticity and the steeper the demand curve, the lesser is the elasticity.
The different degrees of elasticity have been discussed in this section.
Perfectly Elastic Demand
ep = (in absolute
terms). In this case, unlimited quantities of the commodity can be demanded at the prevailing price and
even a negligible increase in price would result in zero quantity demanded. As shown in Figure 5.1, the
perfectly elastic demand curve is a horizontal line, parallel to the quantity axis. You would learn more
about such a demand curve when we discuss perfect competition under market morphology.
Highly Elastic Demand
When proportionate change in quantity demanded is more than a given change in price, the commodity
is regarded to have a highly elastic demand. In other words, ep > 1 (in absolute terms), such that a
proportionate change in quantity demanded is more than a proportionate change in price. Such a degree
Price
Price
goods are called luxuries
a proportionately greater increase in quantity demanded from Q1 to Q .
D
D
P1 to P leads to
D
P1
P2
D
O
Fig. 5.1
Q1
Q1
Quantity
Perfectly Elastic Demand Curve
O
Fig. 5.2
Q1
Q2
Quantity
Highly Elastic Demand Curve
Unitary Elastic Demand
When a given proportionate change in price brings about an equal proportionate change in quantity
demanded, then demand for that commodity is regarded as unitary elastic. In other words, ep = 1
(in absolute terms). Demand curves with unit elasticity are shaped like a rectangular hyperbola,
asymptotic to the axes; the rectangles formed with the axes and the demand curve are equal. As in
Figure 5.3, OP1 ◊ OQ1 = OP ◊ OQ . However, such cases are rarely found in real life.
Managerial Economics
D
Price
Price
134
P1
P1
P2
P2
D
D
O
Q1
Quantity
Q2
Fig. 5.3 Unitary Elastic Demand Curve
D
O
Q1 Q 2
Fig. 5.4
Quantity
Relatively Inelastic Demand Curve
Relatively Inelastic Demand
When change in quantity demanded is found to be offset by change
in its price, then the commodity has a relatively inelastic demand.
In other words, ep < 1 (in absolute terms), such that proportionate
change in quantity demanded is less than a proportionate change in
price. Such commodities have a steeper demand curve and are called
necessities, since they are less responsive to a given change in price.
As you can see from Figure 5.4, a large decrease in the price of the commodity from P1 to P leads
to a comparatively small increase in its quantity demanded, from Q1 to Q .
ep = : Perfectly elastic demand
ep = 0: Perfectly inelastic demand
ep > 1: Highly elastic demand
ep < 1: Relatively inelastic demand
ep = 1: Unitary elastic demand
This is the other extreme of the elasticity range
in which elasticity is equal to zero, i.e., ep = 0 (in
absolute terms). In this case, the quantity demanded
of a commodity remains the same, irrespective of
any change in the price, i.e., quantity demanded is
totally unresponsive to changes in price. Such goods
are termed neutral and have a vertical demand curve,
parallel to the price axis.
As is evident from Figure 5.5, at all price levels, say
OP1 and OP , quantity demanded remains constant
at OQ1.
THINK OUT
OF
Price
Perfectly Inelastic Demand
D
P1
P2
O
Fig. 5.5
D
Q1
Quantity
Perfectly Inelastic Demand Curve
BOX
curve has a greater absolute value of price elasticity of demand? Why?
Elasticities of Demand and Supply
135
Methods of Measuring Elasticity
After a discussion on the degrees of elasticity, let us explain the various
ways in which we can measure price elasticity.
Ratio (or Percentage) Method
In ratio method, price elasticity of demand
is expressed as the ratio of proportionate
change in quantity demanded and
proportionate change in the price of the
commodity.
This is the most popular method used to measure elasticity, according
to which, elasticity of demand is expressed as the ratio of proportionate change in quantity demanded
and proportionate change in the price of the commodity. Thus,
Quantity demanded =
Proportionate change in quantity demanded of commodity X
Proportionate change in price of commodity X
…(1)
The proportionate measure of elasticity has some distinct advantages over the other measures. This
method allows comparison of changes in two qualitatively different variables, namely changes in
physical units (demand) and changes in monetary units (price).1 It is also helpful in deciding how big a
change in price or quantity is.
Q - Q /Q
ep =
P - P /P
where Q1 = original quantity demanded, Q = new quantity demanded, P1 = original price level,
P = new price level.
Since price and quantity demanded of a commodity are inversely related for a normal good, they
would move in the opposite direction. Hence, ep will always be negative for a normal good. Economists
ignore the negative sign and use the absolute value of ep; since the negative value is only an indicator
that the commodity under consideration is a normal good.
Let us explain price elasticity of demand with an illustration.
Suppose quantity demanded of coconut is initially 800 units at a price of `10 and increases to
1000 units when price falls to `8. Calculate price elasticity of demand of coconut.
Solution:
ep =
Q - Q /Q
P - P /P
Putting the respective values we get,
ep =
800 10
Since value of ep > 1, therefore, it can be said that demand for coconut is relatively elastic.
1
136
Managerial Economics
ep =
DQ / Q1
DP / P1
…(3)
DQ = Q – Q1 and DP = P – P1
where
Here you may see that elasticity is being measured at a point of demand curve, thus, it is also referred
as point elasticity of demand. Now, this would be the point elasticity
Point elasticity measures elasticity at a
of a linear demand curve. In case the demand curve is non-linear,
point on a demand curve.
we need to apply calculus to calculate point elasticity. As changes in
DQ
price become smaller and smaller and approach zero, the ratio
DP
dQ
derivative of the demand function with respect to price, i.e.,
dP
dQ / Q
dQ P
◊
=
…(4)
ep =
dP / P
dP Q
Let us illustrate this concept with a numerical example.
The following linear equations represent different possible demand functions for three
commodities, X, Y and Z DX
P, b. DY
P, c. DZ
P.
i. What are the associated price elasticities at P = 4? Comment on the values obtained.
ii. Which of the three is a Giffen good?
Solution:
i. We know that
ep =
dQ / Q
dQ P
◊
=
dP / P
dP Q
By putting the value of P in the demand function for X we get,
dQ
= –3
¥
DX
dP
ep(X) = –
3¥ 4
fi Demand for X is highly inelastic)
By putting the value of P in the demand function for Y we get,
DY
¥
50 ¥ 4
fi Demand for Y is highly elastic)
Hence,
ep(Y) = –
By putting the value of P in the demand function for Z we get,
DZ
¥
¥
Hence,
ep(Z) =
= 0.833 (fi Demand for Z is less elastic, but positive)
ii. Commodity Z is a Giffen good because its price elasticity is positive.
Elasticities of Demand and Supply
137
Arc Elasticity Method
and quantity are discrete, and it is possible to isolate and calculate the
Arc elasticity measures elasticity at the
midpoint of an arc between any two points
on a demand curve.
we want to calculate price elasticity of demand between any two
an arc between any two points on a demand curve, by taking the average of the prices and quantities.
portion (arc) of a demand curve.
The basic assumption of this method is that elasticity is the same over the range of the values of the
ep =
Q -Q
Q +Q
∏
P -P
P+P
…(5)
where Q1 = original quantity demanded, Q = new quantity demanded, P1 = original price level,
P = new price level.
Q -Q P -P
¥
=
Q +Q P+P
this question with a numerical example.
Price
4
Quantity
1000
The difference between point elasticity and arc elasticity can be understood by creating two scenarios.
a. If P1= 3, Q1
Then, ep
P = 4 and Q = 1000.
ep
b. If P1= 4, Q1 = 1000, P = 3 and Q
Then, ep = –4 on the basis of point elasticity and ep
You can, thus, see that measuring elasticity for two different points Use of average in arc elasticity makes the
has given different values of ep, depending on whether price rises value of ep independent of the direction of
or falls, even for the same unit change in price and quantity. On the movement along the demand curve.
other hand, in arc elasticity method, the value of ep remains same,
irrespective of the direction of movement of price level. In other words, use of average makes the result
independent of the direction of movement along the demand curve.
Total Outlay Method
The total outlay method, proposed by Marshall, seeks to answer how
would any change in the price of a commodity affect the revenue (or
According to total outlay method, elasticity
is measured by comparing expenditure
levels before and after any change in price.
138
Managerial Economics
method, elasticity is measured by comparing expenditure levels before and after any change in price,
i.e., whether the new expenditure is more than, or less than, or equal to the initial expenditure level. This
method helps a seller in taking a decision to raise price only if the reduction in quantity demanded does
not reduce total revenue of the seller. Or a reduction in price increases the quantity demanded to the
extent that total revenue also increases. Table 5.1 illustrates the total outlay method of measuring elasticity.
Table 5.1
Measuring Elasticity by Total Outlay Method
Degree of Elasticity
Highly elastic (ep > 1)
Unitary elastic (ep = 1)
Highly inelastic (ep < 1)
Price (`)
Quantity Demanded
(Units)
Total Outlay (`)
Increased
Decreased
Decreased
Decreased
Increased
Increased
Increased
Decreased
No change
Decreased
Increased
No change
Increased
Decreased
Increased
Decreased
Increased
Decreased
Table 5.1 can be further explained by taking a numerical example to illustrate the three degrees of
price elasticity by total outlay method. The various degrees, thus, obtained have been summarised in
price. Elasticity in this case is greater than one. On the contrary, elasticity is unitary when there is no
change in the outlay with increase (or decrease) in the price of the commodity. Elasticity is less than
unity if the price of the product changes in such a way that the outlay decreases (or increases) with
decrease (or increase) in price.
Table 5.2
Elasticity by Total Outlay Method
Price (`)
Quantity Demanded
Total Outlay (`)
Elasticity
6
200
1200
ep > 1
8
60
480
4
350
1400
6
200
1200
8
150
1200
4
300
1200
6
200
1200
8
180
1440
4
250
1000
ep = 1
ep < 1
Elasticities of Demand and Supply
139
Elasticity at Different Points on a Linear Demand Curve
If the demand curve is a straight line, we can easily calculate price elasticity of demand at different
ep =
Lower segment of demand curve
Upper segment of demand curve
Let us calculate ep at various points on the demand
curve AB
At point A on the demand curve, ep = ; at point B, ep Fig. 5.6 Elasticity on a Linear Demand Curve
= 0; at the midpoint of AB, i.e., M, ep = 1. As is evident,
all the points above M have elasticity greater than 1, and those below M have elasticity less than 1.
Determinants of Price Elasticity of Demand
You have seen the various degrees of price elasticity of demand and can realise that price elasticity of
demand varies across commodities—luxury to necessity to neutral. Let us understand the factors that
determine price elasticity of demand and contribute to its disparity across commodities.
Nature of Commodity
By nature of commodity, we imply whether the commodity is a necessity or a luxury. You should note
element of relativity involved. What may be luxury to one consumer may be a necessity to another.
A typical example may be a mobile phone and its multi-utility versions like Blackberry. Moreover,
the distinction between luxury and necessity is very dynamic. What was luxury yesterday may be a
necessity today, due to changes in lifestyle, income levels and technological advances. All household
appliances can explain this phenomenon.
eality
B ites
Cup of Life!
Venkatram and Deodhar (1999) have conducted a study to estimate the aggregate domestic demand
for coffee econometrically, the results of which show that while demand for coffee in India is inelastic in
(Contd.)
140
Managerial Economics
very responsive to price of coffee. Moreover, they have found that short run elasticity is much smaller
than the long run elasticity. With regard to substitute product, tea, although demand for coffee is more
responsive in the long run, it has low elasticity. The authors have also observed that the Coffee Board
of India had proposed a promotional campaign in order to increase domestic demand for coffee. They
have suggested that the Board may focus efforts on non-price factors rather than price incentives in
their generic coffee promotional campaign.
Sources: www.iimahd.ernet.in/~satish/coffee.pdf), accessed on 28/11/2007.
Dynamic Demand Analysis of India’s Domestic Coffee Market IIMA Working Paper # 99-11-05, available at www.
scribd.com/document/338211519/Coffee-demand-pdf, accessed on 30/7/2017.
Availability and Proximity of Substitutes
One of the most important determinants of price elasticity of demand
of a commodity is the number of substitutes to the commodity that are
available to the consumer and also how close are these substitute to
the commodity. The logic is very simple. In case a commodity has a
close substitute, then a change in the price of the commodity would lead to a great deal of substitution,
given that the price of the substitute remains the same. You have already learnt about substitution effect
and income effect in Chapter 4. Such substitution, however, can be in favour or against the commodity.
Let us add a word about brands here. Price elasticity of demand of a brand of a product would be
quite high, given availability of other substitute brands. Thus, if price of apparels sold by Pantaloons
India Ltd. goes up, consumers may switch over to apparels from Shoppers Stop or Westside or FabIndia.
Thus, brands have a high degree of substitution effect.
Price elasticity of demand of a brand of
a product would be quite high, given
availability of other substitute brands.
Alternative Uses of the Commodity
If a commodity can be put to more than one use, it would be relatively price elastic. Consider electricity,
it is used for various purposes; when it is relatively cheap, it is used for all possible purposes, otherwise
its use is restricted to the most immediate purpose. Even the most common commodity water falls under
demand is elastic. On the contrary, consider an item like a calculator, or salt or life saving drugs, which
have only one use. Demand for such goods would, thus, be relatively price inelastic.
Proportion of Income Spent on the Commodity
The greater the proportion of income a consumer spends on purchasing a commodity, the more sensitive
would the commodity be to price, due to the income effect. The reverse also holds good. Consider the
example of match box, or post cards or salt. In case there is an increase in the price of salt, say from `10
to `
would not mind paying the extra amount for salt and will not reduce demand for salt. Or say match box,
if its price increases from `0.50 to `1.00, its demand would remain the same.
Elasticities of Demand and Supply
141
Time
Demand for any commodity is usually more price elastic in the long run. The reason is simple, consumers
A shift from petrol driven automobiles to CNG driven ones is a typical example. It may not be feasible
for consumers to switch from petrol driven cars in the short run, but they would gradually shift to CNG
driven vehicles in the long run.
Durability of the Commodity
Perishable commodities like eatables are relatively price inelastic in comparison to durable items like
consumer electronic appliances, cars, etc. We can explain this by the logic of postponement of purchase,
which is applicable to durables, and not to perishable ones. Postponement is also not possible in case
of urgency of consumption, as in the case of items like medicines. Another argument is the duration
consumers do not mind paying little more for higher satisfaction.
Items of Addiction
Items of intoxication and addiction are relatively price inelastic. Consider the example of cigarettes, if
their price rises, smokers may not be able to promptly cut down their consumption of cigarettes and may,
thus, not respond instantly to an increase in price.
REVENUE
AND
PRICE ELASTICITY
OF
DEMAND
would always be interested to earn more revenue. In previous sections, you have learnt that if the
commodity has a relatively elastic demand, then an increase in price would lower the level of revenue
inelastic demand, a change in price would have a greater effect on revenue than a change in quantity
INCOME ELASTICITY
OF
DEMAND
In Chapter 4 you have learnt that income of the consumer is an important determinant of demand.
Although income does not vary in the short run, its impact on long-term demand analysis is very crucial.
Therefore, it is useful to learn income elasticity of demand (ey).
142
Managerial Economics
Income elasticity of demand measures the
degree of responsiveness of demand for a
commodity to a given change in consumer’s
income.
ey =
Income elasticity of demand is the degree of responsiveness of
demand for a commodity to a given change in the income of the
consumer. When we measure income elasticity of demand, we assume
that all other variables (including price of the good) are given (ceteris
paribus). Using the proportionate method, ey
Proportionate change in quantity demanded of commodity X
Proportionate change in income of consumer
…(8)
Q - Q /Q
…(9)
Y - Y /Y
where Q1 = original quantity demanded, Q = new quantity demanded, Y1 = initial level of income,
Y = new level of income.
=
P1 and P by Y1 and Y respectively.
Degrees of Income Elasticity
Income elasticity of demand also has similar degrees of elasticity like price elasticity of demand, namely
perfectly elastic (ey = ), perfectly inelastic (ey = 0), relatively elastic (ey > 1), relatively inelastic
(ey < 1), and unitary elastic (ey = 1). Hence, when the proportionate change in demand is more than
that in income, demand is highly elastic; when the proportionate change in demand is less than that of
income, demand is highly inelastic. You should recall here that income normally has positive impact
on demand, but in case of certain goods, the impact can be negative, and such goods are called inferior
goods. Hence, the value of income elasticity can be either negative or positive, depending upon nature
of product. Let us explain in detail.
Positive Income Elasticity
A good that has positive income elasticity is regarded as a normal good. You have learnt in Chapter 4
that a normal good is one which a consumer buys in more quantities when his/her income increases.
Zero Income Elasticity
Zero ey implies that there is no change in the demand for a commodity when there is a change in income.
Such goods, as explained before, are known as neutral goods. Typical examples can be match box, salt,
postcard, needles, etc.
Negative Income Elasticity
Negative ey implies that demand for a commodity decreases as the income of the consumer rises. A
good that has negative income elasticity of demand is regarded as an inferior good, i.e., the consumer
buys less of such a good when his/her income increases. Typical examples would be inferior quality of
cereals, a consumer would switch over consumption to superior quality with increase in income.
Elasticities of Demand and Supply
143
eality
B ites
Demand for Necessities
Mohanty and Rajendran (2003) used income elasticity approach to estimate urban and rural demand
projections for food grains and other consumption necessities. They modeled the Engel curve to
to yield the following:
Double Log: ln (Y) = a + b ¥ ln X
…(i)
where Y is the quantity consumed, X is the income level and b is income elasticity. But this functional
form is not considered to be theoretically desirable because of its limitation that all food consumption is
expected to increase with rising income levels. Other functional forms include semi-log, log-log inverse
and log-quadratic.
Semi-Log: Y = a + b ¥ ln X
…(ii)
Income Elasticity = b/Y
Log-Log inverse: ln (Y) = a + b/X + c ¥ ln X
…(iii)
Income Elasticity = b/X–c
Log Quadratic: ln (Y) = a + b ¥ n X + b ¥ ln X2
…(iv)
Income Elasticity = b + 2c ¥ ln X
Source: Mohanty, S. and Rajendran K. (2003), ‘2020 Vision for Indian Poultry Industry’, International Journal of
Poultry Science, Vol. 2, No. 2, pp. 139–143, accessed on 13/12/2007.
CROSS ELASTICITY
OF
DEMAND
We now move on to another very important determinant of demand for any commodity, namely
price of “related” commodities and would discuss cross elasticity of demand (ec), which explains the
responsiveness of demand for one good to the changes in price of another related good (ceteris paribus).
Expressed in ratio form, cross elasticity (ec
ec =
=
Proportionate change in quantity demanded of commodity X
Proportionate change in price of commodity Y
…(10)
Q X - Q X /Q X
PY - PY / PY
…(11)
where Q X1 = original quantity demand for commodity X, Q X = new quantity demanded of commodity X,
PY1 = initial price level of commodity Y, PY = new price level of commodity Y.
144
Managerial Economics
Similar to price and income elasticity, arc cross elasticity may also be calculated.
If X and Y are related goods and an increase in price of Y results in a fall in quantity demanded of X,
it means X and Y are complements; on the other hand, if increase in
Cross elasticity of demand of a commodity
price of Y increases the demand for X, the two goods are substitutes.
X measures the degree of responsiveness of
its demand to a given change in the price of
another commodity Y.
The answer is that, it will help in various types of policy matters, like
how to respond to a change in the price of another good, should it be
ignored or should it be taken note of. It is here that the cross elasticity of demand provides useful
information.
Like price and income elasticities, cross elasticity can be either highly elastic or highly inelastic.
One point is to be kept in mind that, in case of substitutes, the value of ec would be positive, and in case of
Positive Cross Elasticity
Positive cross elasticity implies that between two goods X and Y, quantity demanded of X moves in the
same direction as the price of Y. From our previous discussions you would be able to recall that such
goods are known as substitutes, for example, Coke and Pepsi, Zen and Santro, etc.
Negative Cross Elasticity
●
●
For substitutes, quantity demanded of
one good moves in the same direction
as the price of the other.
For complements, quantity demanded
of one good moves in the opposite
direction as the price of the other.
Negative ec implies that between any two commodities X and Y, the
quantity demanded of one would move in the opposite direction as the
price of the other. From our previous discussions you would be able to
recall that such goods are known as complements, example, bread and
butter, tea and sugar, pen and ink, etc.
Let us see how we can determine such relationships among goods
with the help of an example.
1. Consider two goods X and Y. There was no change in price of X, but its demand was
commodity Y
Y and the relationship between the two goods.
Solution:
ec =
-
Since elasticity is negative, it can be concluded that X and Y are complements.
X and
Elasticities of Demand and Supply
145
X and Y. There was no change in price of X, but its demand increased
Y
relationship between the two goods.
X and Y and the
Solution:
-
ec =
Since elasticity is positive, it can be concluded that X and Y are substitutes.
PROMOTIONAL ELASTICITY
OF
DEMAND
Advertising and promotion are vital tools in the competitive market to
generate awareness about its products, and thus, to stimulate demand.
Some goods (like consumer goods) are more responsive to advertising
Promotional elasticity of demand measures
the degree of responsiveness of demand to
a given change in advertising expenditure.
would be interested to ascertain the dimension of the effect of incurring an “expenditure” on advertising,
vis-à-vis an increase in demand. Remember advertisement is a burden on cost and therefore, must be
(ea) measures such an effect, ceteris paribus. In ratio form, ea
ea =
=
Proportionate change in quantity demanded (or sales) of commodity X
Propotionate change in advertising expenditure
Q - Q /Q
A - A /A
…(13)
where Q1 = original quantity demanded (or volume of sales), Q = new quantity demanded (or volume
of sales), A1 = initial level of advertising expenditure, A = new level of advertising expenditure.
Here also degrees of elasticity are similar to those discussed ● When e > 1, a firm should go for heavy
a
in context of price. The decision-making component is that when
expenditure on advertisement.
ea > 1, one should go ahead with heavy expenditure on advertisement ● When ea < 1, a firm should not spend
too much on advertisement.
but when ea < 1, it is not advisable to spend too much on advertisement
and promotion, because the product is not sensitive to promotion.
advertisements for electricity, petrol or diesel.
eality
B ites
Demand for Electricity in India
Energy demand, and in particular electricity demand, in India has been growing at a very fast rate over
the last decade. Moreover, given the current trends in growth of population, rapid rate of industrialisation,
(Contd.)
146
Managerial Economics
urbanisation, modernisation and income growth, consumption of electricity is poised to increase
substantially in the decades to come. However, the effects of any price revision on consumption of
electricity would depend on the price elasticity of demand for electricity. Earlier studies on electricity
demand in India have been based on aggregate macro data at national or sub-national or State level.
Filippini and Pachauri (2002) have estimated price and income elasticities of electricity demand in
the residential sector of all urban areas of India using disaggregate level survey data for over 30,000
data for winter, monsoon and summer seasons. The results of their study show that electricity demand
is income and price inelastic in all three seasons, and that household, demographic and geographical
variables are important determinants of demand for electricity.
Source: Filippini, M. and Pachauri, S. (2002), ‘Elasticities of Electricity Demand in Urban Indian Households’, CEPE
Working Paper No. 16, March, 2002, www.cepe.ethz.ch, accessed on 1/12/2007.
the measurement of these elasticities with the help of a simple example.
Movers and Shakers Company Pvt. Ltd. concludes that the demand function for its product X
Qx
Px
Py
Y
A, where Qx = quantity demanded of its product X, Px
= price of X, Py = price of Y (a substitute to X), Y = consumer’s income and A = advertisement
At present, Px = `100, Py = `
Y = `10,000, and A = `
X
product X and rival’s product Y.
Solution:
By putting the respective values in the demand function, we get,
Qx
¥1
¥
¥
¥
100
a. Price elasticity of X ep
¥
= – 0.133
1500
b. Income elasticity for X
¥
10,000
1500
c. Advertisement elasticity for X
d. Cross elasticity between X and Y
IMPORTANCE
OF
ELASTICITY
OF
¥
1500
¥
1500
= 0.04
= 0.04
DEMAND
The concept of elasticity of demand has gained importance not only in terms of theoretical relevance, but
the relevance of each type of elasticity in their respective sections, nevertheless, we shall discuss them
here in further depth.
Elasticities of Demand and Supply
147
Determination of Price
demand of the product in perspective. It tells that products having elastic demand should be sold at lower
price, while those having inelastic demand should be sold at high prices in order to maximise revenue.
Basis of Price Discrimination
Price discrimination is the practice of charging different prices for the same product from different
consumers on the basis of place, use, time etc. Elasticity is one very important variable for price
discrimination. You will learn more about this practice in Chapter 11. Knowledge of price elasticity
enables the seller to charge higher price to a consumer who has relatively inelastic demand.
Determination of Rewards of Factors of Production
Rewards to factors of production are determined on the basis of their elasticities of demand. Factors
having inelastic demand are rewarded more than factors that have relatively elastic demand. For
example, the wages of unskilled labour may vary from `150 to `300 a day, whereas the salary of the
CEO of a multinational company can be beyond imagination of any layman.
Government Policies of Taxation
Government policies of taxation and excise duties are based on studies of elasticities of demand of
different products. Goods having relatively elastic demand are taxed less than those having relatively
inelastic demand. Governments know that sellers transfer the burden of tax on the consumer, therefore,
the authorities impose high tax on goods that have relatively inelastic demand and low tax on goods with
relatively elastic demand. The concept of other types of elasticities is useful in determining economic
ELASTICITY
OF
SUPPLY
You have understood various aspects of elasticity of demand. But you know that knowledge of demand
of fruits increases but supply remains same? As per law of supply, you know that higher the price higher
supply of fruits is inelastic in the short run. Just as we have learnt that responsiveness of demand for any
commodity to price of that commodity is known as elasticity of demand, similarly that responsiveness
of supply of any commodity to price of that commodity is known as elasticity of supply.
On the same lines with elasticity of demand, elasticity of supply (es) measures the degree of
responsiveness of quantity supplied of any commodity to a given change in price of the commodity.
In terms of the ratio method we can express es
es =
Pr oportionate change in quantity supplied of commodity X
Proportionate change in price of commodity X
148
Managerial Economics
demand, namely perfectly elastic (es = ), perfectly inelastic (es = 0), relatively elastic (es > 1), relatively
inelastic (es < 1), and unitary elastic (es = 1).
Obviously, in case of elasticity of supply, we would deal with movements along the supply curve
of a commodity. You know that price and supply have a positive relationship, which why the slope of
supply curve is also positive. Therefore, it would be rather easy for you to understand that value of es
will always be positive. Also, the higher the value of es, the more sensitive producers and sellers would
be to changes in the price of a commodity. A high value of es implies that if there is a unit increase in
price of the good, sellers will supply more than proportionate quantity of the good and when the price
of the good falls, sellers will respond by supplying less.
The different degrees of elasticity of supply can be understood with the help of supply curves.
However, you should keep in mind that as per the principles of geometry, slope of supply curve may not
be an indicator of elasticity.
DEGREES
OF
PRICE ELASTICITY
OF
SUPPLY
This is one extreme of the elasticity range, when elasticity is equal to
es = (in absolute terms). In this case, at the prevailing
price unlimited quantities of the commodity can be supplied, and even
the smallest increase in price would result in a huge increase in supply
of the particular commodity.
However, if price is reduced by even a very small amount, quantity
Price
Perfectly Elastic Supply
P1
O
supply curve is a horizontal straight line, parallel to the quantity axis.
Such a case of perfectly elastic supply is more of theoretical interest.
However, it can be found in some cases of durable goods which can
be stored for long time, such as real estate.
Fig. 5.7
S
Q1 Q 2
Quantity
Perfectly Elastic
Supply Curve
Perfectly Inelastic Supply
This is the other extreme, in which elasticity of supply is equal to zero, i.e., es = 0 (in absolute terms)
irrespective of price. In other words, quantity supplied is totally unresponsive to changes in price. That
is, whatever be the price the supply remains unchanged. This is also not a normal situation. However,
in real world its application can be seen in very short run market, especially where supply cannot be
changed for the day or time or moment. Say for example, you went to a mall and liked a dress but it was
not available in your size. You have to wear that dress in the same evening for your friend’s engagement.
You are willing to offer double the price, but the sales girl tells shows her inability to provide the dress
in your size. So you can say that the supply of that dress for that moment is perfectly inelastic to any
change in the price.
Elasticities of Demand and Supply
Unitary Elastic Supply
S
Price
The shape of a perfectly inelastic supply curve is vertical, parallel
to the price axis, as given in Figure 5.8. At all price levels, say OP1
and OP , quantity supplied remains constant at OQ1.
Apart from these two extremes, there is another situation when
supply is moderately responsive to price change. This may result in
three variants, i.e., unitary elastic, highly elastic and highly inelastic
supply. Figure 5.9 shows the three situations. We shall see them one
by one.
149
P1
P2
O
Fig. 5.8
Q1
Quantity
Perfectly Inelastic
Supply Curve
When a given proportionate change in price brings about an equally
proportionate change in quantity supplied, it is known as unitary elastic supply. In other words, es = 1
(in absolute terms) as in “Panel a” of Figure 5.9. As you have seen in elasticity of supply, this situation
cannot be predicted or estimated in advance, it is a coincidental. In large cases, it happens that the
proportionate change in supply is more or less equal to the proportionate change in price. That is if price
It can be called unitary elastic supply for all practical purposes.
Price
Panel c
S
P1
S
S
O
P1
P2
P1
P2
P2
Q1 Q2 Quantity
O
S
Price
Panel b
S
Price
Panel a
Q1 Q2 Quantity
O
S
Q1 Q2
Quantity
Fig. 5.9 Supply Curves with Different Levels of Elasticity
Highly Elastic Supply
Then there are goods whose supply is highly elastic to price; it is also called relatively elastic supply. A
small change in price brings a large change in supply. When es > 1 (in absolute terms), a proportionate
change in quantity supplied is more than a given change in price, it is called relatively elastic supply.
Goods of fashion, may be covered under this category. It can be seen as in “Panel b” of Figure 5.9.
Relatively Inelastic Supply
You must understand at the onset that relatively inelastic, highly inelastic and less elastic can be used
interchangeably to explain same phenomenon in the context. There may be case of less elastic or relatively
inelastic supply which will happen when es < 1 (in absolute terms). That is the proportionate change
in quantity supplied is less than a proportionate change in price, as shown in “Panel c” of Figure 5.9.
it is a case of highly inelastic supply. Or, for that matter if prices fall by 8 percent but supply reduces by
only 3 percent is also a case of relatively inelastic supply.
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Managerial Economics
DETERMINANTS
OF
PRICE ELASTICITY
OF
SUPPLY
function that you have already learned in previous chapters. These include, time, inputs, nature of goods,
Time
always faces inelastic supply. Elasticity increases with the length of time. The logic is that when time is
available suppliers can increase the supply to take advantage of increased prices. Recall the example of
the dress that you wanted to buy even for double the price. Supposing, you did not need the dress same
evening but next week or may be next month, then… the salesgirl could have helped you by providing
with greater ease than in the short run.
Availability of Inputs
Greater availability of inputs implies higher elasticity of supply. You would appreciate that this variable
is dependent largely upon the time available to increase or decrease inputs. In the forthcoming chapter on
Production Analysis, you will learn that in the long run every input can be increased or decreased. The
supply can be enhanced as compared to when it is scarce. If all materials are available but trained human
resource is not available, supply will remain less elastic. Many countries have faced this problem and
eality
B ites
The Japanese Demographic Pinch
Labour-intensive industries like logistics and restaurants in Japan are recently experiencing the trend of
fewer workers. Japan’s working age population has shrunk from 87.2 million in 1995 to 75.9 million in
in face of strong demand, companies are compelled to pay more overtime and hire part-time workers.
Average pay for temporary workers in the three biggest cities rose 2.1 percent in December, from 2015.
Reuter’s analysis reveals labour costs as a portion of overall sales are at the highest since the past
Commerce and Industry.
Source: Fewer workers, higher wages: Japan Inc. feels demographic pinch, Times of India, Ranchi, Friday,
3/03/2017.
Elasticities of Demand and Supply
151
Nature of Goods
Supply of durable goods is more elastic as compared to supply of perishable goods. Continue with our
example of semi constructed houses/apartments; supposing material gets available and the houses are
complete, still they may lie vacant why because builder is waiting for the market to improve. As soon
as prices of houses will go up, they will be put up for sale. Supply is highly elastic to price because it is
possible to hold back the goods without fear for spoilage. You would appreciate that this could not be
possible for eatables.
Storage Capacity
Another aspect is that greater the available stock of goods with the producers, the faster they can respond
to any change in prices. All industrial products are stored before being supplied to the consumer. Storage
takes place at every level, at the factory store house, dealer/distributor and retailer; though the capacity
goes down at every level of the supply chain. This facilitates the supplier to respond to opportunities
emerged due to increase in demand and price for that commodity. At the same time, quite a many of
agricultural products can be safely stored for some time affecting the elasticity of supply.
Technology
storages and other refrigeration facilities, the producers had no control over the supply. Needless to say
that technology has impacted even elasticity of supply among innumerable other things.
ON
MARKET EQUILIBRIUM
Figure 5.10 is drawn to depict the different situations of
equilibrium when there is a change in demand without any
change in supply. The diagram might appear to be frightening
initially because of so many lines. But it is very simple. We have
es = 0
Price
EFFECT
es < 1
es = 1
es > 1
elasticity in one diagram against a single demand curve D. Two
es =
situations are imagined, one when demand increases and is
P
shown at demand curve D1 and when demand decrease at curve
D . You can see that the new price is determined according to
D1
D2 D
degree of elasticity of supply.
O
Quantity
Q
Let us start with the initial demand curve D. When demand
increases, shown by the new demand curve D1, the, new price Fig. 5.10
is higher than the prevailing price. But the higher the degree of
Different Levels of Elastielasticity of supply, lower is the increase in price to the extent
city of Supply
that in case of perfectly elastic supply, there is absolutely no
change in price. Similarly, when demand falls and the demand curve shifts to D , the new price is lower
than the prevailing price. But the lower the degree of elasticity of supply, higher is the change in price
to the extent that when elasticity is zero, price fall is the highest.
152
Managerial Economics
The most important use of knowledge of elasticity of supply is that it helps in determining the
Producers also know which inputs might restrain their supply and result in low elasticity. You now surely
like to control the factors that reduce elasticity.
Furthermore, government would also like to know the elasticity of supply of various goods for the
purpose of taxation.
SUMMARY
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
Elasticity of demand measures the degree of responsiveness of the quantity demanded of a
commodity.
Price elasticity of demand (ep) measures the degree of responsiveness of the quantity demanded
of a commodity to a given change in its price, other things remaining the same.
By the percentage method, ep is expressed as the ratio of proportionate change in quantity
demanded and proportionate change in price of the commodity.
As per the total outlay method, elasticity is measured by comparing expenditure levels before and
after any change in price, i.e., whether the new expenditure is more than, or less than, or equal to
the initial expenditure level.
Arc elasticity is used to calculate elasticity of demand at the midpoint of an arc between any two
points on the demand curve, by taking the average of the prices and quantities; point elasticity can
be approximated by calculating the arc elasticity for a very small arc on the demand curve.
If the demand curve is a straight line, price elasticity of demand at different points of the demand
curve can be calculated by the ratio of the lower segment and upper segment of the demand curve.
The factors that determine ep include the number of substitutes available and their closeness to the
commodity, nature of the commodity, its alternative uses, proportion of income spent on it, time,
Income elasticity of demand (ey) measures the degree of responsiveness of the quantity demanded
of a commodity to a given change in consumer’s income. For normal goods, ey is positive; for
neutral goods, ey is zero and for inferior goods, ey is negative.
Cross elasticity of demand (ec) shows how changes in prices of other goods would affect the
demand for a particular good. For substitutes, ec is positive; and for complements, ec is negative.
Advertising (or promotional) elasticity of demand (ea) measures the effect of incurring an “expenElasticity of supply (es) measures the degree of responsiveness of quantity supplied of any commodity to a given change in price of the commodity. Degrees of elasticity of supply are perfectly
elastic (es = ), perfectly inelastic (es = 0), relatively elastic (es > 1), relatively inelastic (es < 1),
and unitary elastic (es = 1).
◆
hold back the good, and technology.
Elasticities of Demand and Supply
153
KEY CONCEPTS
Elasticity
Price elasticity
Cross elasticity
Arc elasticity
Responsiveness
Income elasticity
Advertising elasticity
Point elasticity
Elasticity of demand
Elasticity of supply
QUESTIONS
Objective Type
I. State True or False
i.
ii.
iii.
iv.
v.
vi.
vii.
Two linear demand curves parallel to each other will have equal elasticities at a given price.
Arc elasticity measures elasticity at a point on the demand curve.
Demand for electricity is relatively inelastic.
Demand for salt is inelastic.
A higher positive ec implies greater substitutability between two items.
If more inputs are available, then elasticity of supply is lower.
Price discrimination is the practice of charging different prices for different products from the
same consumer.
viii. AR is the revenue earned per unit of output sold.
ix. If shoes of Reebok are available, then the price elasticity of demand of Woodland shoes would be
low.
x. ep at the midpoint of a linear demand curve is equal to one.
II. Fill in the Blanks
P and Q.
iii. When ea
iv. A high ea
product.
ep.
154
Managerial Economics
III. Pick the Correct Option
i. If MR=AR, value of e
a. = 1
c. =
b. = 0
d. < 0
a. =1
c. >1
b. =0
d. <1
a. Unit elasticity
c. Zero elasticity
b. Point elasticity
d. Negative elasticity
a. Nature of commodity
c. Time
v. Negative ec
a. Complements
c. Inferior goods
vi. What happens to elasticity with time?
a. Decreases
c. No change
b. Proximity of substitutes
d. Government policies
b. Substitutes
d. Luxuries
b. Increases
d. None of the above
a. Positive
b. Negative
c. Unitary
d. Zero
viii. In which of the following situations is elasticity less than unity?
a. If the outlay increases with decrease in price.
b. If the outlay decreases with increase in price.
c. If the outlay increases with increase in price.
d. If the outlay remains same with decrease in price.
ep
a. Giffen
c. Veblen
b. Inferior
d. Normal
Analytical Corner
1. Does frequency of consumption affect elasticity? Support your answer with illustrations.
a. Point Price elasticity of demand and Arc Price elasticity of demand
b. Elasticity of demand and elasticity of supply
Elasticities of Demand and Supply
155
a. Superior goods and inferior goods
b. Complements and substitutes
the price for this new drink?
5. Is it always useful for a seller to lower the price in order to increase sales revenue? Support your
arguments with logic from this chapter.
income, which types of goods are likely to face reduction in demand?
Q = a – bP, the price
elasticity of demand is equal to –1 at the midpoint of the demand curve.
8. Consider the demand function for printers manufactured by Lazer Printers Pvt. Ltd. as given by
Qdx = áP xâ Y èP çy Aã, where Qdx is the demand for printers, Px is the price of printers, Y is the income
of consumers, Py is the price of printers manufactured by the competitors of Lazer Printers and A
represents the level of promotional outlay of the company. á, â, è, ã and ç are real numbers.
a. Can you tell which type a function is this?
b. You have so far dealt with linear demand functions. Can you calculate own price, income,
cross and advertising elasticities of demand of the demand function cited above? How?
`
`18 per kg. What is the elasticity of demand for apples in
the town?
10. In the following demand schedule, calculate the elasticity of demand with `4 as the initial price.
Quantity demanded (units)
15
Price (` per unit)
3
9
5
goods. Two of its products “Tea” and “Coffee” are related in consumption. The past experience
Year
Coffee (`/kg)
Quantity of coffee
bought (kg)
Income
Price of Tea
(`/kg)
1
95
20
1000
35
2
98
18
1000
35
3
98
21
1050
35
4
95
21
1000
40
Compute all the relevant elasticities of demand from the above data.
156
Managerial Economics
P
number of pen drives sold per month.
Q, where P is the price of a pen drive, and Q is the
b. If it sets a price of `500 for a drive, how many drives will it sell per month?
c. What is the price elasticity of demand if price is `500?
d. At what price, if any, will the pen drives of Unlimited Storage Inc. have negative unitary
elastic demand?
13. After a careful statistical analysis, Tasty Burgers of Mumbai concludes that the demand function
for its burgers is Q = 500–3P Pi
Y,
where Q = quantity demanded of its burgers, P = price of its burgers, Pi = price of burgers
of Jumbo Burgers, the closest rival of Tasty Burgers, Y = disposable income of consumers of
P = `10; Pi = `
Y
a. What is the price elasticity for the burgers of Tasty Burgers?
b. What is the income elasticity for the burgers of Tasty Burgers?
c. What is the cross elasticity of demand between the burgers of Tasty Burgers and Jumbo
Burgers?
14. For each of the following equations, determine whether demand is elastic, inelastic or unitary
a. Q = 100 – 4P and P = `
b. Q
P and P = `5
c. P = 50 – 0.1Q and P = `
its products X and Y
Year
Price of X (`)
Price of Y (`)
Quantity of X demanded (Units)
Consumers per
capita Income
2001
15.00
20.00
5,000
1,000
2002
17.50
22.50
5,500
1,050
2003
17.50
25.00
6,000
1,050
2004
20.00
25.00
5,500
1,050
2005
20.00
25.00
6,500
1,250
i. Compute all the relevant elasticities of demand from the above data.
ii. What is the relationship between product X and Y?
iii. Could the (own) price elasticity of demand for X between prices `15.00 and `
computed? Why or why not?
to the advantage of the company. Which aspects of the company can you correlate with the
concept of elasticity of demand?
Elasticities of Demand and Supply
157
Check Your Answers
State True or False
i. F
ii. F
iii. T
iv. T
v. T
vi. F
vii. F
viii. T
ix. F
x. T
Fill in the Blanks
i. negative
ii. slope
iii. greater
iv. more
v. more
Pick the Correct Option
i. c
ii. c
iii. b
iv. d
v. a
vi. b
vii. d
viii. c
ix. c
x. d
Analytical Corner
9. ep
10. ep = –1 in both cases
ep
ep
ep = 3.38
ey
ey = 3.15
ey
ec
ec = 0.38. Arc
(iii) Cross elasticity of demand for coffee (ec
ec
P = `1000, b. Q = 30, c. ep = –0.333, d. P = `1000
13. a. ep
ei = 0.5405, ep
14. a. |Ep| = 4, elastic, b. |Ep
Ep
eD’p
eD’p
eD’I
eD’I
(eD’p) =
eDx, P y
eD’I =0.958 Cross elasticity for coffee (eDx, P y
eDx, P y
(eDx, P y
ii. Since there is positive relationship between price of Y and demand for X, they are substitutes.
iii. Price elasticity of demand for X between prices `15.00 and `
Y and consumer’s income are not constant.
Caselet 1
Regaining its Lost Empire
India is world’s second largest market for phones and smartphones after China. Though Samsung is
still the market leader in overall phone and smartphone segments in the country, according to a study,
158
Managerial Economics
Mobile Business, Samsung India has stressed that the global concern of quality has been addressed
Sources:
Aulakh, G. (2017). Samsung looks to upset Apple Cart, The Economic Times, Lucknow, 20 April
2017, p. 7.
http://www.knowyourmobile.com/mobile-phones/samsung-galaxy-note-8/24018/samsung-galaxynote-8-100-coming-2017-release-date-specs,
http://www.businesstoday.in/technology/news/samsung-galaxy-note-7-comeback--note-7r-likely-tolaunch-in-india-at-cheaper-price/story/251634.html,
Case Questions
1. Elasticity of demand for a product is affected by availability of a substitute. Discuss from the
perspective of Samsung.
announcement?
Caselet 2
CNG Vehicles Have Arrived
CNG models are in production globally by Audi, Fiat, Ford, Honda, Hyundai, Lincoln, MercedezBenz, Opel, Peugeot, Renault, Toyota and Volkswagen. Some of the countries have taken big lead
The main factors causing this rapid growth include the current energy crisis, increasing
environmental awareness, and the price differentials between CNG and petrol. A look at prices will
make the point more clear. In India, CNG costs are at `
with `
transportation vehicles in the world, because the use of CNG is mandated for the public transport
system of Delhi. Consumers throughout the country are following suit. Automakers are currently
vying for marketing positions to further India’s efforts for CNG conversion.
Elasticities of Demand and Supply
159
Source:
www.iangv.org/tools-resources/statistics.html,
http://www.cngnow.com,
Case Questions
1. What is the relation between the demand for CNG and petrol? What will be the impact on
demand for CNG if price of petrol declines?
What more information do you need to give a conclusive answer?
Eating out expenses of Mr. Maram, a Mumbai based Product Manager, have more than doubled in past
two years. Earlier he was spending about `4000 a month on eating out with friends and colleagues, while
now he is spending more than `
Is it due to high Consumer Price Index?
Surprisingly in all the above cases, the answer is negative. It is not that Mr. Maram is compelled to
savings because train/air fare has seen upward trend. More interestingly, neither of the miscomplaining
going to more expensive eateries and oftener than two years ago. Mr. Parikh and family have started
taking international vacations, whereas earlier they were only going to nearby places within the country.
Ms. Ruchika goes on weekend getaways every month, while earlier she used to go only 3–4 times a year.
thirties; these consumers are young, earning well, have no responsibilities but have big aspirations.
This is the time of age marked by rapid career advancements, bringing in fat pay packages. As income
goes up, one tends to spend more on luxuries, fashionable goods, trendy brands and popular lifestyle.
Also an increase in income brings attitudinal change, luxury becomes norm; after all one works hard to
earn more only to live better. Therefore, it is normal to eat out at expensive places, change your mobile
handset every six-eight months, alter wardrobe every season, visit attractive foreign tourist locations,
stay in posh hotels, travel in taxi instead of public transport and the list is endless.
The most intriguing part of this change is that increase in expenses is hardly noticed by these people
income is much lower than this. This surge in expenses is so gradual that it does not pinch. Over a
160
Managerial Economics
period of time you become used to such lifestyle and as your responsibilities increase it may become
Posers
Chapter
6
2. Understand the types of demand forecasting.
3. Explore qualitative techniques of forecasting demand.
4. Understand quantitative and econometric methods of demand forecasting.
5. Point out the limitations of demand forecasting.
INTRODUCTION
Chapter Objectives
1. Introduce the relevance of demand forecasting in business.
162
Managerial Economics
MEANING
OF
DEMAND FORECASTING
“
under a proposed marketing plan.”
Demand forecasting is the tool to
scientifically predict the likely demand
of a product in the future.
American Marketing Association
analytical estimation of demand for a product (good or service) for a
particular period of time
how much
which
when and where
Categorisation by Level of Forecasting
Firm (Micro) level
Industry level
Economy (Macro) level
Categorisation by Time Period
Short-term forecasting
Long-term forecasting
industry
Demand Forecasting
163
Categorisation by Nature of Goods
Consumer Goods
Capital Goods
TECHNIQUES
OF
DEMAND FORECASTING
eality
B ites
New Coke: “Blind” Test
Coca Cola Company conducted a blind taste test on some 200,000 consumers, in which people were
not informed about what they tasted. The company used three different formulations, which it tested
against traditional Coke and Pepsi. Surprisingly not all of the 200,000 consumers who took the test
Apart from taste tests, the company also surveyed a different set of consumers to check whether or
not they favoured the change in concept of Coke. On basis of these results, the Coca Cola Company
decided that it was time to change its formula to make Coke sweeter like Pepsi. New Coke was
nd alteration
of packaging.
The launch of New Coke was met with negative reactions to the extent that there was a revolt among
customers, who could not accept such a change in so called “tradition” of an American product. Coke
New Coke was replaced by Coke Classic.
This is a classic example of the fact that spending millions on gauging consumer opinion may not
necessarily give desired results if a wrong choice is made regarding technique of demand forecasting.
Source: Anne B. (1985). Fisher Coke’s Brand Loyalty Lesson, Fortune, 5 August 1985 pp. 44-46, p 66. Thomas
C. Kinnear, Robert C. Goizueta, The Other Side, Bank Marketing, May 1987, Kenneth L. Bernhardt, Principles of
Marketing 3rd edition, pp. 228-229.
164
Managerial Economics
Choice of a forecasting technique depends
on objectives, costs, time, nature of data,
and complexity of the technique.
subjective
quantitative
SUBJECTIVE METHODS
OF
DEMAND FORECASTING
Consumers’ Opinion Survey
In consumers’ opinion survey, buyers are
asked about their future buying intentions
of products.
users
Census Method
Sample Method
Demand Forecasting
165
Merits
●
●
●
Demerits
●
●
●
●
eality
B ites
Exploring Rural Buyers’ Behaviour Pattern
promotion and penetration of MNCs. The tool of data collection was basically a structured undisguised
questionnaire administered to a sample of 290 households selected on random basis. Several open and
close ended questions were asked to elicit responses from consumers for major product categories.
The investigators were also advised to use observation method for collecting intangible information.
buying was an enterprise and a family event for them. Several rural marketing myths and beliefs were
and local brands on the other. It could be concluded that an insight in consumers’ buying behaviour
and perception is instrumental in identifying new marketing variables such as product offering, pricing
strategy, promotion, transportation and communication.
Source: Agrawal, P. R., Geetika, Singh, T. (2006). Consumer’s Buying Pattern in Indian Villages: Survey of a SubInstitute of Technology, Bangkok, Thailand, during 18-19/11/2006, pp 940-947.
Salesforce Composite Method
166
Managerial Economics
Merits of Salesforce Composite Method
●
●
●
Demerits of Salesforce Composite Method
●
●
●
Experts’ Opinion Method
Group Discussion
Delphi Technique
without
Demand Forecasting
Merits of Experts’ Opinion Method
●
●
●
Demerits of Experts’ Opinion Method
●
●
Market Simulation
observes
Merits of Market Simulation
●
●
Demerits of Market Simulation
●
●
●
167
168
Managerial Economics
eality
B ites
Simulation for Travel Demand Forecasting in India
is inhabited in metropolitan cities. A major effect of this phenomenon is on urban travel, due to rise in
density of existing zones and spatial expansion of city boundaries in order to accommodate the growing
population. Metropolitan planners need to estimate household growth in different zones of a city and
also travel interchanges between such zones.
Type and intensity of various economic activities in different zones and residential location choice
behaviour of households play vital role in zonal population growth. Household decision process for
residential location is quite complex and largely subjective in nature, for which, fuzzy composite
of a metropolitan city. Household growth and travel demand models are integrated dynamically to deal
with any policy intervention.
Sources: https://www.lap-publishing.com/catalog/details//store/gb/book/978-3-8465-3840-1/urban-growth-traveldemand-forecast-by-fuzzy-neuro-simulation, accessed on 16/05/2017.
accessed on
16/05/2017.
Test Marketing
In test marketing the product is actually
sold in certain segments of the market,
regarded as “test market”.
actually
Merits of Test Marketing
●
●
●
Demerits of Test Marketing
●
●
Demand Forecasting
169
●
QUANTITATIVE METHODS
OF
DEMAND FORECASTING
Trend Projection
Trend is a general pattern of change in the
long run.
Secular Trend
Seasonal Trend
Time series data are composed of:
● Secular trend
● Seasonal trend
● Cyclical trend
● Random events
Cyclical Trend
Random Events
170
Managerial Economics
Y =T+S+C+R
Y
or
Y
Y
C
S
R
Merits
●
●
Demerits
●
●
●
●
Methods of Trend Projection
(a) Graphical Method
T
S
C
T
R
Demand for mobiles (in lakhs)
Demand Forecasting
171
200
180
160
140
120
100
80
60
40
20
0
2001
2002
2003
Year
2004
2005
Fig. 6.1
(b) Least Squares Method
Y = a + bX
X
Least squares estimation is based on
the minimisation of squared deviations
between the best fitting line and the
original observations given.
SY = na + bSX
SXY = aSX + bSX
a = Y - bX
S Y -Y X - X
S X-X
172
Managerial Economics
Year
Demand (in lakhs)
2001
120
2002
120
150
2005
180
Solution:
Trend Values of Demand
Year
Demand (in
lakhs) (Y)
X
2001
120
1
2002
Deviations in
Y (y = Y – Y )
2
Deviations in X
(x = X – X )
–22
–2
X2
XY
–2
–1
1
2
120
–22
0
0
0
150
8
1
1
8
Sy = 0
Sx = 0
2005
180
5
N=5
SY = 710
Y
SX = 15
X
–2
Y = a + bX
SY = na + bSX
SXY = aSX + bSX
a=
b
Y
X
Y
Y
Y
Y
Y
76
Sx2 = 10
Sxy
Demand Forecasting
(c) ARIMA Method
Box Jenkins method.
Stage One
Stage Two
Stage Three
Stage Four
Stage Five:
Smoothing Techniques
Moving Average
173
174
Managerial Economics
n
 Di
Dn =
th
Di
i
i
n
n
Month
Jan.
Feb.
Mar.
Apr.
May
Jun.
Jul.
Aug.
Sep.
Oct.
Nov.
Order
120
180
200
100
110
50
80
120
150
90
120
Solution:
 Di
i
n
 Di
=
i
n
+
=
+
+
=
+
+
Weighted Moving Average
In weighted moving average method, we
forecast the future value on the basis of
weights of the most recent observations.
weights
Dn =
 wi Di
i
Di
th
i
wi
ith
n
+
Demand Forecasting
175
Solution:
¥
¥
¥
Exponential Smoothing
Exponential smoothing method assigns
greater weights to the more recent data.
Ft
Ft
= aDt
a Ft
Dt
Ft
a
a
Ft
Ft
Ft
Ft
Ft
Ft
= aDt
= aDt + a
Ft
= aDt + a
+…+a
a aDt
a Dt
a Ft
a Ft
a Dt + a
a Dt + a
a Dt
t
a D +a
a Dt + a
a tF
Ft
a
a
Ft
= Ft
a
Ft = Dt
Dt
Ft
Dt and
176
Managerial Economics
Table 6.1
Weights in Exponential Smoothing
Observations
a = 0.2
a = 0.1
Dt
0.2
0.1
Dt–1
0.16
0.09
Dt–2
0.128
0.081
0.08192
0.06561
0.0729
Dt
Dt
each
Solution:
F = aD
aF
¥
F
¥
¥
¥
Period
Month
Order
Forecasted Order
1
Jan
120
——
2
Feb
180
Mar
200
Apr
100
5
May
110
6
Jun
50
7
Jul
80
106.51
8
Aug
120
98.55
9
Sep
150
10
Oct
90
11
Nov
120
12
Dec
——
120
156.6
112.95
Demand Forecasting
177
Barometric Techniques
leading
indicators
In barometric forecasting, we construct an
index of relevant economic indicators and
forecast future trends on the basis of these
indicators.
coincident series
lagging series
Merits of Barometric Techniques
●
●
Demerits of Barometric Techniques
●
●
178
Managerial Economics
eality
B ites
Information Through Time Series
growth in PC market in India over time, and also predict future prospects with reasonable accuracy.
All the data relevant to PC sales have been acquired from the IDC (India) Ltd. and other published
sources. Though such an econometric analysis necessitates a fairly long time series data, PC sales
It has been assumed that the global and domestic economic conditions affect demand of the domestic
PC growth (Actual)
PC growth (Fitted)
0.50
Estimation
Growth (Fraction)
0.40
Projection
0.30
0.20
0.10
0.00
–0.10
–0.20
2003Q4
2003Q2
2002Q4
2002Q2
2001Q4
2001Q2
2000Q4
2000Q2
1999Q4
1999Q2
1998Q4
1998Q2
1997Q4
1997Q2
1996Q4
–0.30
Fitted and Projected Growth in PC Sales in India
The analysis suggests that PC sales would have risen by 16 percent during the fourth quarter of
Source:www.unpan1.un.org/intradoc/groups/public/documents/APCITY/UNPAN022626.pdf, accessed on
Econometric Methods
and statistical inference are applied to the analysis of economic phenomena.
Goldberger
Demand Forecasting
179
Econometric methods apply statistical tools
on economic theories to estimate economic
variables.
Regression Analysis
Regression analysis relates a dependant
variable to one or more independent
variables in the form of a linear equation.
Dx = a + a Px + a Y + a Py + a A + a t + a Vn
Dx
t
X Px
X Py
Y A
Vn
a a
Px Y Py
Dx
(i) Simple (or Bivariate) Regression Analysis
Px Y
a
180
Managerial Economics
one
D = a + bP
b
a
Y
D
D
a and b
Table 6.2
Demand for Cars in 2006
Price of Cars (in ` Lakh)
Price (in ` lakh)
Number of Cars (in thousands)
5
10
15
20
25
250
180
160
150
110
100
40
35
30
25
20
15
10
5
0
0
50
100
150
200
Number of Cars (in thousands)
Fig. 6.2 Demand for Cars in 2006
250
300
80
Demand Forecasting
P Q R S T and V
181
Y
P
Q
R
T
S
D and P
V
O
X
P and D
Fig. 6.3
Scatter Diagram
D = a + bP + e
a and b
e
a and b
Q R T and V
P
S
a and b as a^ and b
D = a^ + b^P
e
a^ and b
(
`
`
Price (`/kg)
18
20
25
Demand (in kg)
90
85
75
70
65
Solution:
X2
Price (`/kg) (X)
Demand (in kg) (Y)
18
90
1620
20
85
1700
XY
Contd.
182
Managerial Economics
Contd.
25
75
625
70
900
1875
2100
65
n = 5 SX = 125
2080
SX2
SY
SXY
Y = a + bX
SY = na + bSX
SXY = aSX + bSX
a
Y
`
`
b
X
Y
Y
Regression statistics
R
and the F
R2 statistic measures the proportion of the
variations of the dependent variable that is
explained by the regression line.
R Square R
ei
R
actual D
D
D
R =
R =
-
183
Demand Forecasting
R
R
R
£R £
R
R
R
R
R
R
R ◊
NN -k
k
F Statistic
N
F
R
F=
R
R k-R
N -k
F
F
Standard error of regression
N -k
(ii) Non-linear and multiple regression analysis
184
Managerial Economics
(a) Non-linear Regression
D =A+B
P+e
A and B
D
D and P
P
D* = a + b P* + e
(b) Multiple Regression Analysis
P
A
D = a + a ◊P + a ◊A + e
a a and a
two
a a and a
a^ a^ and a^
D^ = a^ + a^ P + a^ A
R
Demand Forecasting
185
Problems associated with regression analysis
(i) Multicollinearity
(ii) Autocorrelation
(iii) Heteroscedasticity
Multicollinearity is the situation in which
two or more explanatory variables in the
regression model are highly correlated.
186
Managerial Economics
(iv)
(b) Simultaneous Equations Method
Simultaneous equations method
incorporates mutual dependence
among variables.
●
●
●
●
Demand Forecasting
n
LIMITATIONS
187
n
OF
DEMAND FORECASTING
Change in Fashion
eality
B ites
Let There Be Light!
relevance, which has led to the development of various new tools and methods for forecasting in the last
two decades. Among the different techniques available, the econometric approach combines economic
theory with statistical methods to produce a system of equations for the purpose of forecasting energy
electricity demand and other economic variables.
Here the dependent variable, namely demand for electricity, is expressed as a function of various
economic factors like population, income per capita or value added or output (in industry or commercial
sectors), price of power, price(s) of alternative fuels (substitutes), proxies for penetration of appliances/
equipment (capture technology effect in case of industries) etc. Thus, we get,
ED = f (Y, Pi, Pj, POP, T), where ED = electricity demand, Y = output or income, Pi = own price, Pj =
price of related fuels, POP = population, T = technology.
Source: Bharadwaj, A. G. and Mehra, M. K. (2001). Demand Forecasting for Electricity: the Indian experience, In
Sarkar S K and Deb Kaushik (Eds). Regulation in Infrastructure Services: progress and the way forward. TERI,
2001. ISBN: 8185419884, pp. 175-192.
Consumer Psychology
188
Managerial Economics
Uneconomical
Lack of Experts
Lack of Past Data
SUMMARY
◆
◆
◆
◆
◆
without
◆
◆
◆
◆
Demand Forecasting
◆
◆
◆
KEY FORMULAE
Y = T.S.C.I
Y=T+S+C+I
Y = a + bX
SY = na + bSX
SXY = aSX + bSX
a = Y - bX
b=
S Y -Y X - X
S X-X
n
 Di
Dn =
i
n
n
Dn =
Â
wi Di
i
Ft = aDt
Ft = aDt + a
+…+a
a
t
a Ft
a Dt + a
a Dt + a
a Dt
t
D +a
a Dt + a
a F
R =
R
R
F=
SE =
R ◊
NN -k
R k-R N -k
N -k
189
190
Managerial Economics
QUESTIONS
Objective Type
I. State True or False
II. Fill in the Blanks
F
III. Pick the Correct Option
Demand Forecasting
F
F
F
F
Analytical Corner
R
191
192
Managerial Economics
`
Sales (in thousands)
7
2
6
15
0.2
0.26
16
12
0.5
`
(
`
Price (in ` thousands)
1
2
Supply (in thousands)
5
180
210
260
(
Price (in ` hundreds)
100
150
200
Demand (in thousands)
20
18
15
12
5
X on X and X
X1
5
7
X2
15
12
8
9
8
6
10
20
X
Month
Demand for pizzas (in thousands)
1
15
10
2
18
5
20
16
6
25
193
Demand Forecasting
Month
1
2
Demand for book (in thousands)
20
18
Month
Sales (in thousands)
Check Your Answers
State True or False
Fill in the Blanks
1
5
26
17
2
21
21
18
6
28
5
6
15
12
194
Managerial Economics
Pick the Correct Option
Analytical Corner
¥
¥
¥
X
X
X
Caselet 1
The Pilot CNG
Demand Forecasting
195
Sources:
Aggarwal and Prasad (2014). Pilot project for CNG-run two wheelers launched in Delhi, Live Mint,
24/06/2016. Available at: http://www.livemint.com/Politics/u3nv21jnjayLO0bXrMCTGJ/Pilotproject-for-CNGrun-two-wheelers-launched-in-Delhi.html,
http://www.cseindia.org/node/209,
http://auto.ndtv.com/reviews/honda-activa-3g-with-cng-kit-review-1647696,
Case Questions
Caselet 2
Forecast to Reduce Risk
Source:
http://www.cgdev.org/content/publications/detail,
Case Questions
196
Managerial Economics
Forecasting Electricity Price
Sources:
Market, International Journal of Enhanced Research in Science Technology & Engineering, Vol. 3
Issue 1, January 2014, pp. 366–372.
Posers
Part
3
Cost and Production
You are now sufficiently geared up to track the path to production decision-making process.
Part 3 deals with the twin aspects of cost and revenue, and production decisions: firstly, you would
learn about cost, which is very important as it creates a constraint on economic decisions. Here you
would know about various types of costs, short run and long run cost functions, total, average and
marginal cost functions and finally revenue concepts, economies of scale and economies of scope.
The other aspect is of various factors of production/inputs and the relation between inputs and
output, the concept of production function and role of technology. The next part will take you to
the output and price decisions of firms under different market forms.
CHAPTERS
7. Cost and Revenue
8. Production Analysis
9. Financial Evaluation of Long-Term Projects
Chapter
7
2. Explain different types of costs, with focus on the difference between economic and
accounting philosophies.
3. Analyse the importance of matching costs with relevant time frames and to understand
the short and long run costs.
4. Build an understanding of estimation of cost functions.
5. Comprehend the concepts of revenue, economies of scale, economies of scope,
break-even analysis and learning curve.
Chapter Objectives
1. Understand the meaning of cost in economic analysis and its relevance in managerial
decision-making.
INTRODUCTION
What do we mean by costs? What is the fundamental nature of costs? Why do they exist? Why cannot
these things available to you? Obviously you paid
1
cost
1
200
Managerial Economics
Cost is a sacrifice or foregoing that has
occurred or has potential to occur in future,
measured in monetary terms.
2
C= Q T P
where C
KINDS
Q
OF
COSTS
i. Accounting Costs:
only money costs or
2
T
P
Cost and Revenue
costs
ii. Real Costs:
No
Real costs are more or less social and
psychological in nature.
iii. Opportunity Costs:
which is
iv. Implicit Costs:
Implicit costs do not involve actual
payment or cash outflowor reduction
in assets.
201
202
Managerial Economics
v. Explicit Costs: These are also known as out of pocket costs or accounting costs
Explicit costs go to the trading and profit
and loss account.
vi. Social Costs:
Social costs consist of private costs of the
firm and social costs paid by the society.
vii. Replacement Costs:
Replacement costs are current price or cost
of buying or replacing any input at present.
-
Cost and Revenue
203
viii. Historic and Future Costs:
Historic costs are sunk costs, as they cannot
be retrieved from the business without loss.
ix. Direct and Indirect Costs:
Direct costs are those that can be attributed
to any particular activity.
Indirect costs may not be attributable to
output. They are distributed over
all activities.
xi. Controllable and Uncontrollable Costs:
controllable costs are those which
uncontrollable costs are beyond regulation of the
204
Managerial Economics
xii. Production and Selling Costs:
COSTS
IN
SHORT RUN
i. Total Cost Functions and Curves
a. Fixed Costs:
Fixed costs are costs that do not vary with
output.
also referred to as
b. Variable Costs:
Cost and Revenue
205
TC
by the law of variable
Costs
(`)
TVC
TFC
O
Fig. 7.1
Quantity
Costs in the Short Run
Variable costs are costs that vary with
volume of output.
by the
ii. Average and Marginal Cost Functions
Marginal cost is the change in total cost
due to a unit change in output.
206
Managerial Economics
iii. Average and Marginal Cost Curves
Once you have understood the behaviour of the
Fig. 7.2
Costs
Cost and Revenue
Q
Q
Q
+
Q
=
Q
L
=
Q
L
Q
=
◊
=
◊
L
Q
1
MCQ = TCQ – TCQ – 1
where Q
=
L
D
DL
=
DL
=
DQ
◊
1
dTC
dQ
207
208
Managerial Economics
Table 7.1
Cost Functions of Reallyfresh Juices (in ` per day)
Output
TFC
0
500
1
TVC
TC
AFC
AVC
AC
MC
0
500
—
—
—
—
500
50
550
500
50
550
50
2
500
80
580
250
40
290
30
3
500
105
605
166
35
201.6
25
4
500
129
629
125
32.2
157.2
24
5
500
150
650
100
30
130
21
6
500
180
680
83
30
113
30
7
500
225
725
71
32.1
103.1
45
8
500
280
780
62.5
35
97.5
55
9
500
360
860
55.5
40
95.5
80
10
500
450
950
50
45
95
90
11
500
545
1045
45.5
49.5
95
95
12
500
655
1155
41.6
54.6
96.2
13
500
800
1300
38.4
66.6
105
145
14
500
1020
1520
36
73
109
220
15
500
1350
1850
33.3
90
123.3
330
110
th
`
th
th
unit
Cost and Revenue
th
Calculus Corner:
d
=
dQ
d
fi
Q
dQ
=
QdTC dQ - TC
=
Q2
fi
-
Q
fi
Q
=0fi
2
fi
d2
>0fi
dQ 2
fi
Q – 11Q2
Q
Q2
Q
Q
Q2
Q
Q
Q2
209
210
Managerial Economics
d
dQ
d2
dQ 2
=0fi
Q
fiQ
Q
Q – 10Q2
Q
Q2
d
=0fi
dQ
Q
Q
fiQ
Q
d2
dQ 2
Q
Q2
d2
dQ 2
Q
COSTS
IN
LONG RUN
i. Long Run Average Cost
d
dQ
fi
Q
fiQ
Cost and Revenue
211
1
2
q0 to q1
1
q1
1
2
q2
AC,
MC
MC2
MC1
O
SAC1
q1
q0
SAC2
q2
MC2
SAC2 < LAC
Quantity
Fig. 7.3 Long Run Average Cost Curve (Scallop Curve)
LAC curve is known as an envelope curve or
a planning curve.
1
2
212
Managerial Economics
LMC
SMC1
AC,
MC
SAC3
SAC3
SAC1
SMC3
C LAC
SMC2
SAC2
A
O
B
q0
q1
q*
q3
Quantity
Fig. 7.4
ii. Long Run Marginal Cost
The
q0
Aq0
A B and C
Oq
iii. Different Shapes of Long Run Average Cost Curves
economies of scale offset diseconomies
Cost and Revenue
Panel a
AC
AC
Panel b
213
Panel c
AC
LAC
LAC
LAC
O
Quantity
O
Quantity
O
Quantity
Fig. 7.5 Possible Shapes of LAC Curve
are:
●
●
iv. Long Run Total Cost
Cost
LRTC
we can readily derive the
O
Fig. 7.6
COSTS
OF A
MULTI PRODUCT FIRM
Quantity
Long Run Total Cost
214
Managerial Economics
C1 and C2
Q1 and Q2
C1Q1
C2Q2
●
●
●
ACw(Q) =
F + C1( X 1Q ) + C 2 ( X 2Q )
Q
weighted average
Q
F + C1 X1Q + C2 X 2Q
Q
where X1 and X2
Q
1 is 2Q1
Q2
Q
F
C1 X1Q
C2 X2Q
Q
Q
COSTS
OF
JOINT PRODUCTS
Q
Cost and Revenue
215
,
common costs, which
common costs are as follows:
i. Physical measure:
ii. Sales value at split off:
CONCEPTS
OF
REVENUE
`
`
`
one washing machine for `
`
`
216
Managerial Economics
Total Revenue (TR):
TR = Q P
where Q
P
`
¥
¥
¥
Average Revenue (AR):
=
TR
P
=Q◊ = P
Q
Q
`
Marginal Revenue (MR):
Q
= TRQ – TRQ–1
where Q
dTR
dQ
Q
TR = 110Q
Q2
dTR
= 110 – 10Q
dQ
TR
dQ
Q2
Q
Cost and Revenue
217
Price
Revenue
O
Quantity
TR
Price
Revenue
MR is the slope
of TR curve
inverted U
O
Quantity
MR
Fig. 7.7
n
1
n
2
TR = S
or
Table 7.2
Relation between TR, AR and MR
Units Sold
(Q)
Price (`
1
10
2
2
TR = Q ¥ P
`
`
AR = TR ∏ Q = P
`
MRn = TRn – TRn – 1
10 = 1 ¥ 10
10 = 10 ∏ 1
10 = 10 – 0
¥
∏2
¥
∏
¥
∏
¥
∏
¥
∏
¥
∏
¥
∏
¥2
∏
218
Managerial Economics
Relation between Marginal Revenue and Average Revenue Curves
●
●
●
AR is the revenue earned per unit of
output sold.
AR = P
MR is the revenue a firm gains in
producing one additional unit of a
commodity.
MR
MR
MR
AR
AR
MR
O
MR
MR
Quantity
O
Quantity
Panel a
AR
O
Panel b
Quantity
Panel c
Fig. 7.8
Revenue Concepts and Price Elasticity of Demand
ep
ep
ep
ep
ep
È 1˘
MR = AR Í1 – ˙
Î e˚
dTR d
dp
È Q dP ˘
=
PQ = P + Q
= PÍ +
˙
dQ dQ
dQ
Î P dQ ˚
dP P ˘
È
È
˘
= P Í1 - ˙
= P Í1 +
˙
Î e˚
Î dQ Q ˚
È 1˘
P
ÍÎ1 - e ˙˚
e
ep
dQ Q
dP P
219
Cost and Revenue
Price,
Revenue
ep =
ep > 1
ep = 1
Panel a
ep < 1
ep = 1
O
Quantity
MR
Price,
Revenue
Panel b
O
TR
Quantity
Fig. 7.9
fi
=
Prove that ep =
È 1˘
ÍÎ - e ˙˚
ep
-
AB
M
AB
MP and MQ
and draw a straight line from A through K and extend it until it cuts MQ
BM
Price,
ep
M=
AM
Revenue A
DAPM is similar to DMQB
BM MQ
=
AM
AP
DAPK and DLMK
P
K
MP
K
L
M
MK =
KP
ML = AP
ML
MQ MQ BM
=
=
= ep
AP ML AM
AP
L
O
B
Q
MR = 0
MR
Quantity
220
Managerial Economics
MQ = Price =AR and ML = MQ – LQ = AR
AR
Therefore ep =
AR fi ep = 1 and AR
fi ep
fi ep = 0
AR
fi ep =
fi ep < 1
Relation between Cost, Revenue and Profit
Normal profit is that amount of return
which must be earned to keep to the
entrepreneur in that business activity.
Supernormal profit is the accounting profit
that occurs when total revenue exceeds
total cost.
should know that economists differentiate
be earned
Q
2
10Q – Q
Q2
Q
dTR
= 110 – 10Q
dQ
dTC
= 10 – 2Q
Q
TR
Q
Q2
Q
TC
= 10 – Q
Q
Q2
Cost and Revenue
fi 110 – 10Q = 0 fi Q
Q
=0fiQ
221
d Ê dTR ˆ
dQ ÁË dQ ˜¯
fi
Q
d Ê dAC ˆ
dQ ÁË dQ ˜¯
Q
BREAK-EVEN ANALYSIS
Break-even point is the point where total
cost just equals the total revenue; it is the
no profit no loss point.
a. Graphical Method
222
Managerial Economics
E
Cost,
Revenue
TR
TC
E
VC
FC
O
Q
Quantity
Fig. 7.10 Determination of Break-even Point
b. Algebraic Method
P
Q the
Q* be
Total Revenue = P Q
Q
Cost and Revenue
fi
P
fi
PQ
Q
Q*
Q* =
P-
Contribution Margin:
P
PV Ratio:
PV Ratio =
FC
PV ratio
Margin of Safety:
Limitations of Break-even Analysis
●
●
●
●
●
223
224
Managerial Economics
`
also incurs a cost of `
`
`
`
`
`
P Q* =
`
PV Ratio =
FC
PV ratio
ECONOMIES
OF
SCALE
-
= 2000
Cost and Revenue
225
associated
`
`
`
Economies of scale mean lowering of costs
of production by producing in bulk.
Internal economies: cost per unit depends
on size of the firm.
External economies: cost per unit depends
on the size of the industry, not the firm.
external economies
The following are some of the reasons behind economies of scale:
a. Internal Economies
Specialisation:
Managerial economies:
Financial economies:
Production in stages:
226
Managerial Economics
b. External Economies
Technological advancement:
large growing industry would encourage investment in research
Easier access to cheaper raw materials:
Financial institutions in proximity:
Pool of skilled workers:
ECONOMIES
OF
SCOPE
Economies of scope arise with lower
average costs of manufacturing a product
when two complementary products are
produced by a single firm.
reasons for marketing strategies like
branding or
family
Cost and Revenue
Scope Index (S) =
the individual costs of these activities are C1 C2 and C
are carried out
S=
227
(C 1 + C 2 + C 3 – C t )
C1 + C2 + C3
Ct is the total cost in case the three activities
C + C + C - Ct
C +C +C
S
COST
AND
LEARNING CURVES
Learning by doing refers to the process by
which producers learn from experience.
228
Managerial Economics
Technological change is an increase in
the range of production techniques that
provides new vistas to producing goods.
Though it may seem that technological change occurs only in high
Learning curves represent the extent to
which average cost of production falls in
response to increase in output.
C = AQb
where C
A
Q
b has
ln C = ln A
b
costs
SUMMARY
◆
◆
◆
◆
b ln Q
Cost and Revenue
◆
◆
◆
◆
◆
◆
◆
◆
◆
KEY CONCEPTS
REFERENCES
10th
AND
FURTHER READING
229
230
Managerial Economics
rd
th
th
QUESTIONS
Objective Type
I. State True or False
II. Fill in the Blanks
III. Pick the Correct Option
Cost and Revenue
231
232
Managerial Economics
Analytical Corner
making:
Output
TC
TFC
TVC
AFC
AVC
AC
MC
0
1
200
2
290
100
100
95
3
123
4
110
5
6
7
8
9
10
420
20
84
1098
80
103.8
107
751
801
998
71
128
197
10
Q
123.2
Q2
Cost and Revenue
Q
TC
0
1
2
3
4
5
6
7
8
9
250
MC
TFC
TVC
AFC
AVC
233
ATC
10
210
220
510
60
100
60
590
90
Q = 2 KL
Q
K
`
and L
Q
Q2
Q
`
P
Q
`
`
Why or why not?
`
Overheads are `
`
`
order? Why or why not?
234
Managerial Economics
Year 1
Year 2
Sales (`)
1,50,000
1,50,000
`)
15,000
25,000
`
Check Your Answers
State True or False
Fill in the Blanks
Pick the Correct Option
Analytical Corner
2Q 2
K
K
Q
Q=
S
=
2Q 2
S
10
=
2Q
10
+
20
Q
Q
10
Q
`
`
Caselet
Would IndiGo?
Q = 10
Cost and Revenue
Case Questions
Cement Industry in India
235
236
Managerial Economics
Posers
Disrupting FMCG the Swadeshi Way
237
Cost and Revenue
`
`
announced to invest `
accessed
Posers
Chapter
8
2. Develop an understanding of the distinction between short run and long run
production functions.
3. Build up a critical appraisal of the law of variable proportions and returns to scale.
4. Introduce the concepts of isoquant, isocost line, marginal rate of technical substitution,
elasticity of substitution and expansion path.
5. Develop an understanding of technical progress and its nuances.
Chapter Objectives
1. Examine the economic analysis of a firm’s technology, different types of inputs and
the process of production.
INTRODUCTION
Do you ever wonder where those huge black pieces of plastic called telephone have gone? Or those big
video cameras which had to be carried on shoulders or those audio/video cassettes and recorders? Or
Sholay
Production Analysis
Production is the process of transformation
of inputs into goods and services of utility
to consumers and/or producers.
239
Production is the process of transformation of
creation of value or wealth through the production of goods and services that have economic value to
form (input to
place
changing hands
eality
B ites
‘Hamara’ Bajaj
Nano
Hamara.
`
Source: http://economictimes.indiatimes.com/News/News_By_Industry/Auto/Automobiles/ Bajaj_rolls_out_
hamara_small_car_prototype/articleshow/msid-2684506,curpg-1.cms,
TYPES
OF
INPUTS
240
Managerial Economics
Technology
technology is one of the most important inputs in any production
point
period
Fixed and Variable Inputs
Unlike fixed input, variable input can be
made to vary in the short run.
short run and the long run
Variable input
eality
B ites
Technological Progress in Pharma
Source: http://www.hindu.com/2006/11/26/stories/2006112617060300.htm,
Production Analysis
241
Factors of Production
factors of production for identifying
There are five factors of production: land,
labour, capital, enterprise and organisation.
Land
gift of nature and not the result of human effort
return from land is called rent
Labour
wages and salary
Capital
Physical
capital
human capital
is interest
Enterprise
economic gains is known as
herein are
ability to
take risk
Organisation
a
242
Managerial Economics
PRODUCTION FUNCTION
Production function is a technological
relationship between physical inputs and
physical outputs over a given period
of time.
A production function is the technical relationship between inputs
can be said that production function is purely a technological relationship between physical inputs and
●
●
Always related to a given time period
Always related to a certain level of technology
●
cost is not
given
Production function shows the
of output can be produced by different combinations of inputs and each of these combinations may be
Q=f(
1
2… n
Production Analysis
where Q
1
1
2
2
243
n
n
Q = f(L K l R E
where Q
L
K
l
R
E
two variable inputs or
PRODUCTION FUNCTION
WITH
ONE VARIABLE INPUT
The short run production function shows
the maximum output a firm can produce
when only one input can be varied.
variable proportion production function
The short run
Q = f(L K
where Q
L is labour and K
run production function is governed by law of variable proportions
total product is a function of labour and is given as:
L
= f( K L
K
= f( L K
APL =
L
244
Managerial Economics
K
APK =
L
L
L
=
D
DL
L
=
∂
∂L
as:
Average Product is total product per unit
of variable input. Marginal Product is the
addition in total output per unit change in
variable input.
K
production with an investment of `
that as the manufacturer increases units of labour keeping investment
rd
Table 8.1
Law of Variable Proportions
Labour (’00 units)
1
4
7
Total Product (’000
tonnes)
Marginal Product
–
Average Product
Stages
Production Analysis
245
200
Output
150
Total Product
(’000 tonnes)
100
Marginal
Product
50
Average
Product
0
1 2 3 4 5 6 7 8 9
–50
Labour
Fig. 8.1 Law of Variable Proportions
part of the workforce becomes ineffective and the marginal product of
Law of variable proportions states that
with increase in the quantity of the variable
factor, its marginal and average products
will eventually decline, other inputs
remaining unchanged.
law of diminishing marginal
returns
A B and C
A is the
A
A
B
B
falling to the right of B
beyond C
C
C* of C
C
246
Managerial Economics
Increasing Returns to the Variable Factor
from the origin and continue to a point where APL
Total Output
C
TPL
B
A
Total Output
O
O
Fig. 8.2
Labour
Stage
I
Stage
II
Stage
III
A*
B*
APL
C*
MPL Labour
Total, Average and Marginal Product Curves
Diminishing Returns to the Variable Factor
Increasing Returns: MP > 0 > AP
Diminishing Returns: MP > 0 < AP
Negative Returns: MP < 0 while AP is falling
but positive.
process beyond some point will result in diminishing marginal returns
Negative Returns to the Variable Factor
Production Analysis
Q = 10 KL2 – L
K denotes
L
has a capital stock K
Solution:
DQ
= 20KL L2 = 200L
L2
DL
Q
Average product of labour = APL =
= 10 KL – L2 = 100L – L2
L
d
labour
d
L
dL
eality
B ites
Productivity of Labour
Sources:
exception/articleshow/58255120.cms
L
dL
= 0 fi 200 – 6L
0 fi 100 – 2L
247
L
L = 50
248
Managerial Economics
PRODUCTION FUNCTION
WITH
TWO VARIABLE INPUTS
all
of production functions with two variable inputs and a single output and introduce you to the realms
An isoquant
equal
quantity
REMEMBER
eality
B ites
Challenge 50’
Q = f (L K
we have an implicit relationship between units of labour (L
Q = f(L K
Q
K
Production Analysis
with an investment of `
which different combinations of these two inputs can be used to
possible combinations of labour and capital which can produce this
Table 8.2
249
An isoquant is the locus of all technically
efficient combinations for producing a
given level of output.
Input Combinations Producing the Same Output
Labour (’00 units)
Capital (` crore)
45
40
35
30
25
20
15
10
5
0
A
Capital
Capital (` Crore)
7
B
C
D
6
7
8
Labour (¢00 units)
Fig. 8.3
9
10
Isoquant
Q1
Labour
Fig. 8.4
A on the curve Q1
of capital of `
`
point C
`
O
B
`
D
Isoquant
250
Managerial Economics
on
Q0
render lesser output than points on Q1
above Q1
is possible to draw numerous such curves like Q0 Q1 and Q2
Q2
Q1
Characteristics of Isoquants
Downward Sloping
implies that using more of one input to produce the same level of output must imply using less of the
-
C
B
Panel b
A
Capital
Capital
Panel a
DK
DL
A
B
C
Q2
Q0
O
Q1
Q1
Q2
O
Labour
Labour
Fig. 8.5 Isoquants Map
A higher Isoquant Represents a Higher Output
Q2
A on the curve Q1 and point C on
C has more of both labour and capital as compared to A
at least one of the two inputs as in case of A and B
both
inputs and more of either
Q2
Q1
Production Analysis
251
Isoquants do not Intersect
Q1
the same level of output Q2
A and B be two different points on Q1 and Q2
Q1 and Q2 intersect each other at point C
B and C of
Q1
A and C
Q2 denote
A and B
A denotes a higher level of output than B
Convex to the Origin
K
to produce additional units of output only by increasing labour (L
LK
Marginal Rate of Technical Substitution
K
technical substitution of labour (L
MRTS measures the reduction in one input,
due to unit increase in the other input that
is just sufficient to maintain the same level
of output.
LK
KL
Q1
LK
would measure the downward vertical
ratio between rates of change in L and K
LK
= -
DK
DL
DL units of labour are substituted for DK
252
Managerial Economics
output due to increase in DL
in DK
DK ¥
K
DL ¥
L
DL ¥
L
= DK ¥
K
= – DK
L
K
DL
DQ
DK
change in labour input (DL
DQ
L
¥ DL
K
¥ DK
DQ
L
DL
K
DK = 0
L
fi
= -
K
DK
fi
DL
LK
=
L
K
Special Shapes of Isoquants
Linear Isoquants
Q = f(L K
where a b
L=
dQ
=a
dL
a
LK =
b
aK + bL
K=
dQ
=b
dK
LK
diminishes
Production Analysis
253
Right Angled Isoquants
perfect complements
Leontief production
function takes the following form (assuming two inputs K and L
Ê L Kˆ
Q = min Á
Ë a b ˜¯
where a and b
L
Capital
Panel b
Capital
Panel a
O
Q1
Q2 Q 3
Fig. 8.6
ELASTICITY
OF
K
Q3
Q2
Q1
O
Labour
Labour
Special Types of Isoquants
SUBSTITUTION
independently by
of substitution measures the percentage change in factor proportions due to a change in marginal rate of
d KL
s=
K /L
d
254
Managerial Economics
L
K
d KL
s=
K /L
d
L
K
s is effectively a measure of the curvature
Elasticity of substitution measures the
percentage change in factor proportions
due to a change in MRTS.
less is the resulting
L
is no substitutability between the inputs and thus the elasticity of substitution s
perfect substitution or linear
s=
Production Possibility Curve
For an individual, PPC demonstrates the
different combinations of two commodities
that the individual can have, with a given
income or within a given budget, and at
given prices of the commodities being
purchased.
microeconomics to show the options of production or consumption
macroeconomics to show the production possibilities of a nation or
Food
A
M
P
FP
commodity only by giving up some units of the
AB
amounts of purchases of two commodities (here
N
Q
FQ
O
CP
Fig. 8.7
CQ
B
Clothing
PPC for an Individual
Production Analysis
255
P on AB shows that at a
FP units of food and CP
FP
Q
CQ units of clothing (CQ is more than CP
FQ units of food (FQ is less than
M
N
PPF for a society:
have more of one good if it does not have less of
Food
Infeasible Area
Substitution is the law of life in a full employment
P
FP
frontier depicts the society’s menu of choices
Q
FQ
Productively
inefficient area
O
CP
CQ
Fig. 8.8 PPC for the Society
Clothing
256
Managerial Economics
n
P
FP of food and CP of clothing can be produced when
FQ of food and CQ of clothing at point Q
P and Q
but productively
P to point Q indicates an increase in the units of
This decrease in the units
What are the determinants of the production
Food
level of technology and factor endowments
available to the economy at the point of time
O
Clothing
this would increase the amount of each good that
Fig. 8.9
Shifts in the PPC for the Society
Production Analysis
257
ISOCOST LINES
isocost line is similar to that of budget line for the
w
wL
The isocost line is the locus of points of all
the different combinations of labour and
capital that a firm can employ, given the
total cost and prices of inputs.
r
rK
C = wL + rK
The isocost line represents the locus of points of all the different combinations of two inputs that a
labour
C
is not used in the production process and is given by
r
C
w
DK
C/r
w
=
=
DL
C /w
r
Panel a
A2
Capital
A2
Capital
by
gives
A
A1
O
B1 B
B2 Labour
Panel b
A
A1
O
B2
Fig. 8.10 Isocost Line and Isocost Map
B
B1 Labour
258
Managerial Economics
AB
shows a rise in w
rise in r
AB1 shows a fall in w
BA2 shows a fall in r
AB2
BA1 shows a
PRODUCER’S EQUILIBRIUM
taken on basis of
AB
Q2
employ L* and K
Q
E
AB
Q2 amount of output can also be considered
AB
AB is feasible but not desirable
Production Analysis
259
C
and D
Q1 which is lower than Q2
points C E and D show the combinations of inputs L and K which come for the same cost but give
E is preferred to C and D
feasible
Panel a
Panel b
A
A2
K*
Capital
Capital
R
C
E
Q2
Q1
D
O
Q3
B
A1
K
E
S
Q0
L*
A
Labour
O
L B1 B
Q
B2
Labour
Fig. 8.11 Producer’s Equilibrium
Q and wants to
ascertain that combination of inputs L and K
other because price of L and K (w and r
combinations of two inputs shown by points R S and E
Q output can be produced with three
OK and OL
point E on AB
A1 B1
Necessary condition for producer’s
equilibrium:
Slope of isoquant = Slope of isocost line
260
Managerial Economics
EXPANSION PATH
Expansion path is the line formed by
joining the tangency points between
various isocost lines and the corresponding
highest attainable isoquants.
points between various isocost lines and the corresponding highest
A
Expansion Path
Capital
E1EE2
K*
E
E2
E1
Q2
Q1
Q0
O
L*
Fig. 8.12
RETURNS
TO
B
Labour
Long Run Expansion Path
SCALE
Returns to scale refer to the degree by
which the level of output changes in
response to a given change in all the inputs
in a production system.
to a given change in all
referring every time to the standard production function Q = f(L K
L and 2K amounts of labour and
Q
A
L
K
Production Analysis
Panel a
Panel b
261
Panel c
A
O
200Q
100Q
50Q
Labour
Fig. 8.13
O
A1
B1
Capital
C
B
Capital
Capital
C2
C1
B2
400Q
A2
125Q
90Q
150Q
50Q
Labour
50Q
O
Labour
Constant, Decreasing and Increasing Returns to Scale
Constant Returns to Scale
be
inputs has lead to doubling of output from 50Q (point A
Q (point B
Q (point C
Decreasing Returns to Scale
doubling of output from 50Q (point A1
Q (point B1
Q (point C1
Increasing Returns to Scale
is known as
case has led to more than doubling of output from 50Q (point A2
DIFFERENT TYPES
OF
Q (point B2
Q (point C2
PRODUCTION FUNCTIONS
Cobb–Douglas Production Function
Cobb–Douglas production function was proposed by Wicksell and tested against statistical evidence
by
production function is represented as:
Q = AK aLb
where a and b
to capital and b
A is the
a is the elasticity of output with respect
262
Managerial Economics
Cobb–Douglas production function is a homogeneous production function:
that a homogeneous function is one in which if each input is multiplied by l
l is factored
l is known as the degree of homogeneity and is a measure of
v is one in which if each independent variable
is multiplied by a given factor l
raised to the power of v
Cobb–Douglas production function is homogeneous of degree (a + b
●
●
●
a+b
by a factor l
a+b
a+b
revealed by the sum of the two parameters a and b
c
L
= AK a b L b–1 =
Q
b
AKa Lb = b
= b.APL
L
L
a
Q
= a.APK
AKa Lb = a
K
K
The MRTSLK of the Cobb–Douglas production function is:
K
LK
= AaK a–1 L b =
L
=
K
Ê bQ ˆ
b K
L
= Á aQ ˜ = ◊
Á
˜
a L
Ë
K¯
L
dQ
eL =
b
that a
Q
dL
L
dQ
=
dL
L
Q
L◊
L
bQ
L
=b
A = AbLb–1 Ka◊ =
Q
Q
Q
Production Analysis
Q = AK a L b (with A
263
a b
KL
Solution:
Q = AK aLb
Differentiating totally we get:
dQ = AaKa–1 Lb + AbKa Lb–1
AaKa–1 L bdK = –AbKaL b–1dL fi –
fi
a L
dL
fi
= ◊
b K
dK
1
KL
=
a L
◊
b K
a
Ê Qˆ b - b
Q = AK aLb fi L = Á ˜ K
Ë A¯
1
dL
=
dK
a
Ê Q ˆ b Ê a ˆ - b -1
ÁË A ˜¯ ÁË - b ˜¯ K
dL
dK
K Q
1
a
Ê Qˆ b Ê aˆ Ê a ˆ - b -2
d 2L
- -1 K
2 = Á ˜ Á
Ë A ¯ Ë b ˜¯ ÁË b ˜¯
dK
2
d L
dK 2
K Q
parameters A a and b
Consider the following production functions:
Q = 150 K L
Q = 150 K L
Q = 150 K L
Find out value of Q
K = 1 and L
K = 2 and L
K
L
Solution:
Q
Q
K and L in the function we get:
Q
fi Increasing returns to scale, because
264
Managerial Economics
Q
Q = 600 fi Constant returns to scale because increase in
Q
Q
Q
Q
fi Decreasing returns to scale because
K
and L
Leontief Production Function
perfect complements or the case in
‘L
L
a and b
capital (K
Q is achieved by the smaller of the two values in the
L K
L
< , then Q = , and L is considered as the binding
a
a b
Cobb–Douglas production function:
Q = A K aL b
Leontief production function:
Ê L Kˆ
,
Ë a b ˜¯
K in
Q = min Á
L K
> , then
a b
CES production function:
Q = A[aK–r + (1 – a)L–r]–r/r
Q=
as to what would happen if
in
K
and K becomes the limitative factor or binding constraint on
b
L
K
=
a
b
not lead to any change in the factor proportions and s
Production Analysis
265
CES Production Function
Constant Elasticity of Substitution
Q = A[aK–r + (1 – a L–r]–r/r
a is
£a£
r is the
r is the scale parameter
where A(
The marginal products of factors are given by:
r+ 1
L
Ê Qˆ
= aAr–1 Á ˜
Ë L¯
K
Ê Qˆ
= (1 – a)Ar–1 Á ˜
Ë K¯
r+ 1
LK
L
K
= (a/(1 – a
L/K
r+1
r:
Q* = A[a(lK
–r
+ (1 – a lL
r
increasing returns to scale and if r
TECHNICAL PROGRESS
AND ITS
–r –r/r
]
= lrQ
r
IMPLICATIONS
given
Technical progress refers to research and
development and investments made to
manage technical know-how.
eality
ites
Digital Divide: The Cobb–Douglas Way
Contd.
266
Managerial Economics
Y = AaL1–a
Y = f K L HK D
L HK and D
Y K
K
DK
FK
FKd
Source: Bala, M. (2005). Digital Sector and Foreign Direct Investments: A Case of India, www.ecomod.net/
conferences/ecomod2004/ecomod2004_papers/242.doc,
embodied
disembodied or investment
Neutral Technical Progress
QQ to shift inwards to Q1Q1
QQ
Panel a
Capital
Q1
Panel b
Capital
Q
QL
Q
Q
QK
K
K1
O
Panel c
Capital
Q
Q1
L1 L
Labour
Q
Q
QK
QL
O
Fig. 8.14
Labour
Technical Progress
O
Labour
Production Analysis
267
Labour Augmenting Technical Progress
product of labour increases faster than the marginal product of
LK
Technical progress is:
Neutral if changes in marginal products
of labour and capital are same.
Labour augmenting if MPL increases
faster than MPK.
Capital augmenting if MPK increases
faster than MPL.
Capital Augmenting Technical Progress
LK
SUMMARY
◆
◆
◆
◆
◆
◆
◆
◆
A production function shows the relationship between inputs and outputs given the state of
268
◆
Managerial Economics
A homogeneous function is the one in which if each input is multiplied by l
l is factored
l is known as the degree of homogeneity and is a measure of
◆
L
K
K
KEY CONCEPTS
QUESTIONS
Objective Type
I. State True or False
L
II. Fill in the Blanks
l in a
K
L
increases faster than
Production Analysis
269
III. Pick the Correct Option
LK
L
L
L
is:
a is the:
elasticity of substitution of such production functions
L is considered as:
Analytical Corner
1.
behind this law?
270
Managerial Economics
for most production functions?
returns to scale
th
th
of the 6
Q = 50 L
Q is the
output and L
of locks?
Q = L1/2K1/2
Q = K 2 + L2
Q = 5K + 10L
2
Q=K /L
Q=
Q=L K
L2 + K 2
K+L
L
L
1
4
TPL
MPL
–
APL
–
Production Analysis
Q
L
Q = 150 K
K
L
K
L
271
K
L=6
line necessary?
Q = AKaLb
all productive activities of the economy for a
Check Your Answers
State True or False
Fill in the Blanks
Pick the Correct Option
Analytical Corner
50 L 25 L
L–1/2K1/2
L1/2K–1/2
K/L
272
Managerial Economics
Caselet
Alternative Fuels
Sources:
Case Questions
Expanding the Volvo Way
Production Analysis
273
`26 lakh
`
Sources:
accessed on
Posers
can it avoid diminishing returns to scale?
3D Printing: the Future of Technology
274
Managerial Economics
lay it down onto a print platform to large industrial machines that use a laser to selectively melt metal
Sources:
accessed on
Posers
Chapter
9
2. Understand the importance of project evaluation in achieving a firm’s objectives.
3. Comprehend the methods of project evaluation for judicious decision-making.
4. Appreciate the importance of considering time value of money in project
evaluation.
Chapter Objectives
1. Identify various types of projects which an organisation has to undertake.
INTRODUCTION
Everyday in the news you hear about mergers and acquisitions, opening of new plants, expansion
plans of the companies, and so on. What do these news items imply in terms of economic analysis?
PROJECT
First of all you should understand what a
276
Managerial Economics
capital budgeting.
A project can be viewed as having three basic characteristics:
a. The input characteristics: You have understood in the chapter on production what an input is.
technology, capital, infrastructure and other resources.
b. The output characteristics
combination of these targets.
c. The
to the society.
TYPES
OF
PROJECTS
of the company.
On the Basis of Purpose
which are as under:
i. New Projects
an industry.
ii. Expansion Projects
capital widening process
horizontal integration which we shall discuss little later.
iii. Modernisation Projects: You have seen in the chapter on cost and revenue that capital goods require
Financial Evaluation of Long-Term Projects
277
also called the capital deepening process
nology against traditional one are examples of capital deepening or modernisation projects. You must
have understood from the above discussion that when investment is made to expand, companies widen
their size of capital, whereas when they try to improve existing business they go deep into the activity.
: Another category can be termed as
. Companies
can be of two types: (a) concentric and (b) conglomerate.
(a)
of scale or
economies
Jaguar is also an example of horizontal integration
competition.
(b)
Vertical integration.
steel which it uses for production of automobiles.
eality
B ites
Source: www.marutisuzuki.com, MSIL–MDA Annual report,
On the Basis of Nature: You can also understand the types of projects on the basis of their nature, that
is, whether a project has to be independently assessed or has to be evaluated along with other projects.
278
Managerial Economics
i. Independent
example, a company going to buy a new machine to add capacity or open a new store to expand
interdependent, that is, such projects will require
ii. Contingent
(a) Senility Effect
solescence or economic expiry, it is called senility effect in economics. As they say that the asset
becomes senile
contribution to output.
(b) Echo Effect
the decision not only involved purchase of computers but also creation of air conditioning of the
that is, computerisation echoed on other investments. Such decisions are complicated as they have
to be viewed as one comprehensive project and not in piecemeal.
iii. Mutually Exclusive
independent of each other and are, hence, termed as mutually exclusive.
FEATURES
OF
PROJECT EVALUATION
Once you have understood the various types of projects, you must also understand the basic nature
features can be discussed as under:
i. Long-term investment:
ii.
the project.
iii.
We are utilising current resources for future gains.
Financial Evaluation of Long-Term Projects
279
iv. Irreversible investment: Moreover once committed, the investment cannot be easily reversed.
recovered.
v. High degree of stakes:
critical for success of the company.
vi. Futuristic: Another aspect is that it is a planning exercise; all variables in connection with
estimated, because it is related to distant future.
vii.
IMPORTANCE
OF
PROJECT EVALUATION
the importance of the discussion on evaluating the projects in a planned and detailed manner. Some of
the elements that need further discussion to highlight the importance of project evaluation are as follows:
project cost will include cost of computers, air conditioners, continuous powers supply devices
of the computers, scope of expansion, new recruitments, purchase of computer stationery, etc.
thoroughly evaluate these projects before committing their limited resources for a long time with
little possibility of reversal.
280
Managerial Economics
eality
B ites
`
`
`
Source: Andhra News, September 2002.
DECISION CRITERIA
AND
RELEVANT VARIABLES
decision criteria as follows:
i. Accept /
: Projects which are mutually exclusive and where choice is not available, one has
about the methods.
ii. Ranking: When a number of similar investment opportunities exist the decision is based on
iii. Rationing
when a company has to consider more than one project
rationing is to be done by prioritising the projects.
elucidate the point.
Relevant Variables
as follows:
Financial Evaluation of Long-Term Projects
281
period but it is possible that some cost may occur at a later stage, such as updation of software,
these projects have limited lifespan, the life should be estimated on basis of rate of change of
technology. Remember that wrong estimation of life of project may adversely affect the future of
the company.
a. Initial Flows
+
¥ investment allowance ¥ tax rate)
b. Operational Flows:
calculated on annual basis
c. Terminal Flows
terminated
present value or present cost should be compounded to the future value.
eality
B ites
Contd.
282
Managerial Economics
Source: Paul Cooper, “Management Accounting Practices in Universities”, Management Accounting (UK.), February
1996, pp. 28–30.
METHODS
OF
PROJECT EVALUATION
which consider
1. Payback Period Method
The basic premise of the payback method
is that the more quickly the cost of an
investment can be recovered, the more
desirable is the investment.
recover its initial cost out of the cash receipts that it generates over
‘the time that it takes for
an investment to pay for itself’.
Cash Flow After
recovered, the more desirable is the investment. When there are number of similar projects competing
ranking of the project.
when it is uneven.
=
Annual cash flow
=E+
where
E
B
C
B
C
Financial Evaluation of Long-Term Projects
283
Merits of Payback Period Method
what time they will be able to repay the entire loan.
iv. Another merit of this method is that it is simple to understand and apply and does not need any
Limitations of Payback Period Method
in the initial period.
ii. A very serious limitation is that it does not consider time value of money and evaluates a project
period does not always mean that one investment is more desirable than another.
An example would elaborate the method. For example, Somnath
A shorter payback period does not always
mean that one investment is more
desirable than another.
Table 9.1
Details of Two Models of the Machine
Model A
Model B
`
`
`
`
`
`
`
`
`
`
284
Managerial Economics
Solution:
Table 9.2
Cumulative CFAT of Two Models of the Machine
Model A
Model A
`
Model A
Model B
Model B
Model B
`
`
`
`
`
`
`
`
`
`
`
`
`
`
`
`
`
50000
50000
B is better as it will recover the initial cost at an early date
as compared to Model A.
Table 9.3
Model A
Model B
`
`
`
`
`
`
`
`
Solution:
B appears to be far better.
Financial Evaluation of Long-Term Projects
Table 9.4
285
Cumulative CFAT
Model A
Period
Model B
CFAT
Cumulative CFAT
CFAT
Cumulative CFAT
50,000
90,000
70,000
90,000
2. Net Present Value (NPV) Method
The project is acceptable if the new present
value (NPV) is positive and rejected if it is
negative.
rank the project, the rule is higher the net
=
CFn
– CO
(1 + R) n
CF
CF
+
+
(1 + R) (1 + R)
where
CF
R
is the discount rate
Steps for calculating NPV:
●
●
expected rate of return.
●
●
¥
286
Managerial Economics
¥ CO)
●
¥
●
¥
Rule for evaluation:
project requires initial outlay of `
Table 9.5
Calculation of NPV
`
CFAT
PVF (10%)
PVCFAT (CFAT x PVF)
`
`
`
`
NPV
5464
are smaller, or if they come later, or if the discount rate is higher.
Merits of NPV Method
year out of consideration.
Limitations of NPV Method
Financial Evaluation of Long-Term Projects
amount of initial outlay.
3. Profitability Index (PI)
=
●
●
●
●
●
project at the same time.
4. Internal Rate of Return (IRR)
return” (ERR).
287
288
Managerial Economics
=
CF
CF
CF
+
+
+
(1 + R) (1 + R)
(1 + R)
CFn
= CO
(1 + R) n
R is the internal rate of return.
=
where
LR
Table 9.6
¥
is lower discount rate
Calculation of IRR
`
CFAT
PVCFAT (14%) = (HR)
PVCFAT (13%) = (LR)
Financial Evaluation of Long-Term Projects
=
+
=
+
- -
¥
289
-
¥ =
lower incomes have lower internal rates of return.
Comparison between IRR and NPV Methods
of different duration.
CAPITAL RATIONING
So far you have understood how various projects can be evaluated. You must have noticed that in all
capital
rationing.
290
Managerial Economics
allotment of given amount of funds on a large number of projects. For such decisions, the various
Steps in Capital Rationing
accordingly.
An example will elaborate the process. Somnath Chemicals has to develop a new plant where a
`1 crore,
will be above `
Table 9.7
Machines
Capital Rationing
Initial cost
(` Lakh)
(` Lakh)
NPV
(` Lakh)
Index
Rank on the
basis of PI
II
III
E
I
A, D
`
and E
SUMMARY
◆
◆
Financial Evaluation of Long-Term Projects
291
◆
◆
conglomerate, where a company enters into unrelated areas.
◆
exclusive projects. Contingent projects can be further categorised as those showing senility effect,
where a single asset is replaced, and echo effect, where a group of assets has to be simultaneously
acquired or replaced.
◆
◆
company, determine future cost structure of the company, such projects are not easily reversible
◆
rationing of projects.
◆
◆
◆
Capital Rationing is a method of project evaluation where limited funds are to be allocated to
many projects at the same time.
◆
KEY CONCEPTS
Capital Rationing
QUESTIONS
Objective Type
I. State True or False
292
Managerial Economics
iii. Contingent projects competing with each other to be selected.
II. Fill in the Blanks
or replacement of another asset.
from the project over its entire lifespan.
be achieved from the yield on investment.
III. Pick the Correct Option
c. Expansion projects
d. Replacement projects
iii. Which of the following projects require investment in other inputs also:
c. Expansion projects
d. Contingent projects
Financial Evaluation of Long-Term Projects
293
b. Reduces uncertainty associated with returns
d. Considers time value of money
:
Discussion Questions
tool in such case?
`5,00,000 and
expects to earn an income of `
294
Managerial Economics
`
`
which two models are available. Each of these models is available at `15,00,000 with a lifespan
and (b) explain the difference in results:
Check Your Answers
State True or False
Fill in the Blanks
i. conglomerate
ii. senile
vii. Echo effect
viii. minimum return requirement
Pick the Correct Option
i. c
ii. d
iii. d
iv. c
v. a
vi. b
vii. a
viii. d
ix. a
x. b
Discussion Questions
A
A
A
B
B is better
B
A
A
B
B
Financial Evaluation of Long-Term Projects
295
Caselet
Turnaround of Indian Railways
`
a dedicated multimodal high axle load freight corridor between the four metros over the next 10 years
at an estimated cost of `
Source:
Construction: Foundation of a Growth Portfolio, Investment Monitor, August 2007, pp. 10–14.
Case Questions
your answer.
Strategy 2025
for joint development of products including vehicle architecture, engines and component sourcing. A
development of vehicle concepts in the economy segment.
hundred thousand units is additional leverage and any additional economies of scale will structurally
architecture.
296
Managerial Economics
Sources:
http://www.tata.com/company/releasesinside/tata-motors-mou-volkswagen-group-skoda, accessed on
,
Posers
provide logic for preferring your chosen method.
Geovic Feasibility Study
●
●
●
●
●
●
●
●
Financial Evaluation of Long-Term Projects
solid and defensible.”
lenders, and completion of the Feasibility Study allows this process to be accelerated.
Posers
on the future of the project?
the base case assumptions which are as follows:
assessment.
[Source:
297
Part
4
Market Morphology and
Equilibrium Conditions
A market has many connotations in economics: as a concept, as a process, as a place and as a
phenomenon. In fact, success or failure of business is contingent upon the fine understanding
of the intricacies of market. In this unit, we will discuss the various market forms like perfect
competition, monopoly, monopolistic competition and oligopoly; the basic characteristics of each
type; the pricing and output decisions and behaviour of firms in different time frames. This part also
introduces you to the concepts of risk and uncertainty and the basics of Game Theory in economic
decision-making. This part is expected to set the stage to understand the more advanced pricing
strategies as applicable to products and also of factor inputs in subsequent part.
CHAPTERS
10.
11.
12.
13.
14.
Perfect Competition
Monopoly and Monopsony
Monopolistic Competition
Oligopoly
Choice under Uncertainty and Game Theory
Chapter
10
2. Examine the nature of a perfectly competitive market.
3. Understand market demand and firm’s demand under perfect competition.
4. Analyse the pricing and output decisions of a perfectly competitive firm in the short
run and long run.
Chapter Objectives
1. Introduce the basics of market morphology and identify the different market structures.
INTRODUCTION
By now you have understood every aspect of demand, production and cost; you have also explored into
Now you should also understand the basics of a market, as success or failure of any business is dependent
upon better understanding of
market”
mean? What are its very dimensions? What is the degree of competition in a market? By what extent
All these are important dimensions of a market that need to be understood for effective management of
and sellers; it refers to the interaction between buyers and sellers of
may be at a particular place, or may be over telephone, or even through
Market refers to the interaction between
sellers and buyers of a good (or service) at a
mutually agreed upon price.
302
Managerial Economics
MARKET MORPHOLOGY
Nature of Competition
a very large number of sellers exist and size of an individual seller is very small, whereas there can be
another market with only one
Nature of Product
large number of sellers selling similar yet somewhat different products like cosmetics, medicines and
Number and Size of Buyers
buyers is very large but the size of individual buyer is small, the market will be evenly balanced between
Freedom to Enter into or Exit from the Market
Perfect Competition
Table 10.1
Type of
market
303
Market Morphology
Number of
Nature of
product
Number of
Freedom of
entry and exit
Perfect
competition
Very Large
Homogeneous
Very Large
(undifferentiated)
Unrestricted
Agricultural
commodities, shares
unskilled labour
Monopolistic
competition
Many
Differentiated
Many
Unrestricted
Retail stores,
detergents
Oligopoly
Few
Undifferentiated
or differentiated
Few
Restricted
Cars, computers,
universities
Monopoly
Single
Unique
Many
Restricted
Indian Railways,
Microsoft
Monopsony
Many
Undifferentiated
or differentiated
Single
Not applicable
Indian defence
industry
perfect competition, whereas
PERFECT COMPETITION
appears to be theoretical and hypothetical, but at the same time it deserves a discussion here because
state of equilibrium output and price in the short run and long run, let us see the main characteristics of
Features of Perfect Competition
Presence of Large Number of Buyers and Sellers
There are many sellers (or suppliers) in the market, each being too small in size, relative to the overall
number
Homogeneous Product
304
Managerial Economics
to as product homogeneity; this makes the buyers totally indifferent towards various sellers with respect
Freedom of Entry and Exit
Perfect Knowledge
entrants, know about the production functions, technology(s), input prices and the prevailing market
is complete information or perfect knowledge
Perfectly Elastic Demand Curve
buyers have perfect knowledge about the product and the prevailing market price and they are indifferent
actually invoke a large
are
both these reasons, no
Perfect Mobility of Factors of Production
Perfect Competition
305
of prices charged by the factors, each factor will charge a single price in the market, just as the price of
No Governmental Intervention
Another very interesting aspect of perfect competition is the complete absence of governmental
Firm is a Price Taker
price taker is the most important of all
but a drop in the ocean, ends up accepting the prevalent market price, which is determined by the forces
perfect competition because in this market form the forces of demand and supply are unaffected by any
eality
B ites
A Case Study in Perfect Competition: The U.S. Bicycle Industry
U.S. bicycle industry has been cited as a classic state of perfect competition, featuring component
manufacturers in haste to get the latest designs and functionality to market in time and bicycle suppliers
struggling to design bicycle products that have more value than the competition. Retailers are anxious
about how much to commit for and what to bring to market, whether to become a concept store or
operate independently, and which suppliers to do business with. Alongside, it has also been observed
that each buyer or seller in this industry has a negligible impact on the market price and that everybody
accessed on 21/11/2007.
DEMAND
AND
REVENUE
OF A
FIRM
recall that following the assumption of
dTR
dQ
d
PQ
dQ
dQ
Q. dP + P.
dQ
dQ
P
…(1)
306
Managerial Economics
[P
Under perfect competition, AR = MR = P
P
willing to
Fig. 10.1
Perfect Competition
order to produce an output less than OQ1
of producing any output less than OQ1
OQ1
307
A, where the total revenue
when it produces an output greater than OQ1
OQ
OQ*,
B
OQ
rational producer must produce an output OQ
Calculus Corner
Max P
dp
dQ
fi
fi
R(Q) – C(Q)
dR(Q) dC (Q)
dQ
dQ
…(3)
MR = MC
d
d
dQ
dQ
<0
fi Slope of MR curve < Slope of MC curve
Necessary Condition: Marginal Revenue is equal to Marginal Cost.
Q–Q
Q + 3Q , calculate the output
Solution:
d
dQ
Q
d
dQ
Q
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Managerial Economics
Q
Q
fi
Q
d P
dQ
P
R(Q) – C(Q
Q–Q
Q
Q + 3Q )
Q
P
Q
MARKET DEMAND CURVE
The market demand curve for the industry
is a standard downward sloping curve.
The demand curve for an individual firm is
a horizontal straight line.
AND
FIRM’S DEMAND CURVE
The market demand curve for the whole industry is a standard
downward sloping curve, which shows alternative combinations of
price and output available to the buyers, such that an individual buyer
is able to get the maximum amount of output at each existing price, at
The market supply curve is upward sloping, giving various combinations of price and output; it shows
E; equilibrium output for the industry is given at Q
Fig. 10.2
Perfect Competition
309
P
SHORT RUN EQUILIBRIUM
This depends on the positions of the short run cost curves. These
begin this section with the assumption that in each case, the point of market equilibrium is attained by
the intersection of market demand curve and market supply curve, at point E
the equilibrium price P
P
Case of Supernormal Profit
In the short run, a perfectly competitive
firm may earn supernormal profit,
or normal profit, or can incur losses,
depending on the positions of the short run
cost curves.
E; output at this price
is OQ
OQ* equilibrium output at
equilibrium price P*, the total revenue earned by
OP*EQ*
Q
produce this output, the total cost incurred by the
OABQ* (area
Q
region AP*EB
market price P
Fig. 10.3
310
Managerial Economics
`
Q
Q + Q3
Solution:
Q
Q + Q3
Q + 3Q
P
Q + 3Q
Q
Q
d p
dQ
P
Q
R(Q) – C(Q
P
Q
Q + Q3
Q
Case of Normal Profit
OQ
is the rectangular area OP*EQ
OP*EQ
Fig. 10.4
E in
OQ*
OQ* is also given by the area
Fig. 10.5
Loss in the Short Run
Case of Loss (or Subnormal Profit)
E determines the equilibrium level of output OQ
revenue is given by the rectangular area OP*EQ* (as in the earlier cases) and the cost of producing OQ*
Perfect Competition
level of output is given by the rectangular area OABQ
than the revenue earned by selling OQ
P*ABE
311
OQ* is more
Special Case: Exit or Shut Down Point
If price is less than AVC, a perfectly
competitive firm shuts down operations.
immediately? No.
production in spite of incurring losses, or to shut down operations?
If the prevailing price in the market is more than the average variable cost (AVC) of production, the
Q
Q +
Q3
Solution:
Q
Q
Q
Q3
Q
Q
Q
The shut down point is where P
P
Q
Q
Q
equation, we get P
Q
Q
Q
Q
Q
P
Q
A
actually denotes the shut down point, where price P*
P*
312
Managerial Economics
Fig. 10.6
MARKET SUPPLY CURVE
AND
FIRM’S SUPPLY CURVE
≥
to the short run marginal cost curve above
Fig. 10.7
Perfect Competition
P** (which corresponds to the
and above P
313
Supply curve of the firm is identical to the
short run MC curve above the minimum
point of the AVC curve.
determine the supply curve of the industry, which is obtained by the horizontal summation of the supply
supply curve would be n
D q
P and S q
P
is C
Q
Q
much quantity should it produce?
Solution:
P
fi
P (D
P
C
fi
Q
q
q
MC P
q P
q
P
≥
q
fi
q
q
q
P
S)
314
Managerial Economics
fi
There is a loss of `
`
`
`
LONG RUN EQUILIBRIUM
In the long run, perfectly competitive firms
earn only normal profits.
would force some of them to leave the industry in the long run, as they
Thus, perfectly
Fig. 10.8
Perfect Competition
The long run supply curve of the industry shows the phenomena of
315
Condition for long run equilibrium in
perfect competition is P = LAC = SAC =
SMC = MR = AR
EL
represents the long run equilibrium point at which P
PERFECT COMPETITION: EXISTENCE
IN
REAL WORLD
to exist together in any
product homogeneity,
homogeneous product; most real life products have some
as simple as spices, producers may introduce differentiation by variation in the brand name and
perfect knowledge
it is the agricultural market that probably comes closest to exhibiting
almost all the features of perfect competition; it is characterised by many
small producers (farmers) who do not have the ability to command the
Perfect competition is the most efficient
and ideal form of market where all
economic resources are put to productive
use only and market economy prevails.
exactly perfect) about the product and its price in the market; entry into and exit from the market is also
316
Managerial Economics
SUMMARY
◆
A market is a (imaginary) place of interaction between sellers and buyers that facilitates exchange
◆
◆
◆
◆
◆
◆
◆
above the
◆
The industry supply curve is obtained by the horizontal summation of the supply curves of all
◆
KEY CONCEPTS
Perfect competition
QUESTIONS
Objective Type
I. State True or False
Price taker
Perfect Competition
II. Fill in the Blanks
III. Pick the Correct Option
P
317
318
Managerial Economics
AC
Analytical Corner
all
assumption is relaxed?
P
[Hint: Use the relationship between P, MR and ep ]
Perfect Competition
Q
Q
Q
319
Q3
Q
Q
+ 3Q
Q+
Q
`
Q+
q
p and S
Q +
1 3
Q
3
Q, where Q
`t
p
t
the factory is ` g
l are all positive and a
price?
P a – bQ
dQ + lQ , where a, b, g, d and
d
Q
Q
320
Managerial Economics
Check Your Answers
State True or False
Fill in the Blanks
Pick the Correct Option
Analytical Corner
P
Q
P
Q
should continue operations
Q
t
Q
a -d
l+b
P
la + a b + bd
l+b
Q
Caselet 1
FOREX Trading: Competition or not?
Perfect Competition
321
these sellers and buyers are well informed, and have access to real-time market data and background
the technological upgradation not just makes it faster to access information but also at minimal cost
Sources:
http://economictimes.indiatimes.com/articleshow/53539014.cms?utm._
Case Questions
evident from the details given above?
market to run without governmental intervention?
Caselet 2
Does Perfect Competition Exist?
322
Managerial Economics
Case Questions
similar to perfect competition like condition?
items?
The Fantastic Plastic
cards, cash back cards, platinum credit cards, gold credit cards, silver credit cards, titanium credit cards,
co-branded credit cards, classic credit cards, contactless credit cards, business credit cards, lifestyle
Perfect Competition
323
across cards offered by such companies is that mostly they do not charge joining fees and exempt
also more or less uniform, ranging from `1,000 to `
various charges that come with a credit card usage vary on the basis of income (or purchasing power)
or a certain percentage of the minimum outstanding balance with a minimum and maximum threshold,
sum); overdraft limit (a certain percentage of the overdrawn amount subject to minimum and maximum
amount); and petrol transaction and railway ticket purchase fee (levied as a particular percentage of the
The issuing company needs to provide a document containing the terms and conditions governing
Sources:
http://bkmiba.blogspot.in/2015/08/case-study-perfect-competition-in.html,
http://www.nipfp.org.in/media/medialibrary/2016/11/WP_2016_182.pdf,
must-know-about.htm#1,
https://www.bankbazaar.com/credit-card/different-types-of-credit-cards-in-india.html, accessed on
Posers
Indian Stock Market: Does it Explain Perfect Competetion?
provides a market place, whether real or virtual, to facilitate the exchange of securities between buyers
Participants in the stock market range from small individual investors to large traders, who can be
324
Managerial Economics
maximisers actively competing with each other, trying to predict future market value of individual
market player to either exit or enter; one cannot exit or enter for few days in those stocks which are under
The stock market activity
is increasingly becoming more centralised, concentrated and non competitive, serving interest of big
players only.
Table 10.11 Impact of FIIs’ Investments on NSE
Wave
Date
Index
(` Cr.)
(` Cr.)
Wave 1
From
17/05/04
1388.75
To
26/10/05
2408.50
From
27/10/05
2352.90
To
11/05/06
3701.05
From
12/05/06
3650.05
To
13/06/06
2663.30
1019.75
59520
5,40,391
1348.15
38258
6,20,248
–986.75
– 9709
–4,60,149
Wave 2
Wave 3
Source:
*Source: Business Standard
, April–June 2007, Page 15.
Perfect Competition
325
Sources:
● Business Standard (29/10/07 to 02/11/07).
● Business Standard, (1/11/2007)
● Business Today dated 4 November 2007, p. 98.
● Hagstrom, Robert G. (2001), The Essential Buffett: Timeless Principles for the New Economy,
John Wiley and Sons, New York.
● Indian Journal of Capital market, April–June 2007, pages 15, 28 and 29.
● The Economic Times (29/10/07 to 02/11/07).
Posers
Chapter
11
2. Explore the vistas of emergence of monopoly power, with focus on barriers to enter
the market.
3. Analyse the pricing and output decisions of a monopolist in the short run and long run.
4. Develop an understanding of output and pricing decisions of a multi-plant monopolist.
5. Explore the nuances of price discrimination by a monopolist and the different
degrees of such discrimination.
6. Lay down a representation of the economic inefficiency of monopoly.
Chapter Objectives
1. Examine the nature and different forms of a monopoly market.
7. Introduce the concept of monopsony.
INTRODUCTION
You have learnt about perfect competition in the previous chapter
and you know that it is one extreme case in market morphology. The
other extreme is of monopoly, i.e., no competition. Now what does
monopoly mean? A monopoly (from the Greek word “mono” meaning
single and “polo” meaning to sell) is that form of market in which a single seller sells a product (good
or service) which has no substitute. A monopolist
of a product (good or service) that has no close substitute. If you try to see around, you would wonder
that every commodity we use has some substitute or an alternative. Let us do a small mind game here
A monopoly is a market in which a single
seller sells a product (or service) which has
no substitute.
toothpaste: its substitute can be toothpowder; take pen: its substitute can be pencil. But remember,
these are close substitutes. There can be distant substitutes as well, railways can be considered to be
a distant substitute of airways; coal can be a distant substitute of electricity; and so on. So does that
mean that monopoly is only a theoretical situation? No. Monopoly does exist in real life; it exists when
Monopoly and Monopsony
327
a commodity or service has no close substitute. For example, Indian Railways is a monopoly, since
there is no other agency in the country that provides railway service. Considering railways as a mode
of transport, roadways and airways can be counted as its substitutes, though not close substitutes. So,
railways serve as a very good example of monopoly.
MONOPOLY
Economists often distinguish between pure monopoly and monopoly. Pure monopoly is that market
situation in which there is absolutely no substitute of the product, and the entire market is under control
some
substitute to every good (or service) but such substitutes would vary in terms of their ability to satisfy a
the same (or similar) price as the particular good in question. Take the example of common salt; you may
say that it has no substitute as such. We would, however, like to remind you of rock salt that can be used
as an alternative to common salt. So there is an alternative to common salt, but in terms of availability
and price, there is a wide difference between the two. Hence, common salt appears to be a monopolised
product and if there was only a single seller of salt, it would become a case of monopoly! Therefore, we
agree to say that a monopoly exists when there is no close substitute to the product and also when there
is a single producer and seller of the product, like Indian Railways, as mentioned above.
Before venturing into the causes of formation of monopoly, it is useful to understand the main
characteristics of this type of market. In the previous chapter, you have seen that market characteristics
Therefore, it is worthwhile to study the main features of monopoly under these dimensions.
Features of Monopoly
Single Seller
telephone, electricity, post and telegraph, oil and gas were all government monopolies.
Single Product
A monopoly exists when a single seller sells a product which has no substitute or, at least, no close
substitute in the market. By close substitute we imply goods which satisfy same want, provide similar
close substitutes.
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Managerial Economics
No Difference between Firm and Industry
In that event, the industry as a whole would cease to exist.
Independent Decision-Making
output, based on individual demand and cost conditions and is hence, regarded as a price maker.
Restricted Entry
the emergence and/or survival of a monopoly. We would discuss such barriers in the following section.
REASONS
AND
TYPES
OF
MONOPOLY
A natural question may come to your mind that how does market imperfection reach to this extent that
there is no competition at all among the players? The emergence and survival of monopoly is attributed
existing ones. Barriers to entry are, therefore, the major sources (or reasons) of monopoly power. Stigler1
entry barrier as a cost of producing (at some or every rate of output), which must be
the important barriers to enter in a particular market are explained here under reasons for emergence of
monopoly.
Reasons for Monopoly
Restriction by Law
Such a barrier emerges when the government makes it a law not to allow any competition in the
production and distribution of a particular product. Majority of the State Electricity Boards in India can
be cited as a typical example of such a barrier.
Control Over Key Raw Materials
When the strategic raw material to produce a particular commodity is scarce and is fully controlled by
1.
Stigler G.J. (1968). The Organisation of Industry, Homewood, Ill: Richard D. Irwin.
Monopoly and Monopsony
329
players and monopolises manufacturing of nuclear weapons by maintaining control over the mines of
uranium, the key raw material for nuclear weapons.
eality
B ites
Diamonds Are Forever
De Beers Consolidated Mines was incorporated by Cecil Rhodes about 110 years ago, and it is the
largest and most successful diamond company in the world. In its early years, the company produced
over 90 percent of the entire world’s diamonds; it was then able to “control” the production and hence,
the supply of diamonds. This however, was reduced with the entry of many new players. Many are of
opinion that the company still enjoys a virtual monopoly in diamond supply to the rest of the world. In
fact, DeBeers now owns about 70 percent of the diamond mines in South Africa and produces nearly
40 percent of world’s diamond in terms of value!
Source: www.debeersgroup.com, www.en.wikipedia.org, accessed on 27/11/2007.
Specialised Know How
or licences. IBM is often considered to be a monopoly in mainframes. However, better know-how and
superior technology can be considered to be a barrier that may not hold strong in the long run, as other
Economies of Scale
Another very important reason behind creation of monopolies is the attainment of economies of scale,
often referred to as an “innocent” or a
and survive. Thus, economies of scale play a major role in restricting entry of new players or removing
level without affecting the quality of the product, and is thus, able to charge a low price at which other
Small Market Size
330
Managerial Economics
Heavy expenditure on Research & Development, strong advertising and marketing base, and existence
of sunk costs can be other types of barriers, which we would discuss further in Chapter 13.
Types of Monopoly
On the basis of the different barriers, various types of monopoly are created, which are elaborated here.
Legal Monopoly
Some monopolies are created by the laws of a country in the greater public interest. If the government
of the nation feels that private control may lead to disparity in distribution of wealth, or imbalanced
growth of the economy, it may keep the resources (or product or service) in its own control by imposing
legal restrictions on the entry of other players. For example, in India the public utility sector has been
a Government monopoly. Refer to our discussion on public sector in
A legal monopoly is created when the
Chapter 2 for further understanding of such a rationale on the part of
government restricts entry of other players
in a particular market in order to keep total
control in its hands.
electricity, airlines, post and telegraph, telecommunication, exploration
and distribution of oil and gas, etc., were government monopolies in
India and entry to these industries was prevented by law. Hence, they are referred as legal monopolies.
Even today electricity continues to be a State monopoly in most of the States of India.
in order to keep total control in its hands, a legal monopoly is created. In the private sector also, a legal
monopoly may be created through license or patent and this is known as a
can also enjoy monopoly in marketing of a product. This is possible by obtaining “exclusive marketing
rights” for a product.
Economic Monopoly
An economic monopoly is one which
is created whenever competition is
eliminated due to economic inefficiency of
other players, or due to superior efficiency
of a particular player.
created is regarded as an economic monopoly. A monopoly or “trust”
out of business by slashing prices, buying up and hoarding supplies,
bribery or intimidation (Clayton Antitrust Act of 1914).
Microsoft (MS) is now the most popular name in the computer industry to the extent that Microsoft
such as UNIX and LINUX are nowhere close to MS in terms of market penetration. This, however, is a
debatable issue and has evoked a lot of controversies.
World War, because it had acquired control over almost all sources of supply of bauxite, which is a key
raw material for aluminium.
Monopolies created on account of economies of scale also come under this category.
Monopoly and Monopsony
331
eality
B ites
Exclusive Marketing Rights Create Monopoly
The concept of Exclusive Marketing Rights (EMR) owes its origin to US legislation, namely the Hatchprovision was subsequently meant to protect drugs that either did not have any patent protection, or
way to stop the imitation of patented products by the local industry. EMR is also recognised under Trade
Related Intellectual Property Rights (TRIPS) Agreement of WTO as one of the alternatives to product
patents.
One instance of EMR that evoked a lot of controversy in India was that of pharmaceutical major
Novartis, which was granted EMR to exclusively sell or distribute its patented anti-cancer drug Glivec
containing the active ingredient Imatinib mesylate. At the same time, EMR to Eli Lilly was delayed. This
move affected six Indian pharmaceutical companies which have been manufacturing Imatinib mesylate
at one-tenth its price, under different trade names.
accessed on 27/11/2007.
Natural Monopoly
one player, a natural monopoly is formed. In other words, when only
A natural monopoly is formed when the
size of the market is so small that it can
accommodate only one player.
of output that needs to be produced to satisfy the market demand would actually lead to the removal
of all but one player from the market, thus, creating a “natural monopoly”. Some scholars consider a
monopoly created due to economies of scale as a natural monopoly.
Regional Monopoly
Sometimes geographical or territorial aspects also help in creation of monopolies. Even WTO under
Geographical Indicators
seeds, etc., are covered under this. Such protection creates a barrier to enter the market as a competitor
in the global market.
Measure of Monopoly Power
1. Lerner Index: It would be rather repetitive to say that the monopolist has market power to charge
monopolist does a “mark up” of price over MC. The mark up ratio of the difference between price
332
Managerial Economics
and MC and price is actually used to measure monopoly power and was introduced by economist
Abba Lerner in 1934. In fact, this ratio is named after Lerner as the Lerner Index, and can be
expressed as:
( P - MC)
…(1)
LI =
P
£ LI £ 1. Following equation, we can easily calculate
market power of each different type of industry. Moreover, the greater the difference between
price and MC, the greater would be the monopoly power.
Lerner also linked this index to price elasticity of demand. Let us see how.
Following equation, we can express LI as:
MC
LI = 1 –
…(2)
P
equation, we get:
LI = 1 –
Thus it follows that:
LI =
1
MR
=
, since MR = P ◊
ep
P
Ê
1ˆ
Á1 - ˜ .
ep ¯
Ë
1
ep
…(3)
The degree to which the monopolist raises its price over MC would essentially depend on the
shape of the demand curve, or the price elasticity of demand (ep). As ep
up decreases, and consequently, LI would fall.
The
popularly to ascertain market concentration. It is calculated by squaring the share of the entire
power and an increase in competition.
According to Rothschild, the degree of monopoly power can be
words:
Rothschild index =
Slope of demand curve of firm
Slope of demand curve of industry
thus rendering a value of one to the degree of monopoly power.
…(4)
Monopoly and Monopsony
DEMAND
AND
MARGINAL REVENUE CURVES
FOR A
If you can recollect your lessons of perfect competition, the price taker
333
MONOPOLY FIRM
The monopolist cannot set both price and
quantity at its own will.
price and output, and has a normal demand curve with a negative slope. The main reason behind the
only when it reduces the price of its product. Therein is the trade off for the monopolist, it can increase
its sales if and only if it chooses to lower the price of the product; conversely, sales would go down if
price is increased.
The demand curve of the monopolist is highly price inelastic because there is no close substitute and
consumers have no or very little choice. Hence, if consumers want to consume the product, they would
have to buy it at the price charged by the monopolist. Does this imply that monopoly price will be high?
the slope of MR curve. In case of perfect competition, the
demand curve is perfectly elastic; hence the AR curve of a
MR curve. In monopoly, however, the AR and MR curves
would look like those given in Figure 11.1. The reason is
Revenue, Cost
governed by market demand for its product and the forces affecting demand also affect the monopoly
not perfectly inelastic because pure
monopoly does not exist in real life. Hence, it faces a normal downward sloping curve. The bottom line
is thus clear, the monopolist cannot set both price and quantity at its own will.
You would also recall that the Average Revenue curve
MR
AR
O
is highly inelastic, therefore, AR curve would be downward
Quantity
sloping, and the MR curve would lie below the AR curve. Let
Fig. 11.1 Demand and MR Curves of
us explain the reason. As mentioned before, the monopolist
a Monopoly Firm
has to lower the price of all units of its product, if it wants to
sell an additional unit. As such, the addition to revenue resulting from selling this additional unit would
marginal revenue! Hence for a monopolist, MR is less than price and the MR curve would lie below the
AR curve. In fact, for a linear demand curve, the slope of MR is twice that of AR and the MR curve would
lie halfway between the AR curve and price axis. We would use calculus to prove this.
334
Managerial Economics
P = a – bQ
terms the slope of MR is twice that of AR.
Solution:
P = a – bQ fi R = aQ – bQ2
AR = a – bQ
Slope of AR (absolute) = b.
dR
= a – 2bQ
MR =
dQ
Slope of MR (absolute) = 2b.
Hence, in absolute terms the slope of MR is twice that of AR.
PRICE
AND
OUTPUT DECISIONS
IN
SHORT RUN
maker and faces no competition, why would it not charge a price (or adjust the quantity it sells), to ensure
loss? Answers to all your queries are given in the following sections.
Case of Supernormal Profit
First of all we shall explain the occurrence of
equilibrium is E and the equilibrium output is shown as OQE in Figure 11.2. Now what will be the price
Monopoly and Monopsony
335
of demand, because the monopolist would like to sell its entire product and hence, it would charge a
price OPE, which is the equilibrium price. Since this equilibrium price (or AR) is more than AC, the
OQE at OPE is given by
the rectangular area OPEBQE (the area below the AR curve), whereas the total cost incurred is given by
the rectangular area OAEQE (the area below the AC curve, since TC = AC.Q
APEBE.
B
PE
A
AC
E
AR
MC
Price, Revenue, Cost
Price, Revenue, Cost
MC
B
PE
E
AR
MR
O
QE
Quantity
Fig. 11.2
AC
O
MR
QE
Quantity
Fig. 11.3
Case of Normal Profit
the AC curve is tangent to the AR (or demand) curve, as given in Figure 11.3, equilibrium here occurs at
point E
E, the output that maximises
OQE and equilibrium price (at which total output OQE is sold) is OPE. The total revenue earned
OQE is the rectangular area OPEBQE and the total cost of producing OQE is also
given by the same area OPEBQE
Case of Loss (or Subnormal Profit)
when average revenue is less than average cost, or when the average cost curve is over and above the
price line. First let us understand the conditions when this may happen. Firstly, as mentioned in the
336
Managerial Economics
studying perfect competition that selling less than equilibrium output would only increase the losses.
Thirdly, it is also possible that in order to curb monopoly creation the government may impose tax on
monopoly products, which in turn increases the cost of production. In all of these cases, the monopoly
would either start earning economies of scale,
thus reducing its average cost, or would close
down altogether.
The case of loss is shown in Figure 11.4, in
which the equilibrium is at point E, equilibrium
level of output is OQE and price is OPE
earns total revenue given by the rectangular
area OPECQE (as in the earlier case). But the
cost of producing OQE level of output is given
by the rectangular area OABQE. Thus, the
total cost of producing OQE is more than the
revenue earned by selling it. The amount of
Price, Revenue, Cost
MC
AC
B
A
C
PE
E
AR
MR
O
QE
Fig. 11.4
Quantity
Loss in Short Run
PEABC.
PRICE
AND
OUTPUT DECISIONS
IN
LONG RUN
a monopolist is in full control of the market price; therefore you would agree that it would not continue
to incur loss in the long run. It would instead try to reduce its cost of production by increasing control
not incur loss in the long run.
Monopoly and Monopsony
337
would attract competition and this high price would make it possible for a new entrant to survive. In
this case, the market situation would change to competition and would no longer remain a monopoly.
Q, and the demand
equation for its product is given as P
Q
Solution:
Max P = R(Q) – C(Q)
Objective:
dp
dR(Q) dC (Q)
=
dQ
dQ
dQ
fi
Solving for MR and MC:
Q
Q
Q – 2Q2
Q
fi
d 2P
dMR dMC
2 =
dQ
dQ
dQ
Q
d 2P
dQ 2
P
P = R(Q) – C(Q
SUPPLY CURVE
OF
A MONOPOLY FIRM
From our previous discussion on demand and supply you must
There is no definite supply curve for a
monopolist.
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Managerial Economics
with their individual marginal costs of production and thus, determine the supply curve in the short
competition, it cannot equate its price to MR. Supply of the good by the monopolist at a given price
would be determined by both the market demand and the MC curve. As such, there is no supply curve
for a monopolist.
PRICE
AND
OUTPUT DECISIONS
OF
MULTI PLANT MONOPOLY
a single cost function. However, in real life it is possible that the monopolist produces a homogeneous
cost functions from multiple plants, it faces the same demand function for the entire market. A multi
demand curve and hence, the same average revenue and marginal revenue curves for the entire market.
plants, A and B. Two plants may appear simplistic but it would certainly not affect the understanding of
the decision-making process even when there are more than two plants. Let us further assume that each
of these two plants faces different cost functions. Marginal cost would then be the summation of cost
functions of the two plants. In other words:
MC = MCA
B
allocate this output between the two plants on the basis of the principle of marginalism:
MR = MCA = MCB
The multi plant (say A and B) monopolist
maximises its profit by producing an output
at which MR = MCA = MCB.
…(6)
by producing an output where MC of plant A is equal to MR and
MC of plant B is also equal to MR. Now how would this happen? If
MCA < MCB, the monopolist would increase production in plant A,
which has a lower MC and reduce production in plant B, which has a higher MC, till the condition given
Price, Revenue, Cost
Monopoly and Monopsony
MCA
MC
B1
B
E
Q
B2
R2
E1
R1
R
MR
MCB
ACA
AC
P
339
ACB
P = AR
E2
MC = MR
AR
QA
Quantity
Fig. 11.5 Total Market
QB
Quantity
Fig. 11.6
Plant A
Fig. 11.7
Quantity
Plant B
OQ
output satisfying MR = MC, when MC is rising; OP is the equilibrium price and RPBE
A, in which MC is lesser; Figure
11.7 shows the cost function of plant B in which MC is greater. Since the market is one, hence, only one
price prevails. This is shown by the line PP, which determines AR in both the plants. In order to decide
how much of the output will be produced individually in A and B,
and MCB
A
are individually equal to MR, which is naturally same for both plants. Thus,
QA
QB = OQ
…(7)
Let us do a small exercise to explain this concept further.
Suppose the demand function of a multi plant monopolist is given as P
X, where X is the
level of output. The cost functions of its two plants M and N are given as: TCM
XM and TCN
X N2, where XM and XN are the output of plants M and N respectively. Using this information,
Solution:
X = XM
P
MC1
XN
X
X – X2
- 2(XM
XN)
= XN
2
XM
XN)
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Managerial Economics
Now,
MC1 = MC2 = MR
Equating MC1 with MC2 we get XN
Equating MC1
XM
XN
XM
P
X
X=`
PRICE DISCRIMINATION
You must be aware of the different concessions offered to its passengers by the Indian Railways. Let us
challenged, sports persons and even to unemployed youth travelling for interview. This illustration has
been used here to introduce you to the concept and practice of price discrimination.
When a seller discriminates among buyers on the basis of the price
Price discrimination is the practice of
charged for the same good (or service), such a practice is called price
discriminating among buyers on the basis
discrimination. You may ask why a seller would do this, when is it
of the price charged for the same good (or
possible and how is it done? The answer to the why is very simple.
service).
A seller charges different prices with an objective to maximise
when it is possible
see how he does this.
Prerequisites to Price Discrimination
Market Control
Market imperfection and control are a prerequisite to price discrimination. Monopoly is the most
suitable market condition for price discrimination, because a monopolist is a price maker. Oligopoly and
monopolistic competition can also discriminate on the basis of price, but in their cases, discrimination
The greater the imperfection in the
market, the higher is the possibility of price
discrimination.
cannot do this simply because it has no control over market price. It is,
thus, clear that the greater the imperfection in the market, the higher is
the possibility of price discrimination.
Division of Market
the product would be identical. It must also not be possible to transfer goods from the cheaper market to
the costlier market. Such a practice of buying goods (or services) from a cheaper market and selling them
arbitrage.
Monopoly and Monopsony
341
There are many ways by which a seller can segment a market and discriminate; it can discriminate by
segregating consumers on the basis of their paying capacity, their needs, geography, demography, etc.
Typical examples include a doctor charging high fee from a rich
patient and less from a poor one; a tailor charging extra for delivering Prerequisites for price discrimination:
● Market control
material in less than usual time; petrol being sold at different prices in
● Division of market
different regions of the nation; different tariffs for mobile phone ● Different elasticities
services charged by service providers under different plans. You would
learn more about the bases for such division in the following section.
Different Price Elasticities of Demand in Different Markets
price elasticities of demand should be different in these market segments; otherwise segregation will not
price elasticity of demand helps in
determination of appropriate price, that is, a seller charges a higher price if elasticity is low and a lower
price if elasticity is high. Therefore, for maximisation of revenue it is a must that the different market
segments have different price elasticities.
Hence, to make price discrimination possible, these three conditions must coexist. For a better
understanding, see Figures 11.11, 11.12 and 11.13.
Bases of Price Discrimination
Personal
The most basic form of price discrimination is personal discrimination. When the seller has direct
contact with its customers, it is convenient for the seller to charge different prices from different
knows about the paying capacity of the customers and the intensity of their needs, and hence can easily
estimate the price elasticity for each customer. Moreover, since this discrimination is being done on a
personal basis, the good (or service) is non transferable.
challenged persons and children below a certain age get certain concessions on rail fare, which is not
available to other people. This is
separation of market. Lawyers may charge higher fee
from a person who has a case of life and death as against a client who has some small issue of discontent.
This segmentation is on basis of need. Doctors may treat poor patients free or may charge a concessional
fee; this is on the basis of
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Managerial Economics
Geographical
Another very popular method of market segmentation is on geographical basis, in which people living
in different areas are required to pay different prices for the same product. For example, edible oils
and many packaged food items are sold at different prices in different States of India. There is no
differentiation as regards the product, yet people living in one area pay more, as compared to other areas.
Time
Markets may also be divided on the basis of time, i.e., which time of the day or month or year is the
product being purchased. Interestingly, here the same person may be required to pay different prices
for the same product because of this type of discrimination. Off season discounts on a wide range
of goods serve as a very good example of such type of discrimination. Earlier the Department of
Telecommunications (DoT) in India used to charge different rates for a call to the same distance on basis
telephone tariff. This, however, is no longer into existence. Higher rates for tickets of movie shows in the
The INOX chain of multiplexes in the metro cities of India charge higher price for movie shows in the
weekends. Sunday editions of leading newspaper dailies are charged higher than the daily rates and serve
as another example.
Purpose of Use
Another distinction is on the basis of the purpose for which the product is being purchased. Customers
are segregated on basis of their purpose of use, for example, electricity rates are lower for domestic
purpose and higher for industrial purpose. Banks charge different interest rates for different types of
loans. So, the same person pays different rates for different loans, say loans for car and education.
of the seller to resort to price discrimination, because the markets are clearly segregated, and with the
examples cited above you can make out that price elasticity is also likely to be different between these
market segments.
So far we have discussed price discrimination assuming that the product is homogeneous in all the
markets. However, it is also possible that the same seller introduces some differentiation in the same
product or service and charges different prices. For example, hotels charge different tariffs for different
categories of rooms; railways and airways charge different rates for different classes. You would
appreciate that the basic good (or service) is the same (say, travel in case of railways and airways), but
discussion till here only, because differentiation creates a more valid reason for different prices than the
cases discussed above.
Monopoly and Monopsony
343
eality
B ites
Indian Railways and Price Discrimination
Indian Railways is the largest rail network in Asia and world’s second largest under one management.
It is a multi-gauge, multi-traction system, covering a total of 108706 kilometers through 6853 stations
throughout the length and breadth of the country. It runs 11, 000 trains, of which 7,000 are passenger
trains carrying 13 million passengers everyday. It is the largest employer in the organised sector, with
a workforce of 1.54 million.
Indian Railways is the largest monopoly in the country and charges different fares under various
heads:
i. On the basis of consumer (passenger) categories:
categories of consumers (passengers) on the basis of fare, including normal fare for everyone, 10%,
30%, 40% and 66.6% concession for each covering 1 respective category, viz. doctors, Sr. citizen,
IAFT and PTO Indian Railway, 25% concession for 10 categories of passengers, 50% concession
for 27 categories, 75% concession for 26 different categories for various types of patients, their
escorts and physically/mentally handicap, students and 100% for two categories of passengers
including unemployed youth.
ii. On the basis of class of travel: Railways has introduced seven classes in which a passenger can
travel by paying differential fares for travelling the same distance by the same train, but with different
levels of comfort.
iii. On the basis of category of train: There are nine categories of trains in which normal fare is different
from each other for the same distance and in the same class, such as Rajdhani, Shatabdi, Superfast, Mail/Express, Jan Shatabdi, Garib Rath, Passenger and shuttle (EMU). This discrimination is
on basis of time covered in travel.
Source: www.indianrailway.gov.in, accessed on 4/12/2007.
Degrees of Price Discrimination
2
paying capacity and their willingness to pay. The seller can make a good assessment of consumer surplus
and can discriminate on that basis. We have already discussed about personal discrimination and these
degrees relate to this type of discrimination.
First Degree
When the seller is able to charge different prices for different units of the same product from the same
consumer, such a practice is called price discrimination of
. Joan Robinson referred to it as
2.
The Economics of Welfare, 1st edn., London: Macmillan.
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Managerial Economics
Price discrimination of first degree is when
the seller is able to charge different prices
for different units of the same product from
the same consumer.
perfect discrimination
the maximum price (also referred to as “reservation price”) from the
thus, takes away the entire consumer surplus. You may recall the
principle of diminishing marginal utility to understand this
phenomenon. In fact, price discrimination of the
discrimination.
Second Degree
Price discrimination of second degree
is when the seller divides consumers
in groups on the basis of their paying
capacities and discriminates on the basis of
consumer surplus.
In case of second degree of price discrimination the seller divides
consumers in groups on the basis of their paying capacities and
discriminates on the basis of consumer surplus. Thus, a person with
lower paying capacity is charged a lower price because consumer
surplus is less in this case and a person with higher paying capacity is
major (but not entire) portion of consumer surplus. Many economists are of opinion that second degree
of price discrimination works by charging different prices for different quantities of the same good (or
service). The rationale behind this is that the willingness to pay for more and more units is seen to fall
with increase in consumption of the commodity.
Third Degree
Price discrimination of third degree is when
the seller manages to take away only a
small portion of consumer surplus.
This is that degree of price discrimination in which the seller manages
segregates consumers on different bases such that each group of
consumers is a separate market, and then charges the price on basis of
different price elasticities of the different groups. This is the most common type of price discrimination
found in real life. A typical example is different rates of tickets for different seats in a movie theatre.
Monopoly and Monopsony
345
Price
ree degrees in a more illustrative manner.
P
E
P1
E1
P2
P3
A1 E2
E3
A2
D = AR = MR
O
Q
Fig. 11.8
Quantity
First Degree
shows discrimination of
P1
B
P
A1
E
D
O
Q 1 Q2 Q 3
Fig. 11.9
Second Degree
D
O
Q1 Q
Fig. 11.10
Third Degree
, in which the seller charges the maximum price from each buyer and
OPEQ. This is possible by charging a price exactly equal to the marginal utility derived by the consumer.
Hence, the demand (or AR) curve coincides with the MR curve.
In Figure 11.9, second degree discrimination is shown, in which the seller charges different prices
from different consumer groups on the basis of the paying capacity of the marginal consumer. Thus, the
seller allows some consumer surplus to each group of consumers and still maximises total income. In
A1E1E2 is the consumer surplus for the group which is sold OQ2 amount of output
and area A2E2E3 represents consumer surplus for the consumer buying OQ3
not discriminate and charges a single price to all his buyers? In this case, the income of the seller can be
either the area OP1E1Q1 or OP2E2Q2 or OP3E3Q3.
its revenue as now it is equal to the sum total of the areas OP1E1Q1, Q1A1E2Q2 and Q2A2E3Q3.
charges different prices on the basis of respective price elasticity of each group. Thus, the seller charges
higher price to buyers with less elastic demand and lower price to those with highly elastic demand, and
maximises its revenue. This is price discrimination of third degree. The impact of different elasticities
on price determination has been explained further in Figures 11.12 and 11.13.
PRICE
AND
OUTPUT DECISIONS
OF
DISCRIMINATING MONOPOLIST
namely what would be the equilibrium output and price of the discriminating monopolist and how is it
346
Managerial Economics
MR while MC is increasing. Once the optimum output is determined, the question that arises next is how
M1 with high price elasticity and M2 with low
charge lower price in the market M1 and higher price in the market M2 and it would supply more to the
market M1 and less to the market M2. Figures 11.11, 11.12 and 11.13 elaborate this phenomenon.
The monopolist will:
● Charge lower price and supply more in
the market with high price elasticity.
● Charge higher price and supply less in
the market with low price elasticity.
which OQ is the equilibrium output. Note here that the MR curve
does not have a continuous slope; the reason is that the monopolist
faces two demand curves with different slopes. Since MR is related
to AR, hence, the portion DA of the demand curve refers to the less
elastic demand curve and the portion of the demand curve below A is
equal to MR in each market. Hence, in the market M1 the optimum output is OQ1 and in the market M2
the optimum output is OQ2. You would notice here that OQ1 > OQ2 and OP1< OP2.
MC
MR
Fig. 11.11 Total Market
MR
AR
Fig. 11.12
AR
AR
Price in M1
MR
Price in M2
Fig. 11.13
output OQ
OPEQ, which is less than the area given by
OP1E1Q1 OP2 E2Q2.
Let us sum up price discrimination by a numerical example.
The demand equations of a local movie theatre in Kolkata for balcony seats and dress circle seats
are given respectively as: QB
PB and 3Q DC
PDC. The total cost of running shows
Q. a. What would be the price of tickets with discrimination?
b. What would be the price if the multiplex decides to charge the same price across both the
types of seats?
Solution:
a. For balcony seats QB
PB. Thus, TRB
QB –
1 2
Q , MRB
2 B
.
B
Monopoly and Monopsony
= MRDC. When MC = MRB,
B
QB
fi QB
347
1
Q
2 B
QDC. Thus, TRB
QDC – 3QDC2, MRDC
QDC
fi QDC = 6. When QDC = 6, PDC
QB
PB
For dress circle seats PDC
.
DC
When MC = MRDC
QDC =
38
Answer: With price discrimination PB
PDC = 38
b. If the theatre decides not to discriminate, then there would be a single price, i.e., P = PB =
PDC. Combining the demand functions, we get Q
P
3
-
236 6
- Q
7
7
236 3
P
- Q.
. Thus, P =
7
7
3
Q = 16. When Q = 16, P
= 26.9
Answer: Without price discrimination P = 26.9
ECONOMIC INEFFICIENCY
OF
MONOPOLY
The phenomenon of
is elaborated in Figure 11.14, in which a
comparison is drawn between the long run
under perfect competition, and the other
under monopoly. In order to understand
the extent of excess capacity generated
under monopoly it has been assumed that
Price, Revenue, Cost
You have seen two market forms by now, which are extremely opposite to each other in terms of number
of players, control over price and degree of competition. In all times economists have decried monopoly
and favoured competition. Monopoly is being criticised on two basic grounds. Firstly, it runs at less than
optimum level and secondly, as a consequence, it generates excess capacity in the economic system,
LAC
PM
PC
O
EM
EC
DC
DM
QM
QC
Quantity
Fig. 11.14
DC),
to Perfect Competition
whereas the monopoly firm faces a
downward sloping curve DM,
QC, which it sells at price PC. The monopolist produces an output QM (less than QC), and sells at price PM
(more than PC). We can, thus, infer that a monopolist produces and sells less than a perfectly competitive
OQC – OQM (i.e., QMQC), is
regarded as excess capacity
output where its AR (or demand) curve is still declining (i.e., to the left of point Ec). In fact, normally
it may not be possible for a monopolist to operate at the minimum point on its AC curve. Thus, its AR
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Managerial Economics
curve is tangent to the AC curve at some point to the left of the minimum point of the AC curve. As such,
it does not allow optimum use of all the factors of production, thereby allowing loss of output (QMQC),
which is also termed as deadweight loss to the economy, since this increase in output is actually possible
under perfect competition.
practices from good economics. Several consider this as a loss of social welfare, hence, all regulatory
authorities make regulations to check and prevent monopoly practices.
eality
B ites
Monopoly Breeds Excess Capacity, Competition Expands Vistas
About a little over a decade, only 10 million telephones were there for an astounding 950 million race,
and two million people were on the waiting list! Less than one Indian in one hundred at that time had a
telephone, against a world average of 10 per 100. Since there was a shortage of investment funds to
meet the demand, the government had decided in 1994 to throw open the doors to private telephone
companies, breaking the Department of Telecommunications (DoT) monopoly of foreign and domestic
services.
As per Economic Survey 2006-07, there are 196 million telephone connections, and it is expected
to rise to 200 million by the end of February. Economic Survey predicts that India is likely to have 650
million telephone connections, including 66 million wired and 584 million wireless, by 2012.
The Survey attributes this growth to the progress in the IT-enabled services sector and rapid addition
of telephone connections, especially mobile phones.
accessed on 14/01/2007,
Price, Revenue, Cost
possible. The concept of deadweight loss can be further elaborated with the help of consumer surplus.
Figure 11
D
PM
PC
A
B
E
MC = AC = (MRP = ARP)
ARM
O
MRM
QM
QC
Quantity
Fig. 11.15 Deadweight Loss Due to Monopoly
Monopoly and Monopsony
349
faces the same cost function and is able to produce at the optimum level, i.e., at the point where MC = AC.
In other words, each produces at the minimum point of its AC curve. But due to the basic characteristics
of the two forms of market, the monopolist faces falling AR and MR, whereas the perfectly competitive
OQC output at price OPC.
consumer surplus, which is equal to the area PCDB.
In contrast, the monopolist has control over price; hence it charges OPM price and produces OQM output
and thus, takes away PCPMAE
In other words, the area PCPMAE
which, the consumer gets only the area PMDA as consumer surplus. Note that the triangle with area EAB
society, the area of probable economic activity shown by the triangle EAB
income, and the society is at loss of this much amount of wealth.
A monopolist can also arbitrarily limit the supply of the good or service it provides to create scarcity
and thus, drives the price up. In either case, it collects a “rent” on its domination of a particular sector
product in a competitive market environment.
To summarise it can be said that lack of competition and imperfections in market lead to lower
production and higher market price. This understanding helps in decisions regarding income distribution
and public policymaking.
MONOPSONY
You have understood that in a monopoly market there is a single seller of a product, while number of
buyers is large. It is also possible that there is a market with a single buyer of a product, while many
sellers are willing to sell that product. This situation is known as monopsony; the term is drawn from
Greek, in which the word literally means a single buyer. In economic theory, the credit for introducing
Joan Robinson (1969). In this section, we shall
explain the concept of monopsony so as to develop a better understanding of the concept.
A monopolist has control over price and quality because it is the only supplier of that commodity and
there are many buyers who compete to buy this product from the monopolist. Similarly, the monopsonist
also has control over price as it is the only buyer of a product or service, though there are many sellers
of that commodity or service. It controls both price and quality of the product through control over
quantity demanded.
You might wonder as to how can a buyer control the price. You know that a buyer would want to
pay as less as possible for a product. Now imagine a market where there is a single buyer and many
their product to the buyer and in this process would be willing to sell at a very low price, in some cases
even lower than the marginal cost. So this brings us to another aspect where monopoly and monopsony
350
Managerial Economics
are opposite to each other. As monopoly price is usually high, monopsony price would be usually low.
A monopsonist can push down the market price of a good by reducing the quantity it purchases. Hence,
as price is reduced, the monopsonist would buy more, and vice versa.
The incidence of monopsony power is especially visible in case of input market. A monopolist in the
manufacture of a particular good would also be a monopsonist in the types of labour used only in the
production of that good. De Beers, the diamond producer, is the major employer of diamond workers in
South Africa. Examples of monopsonists can be commonly seen in some small towns, where majority
to multiple other mills in other areas due to transportation costs. Another example is a cold storage in
a town. Mostly a cold storage strikes monopsony power as all the local vegetable growers have to sell
their produce to the cold storage at the price it demands as they do not have any holding power due to
perishable nature of the product.
eality
B ites
Miners in Company Towns
Company towns present a classic example of monopsony, especially those in the late nineteenth and
early twentieth centuries, when transportation was expensive. A company town would be a small town
located in a remote area with only one employer. Such a town would mostly be established near mines,
and its location was governed by mineral deposits. Often the employer owned all the housing and
operated all stores and other services in the town.
In India, Jamshedpur, commonly known as the nation’s steel city, is a perfect example of company
towns. Established near the mines and reserves of coal, iron and limestone, Jamshedpur got its name
given by Lord Chelmsford in 1919, as a tribute to its legendary founder Jamshedji Tata.
Source:
, accessed on 18/05/2017.
Economic Inefficiency of Monopsony
large buyer is typically able to force prices to decline and this type of market contrasts with a monopoly
where a large seller is able to drive prices up.
An employer who enjoys monopsony power holds down wages by limiting the number of workers it
to output is greater than the wage s/he receives. This gap was termed the “rate of exploitation” by
wage enforced by the government or perhaps by a labour union. Thus, the possibility of monopsony can
In goods market, the monopsonist would not procure the last few units of a good whose value to
the monopsonist is greater than their marginal cost, in order to hold down the price paid for prior
Monopoly and Monopsony
351
price for sugarcane, pulses, potatoes and similar other produce.
SUMMARY
◆
A monopoly is that form of market in which a single seller sells a product (or service) which has
no substitute. Pure monopoly is that market situation in which there is absolutely no substitute of
◆
A monopoly has a single seller, sells a single product (pure monopoly) and decides on its own
price and output, based on individual demand and cost conditions and is hence, regarded as a price
maker
Barriers to entry are the major sources (or reasons) of monopoly power and may include
restriction by law, control over key raw materials, specialised know-how restricted through
patents or licences, small market and economies of scale.
◆
◆
price inelastic because there is no close substitute.
◆
◆
◆
◆
short run, but would not incur loss in the long run.
The monopolist being a price maker does not have any supply curve.
A multi plant monopolist decides on how much to produce and what price to sell at so as to
When a seller discriminates among buyers on basis of the price charged for the same good (or
service), such a practice is called price discrimination.
◆
geographical basis and on the basis of time or purpose of use.
◆
◆
price elasticity and a lower price and supply more in the market having lower price elasticity.
Monopoly runs at less than optimum level of output and generates excess capacity in the
economic system, which in turn results in deadweight loss that adds neither to consumer surplus,
◆
prices by reducing quantity demanded.
352
◆
Managerial Economics
Monopoly power refers to the degree of price setting power held by a monopolist on the basis
KEY CONCEPTS
Monopoly
Legal monopoly
Monopsony
Monopoly power
QUESTIONS
Objective Type
i. Charging different prices for similar goods is pure price discrimination.
ii. Difference in price elasticities of demand is a necessary condition for price discrimination.
iii. Government itself may grant franchise to a producer to provide service in a particular area.
aggregate marginal cost of production.
v. Monopoly is against public interest as it limits customer choices.
vi. Close substitutes are goods which provide similar utility.
vii. A monopolist operates at the optimum level of output and charges a higher price.
price discrimination.
x. Supply curve for a monopolist is upward sloping.
i. The Tatkal facility for reservation offered by Indian Railways is an example of price discrimination
of _______ degree.
price elasticity is ________.
iii. The Lerner Index increases when demand becomes more _______.
v. High price of special “box” seats in theatres is an example of price discrimination of _______
degree.
vi. A legal monopoly in private sector is known as ______ monopoly.
Monopoly and Monopsony
353
vii. Maximum consumer surplus is allowed to the buyers in ________ degree price discrimination.
ix. A monopoly that has no substitute is known as ____ monopoly.
i. A monopoly is:
a. One of the few producers of a homogeneous product
b. A single producer of a single product
c. One of the many producers of a homogeneous product
d. One of many producers of a differentiated product
ii. In comparison to a perfectly competitive market, a monopoly market would usually generate:
a. Higher output at higher price
b. Higher output at lower price
c. Lower output at higher price
d. Lower output at lower price
a. MR = MC
c. P = MR
iv. A multi-plant monopolist is an illustration of:
a. Geographical
a. Difference in need
c. Difference in price elasticities
vii. A natural monopoly is characterised by:
viii. Slope of AR is:
a. Equal to slope of MR
c. Thrice the slope of MR
ix. In the long run, a monopolist would always:
b. P = MC
d. P = AR = MR = MC
b. Demographical
b. Separation of market
d. Direct contact with consumer
b. Twice the slope of MR
d. Half the slope of MR
x. Formation of monopoly due to economies of scale is known as:
a. A natural barrier
b. A legal barrier
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Managerial Economics
Analytical Corner
curve is less than one”. Discuss.
How?
competition?
c. Reliance India (polymers)
d. Orkut (social networking website)
it faces downward sloping demand curve”. Discuss.
6. Which, among the three degrees of price discrimination seems to be the most unrealistic to you?
Why?
7. What are the economic entry barriers which create monopoly? Illustrate with examples from
Indian economy.
8. It is said that a monopolist has full control over output and price. In spite of that, why does even
9. If there were no legal entry barrier would there be a competitor to Indian Railway?
competitive market?
11. Is monopoly always socially undesirable? Take any real-life example of monopoly in India and
build your logic in favour of or against this.
12. If elasticities of two markets are equal, prove mathematically that it would not be worthwhile for
the monopolist to discriminate among the markets.
13. A monopolist has a production function as q = 3 x and a demand function as P
q is the level of output and x
C
q, where
q – q2
input required.
14. Consider a monopolist who decides to discriminate between two markets that have demand
curves with the same slopes, but different intercepts. Which market would be charged a higher
price by the monopolist?
P
q; its cost function is
3
2
C = q – 12q
q
16. Consider a monopolist that sells a multipurpose portable music device. The government decides
t
t < 1 and t > 1. Would either affect the price and output
Monopoly and Monopsony
355
17. The cost function of the only multiplex theatre running in a city has been calculated as
C = x3
x2
x
P
x.
Here x
18. Consider a polymer monopolist which operates with two plants, one at Ahmedabad (say plant A)
and the other at Baroda (say plant B
of the plants (in lakhs of Rupees) as: TCA
QA Q A2 and TCB
QB Q B2, where
QA and QB represent the output levels of the respective plants in thousands of units per day. The
demand for polymers is given as P
Q. Find the level of output of each of the plants. How
much should the monopolist charge per unit of fabric produced in the two plants?
Check Your Answers
State True or False
i. F
ii. T
iii. T
iv. T
v. T
vi. T
vii. F
viii. T
ix. F
x. F
vii. c
viii. d
ix. d
x. c
Fill in the Blanks
i.
iv.
vii.
x.
second
natural
third
deadweight
ii. unity
v. third
viii. maker
iii. inelastic
vi. franchise
ix. pure
Pick the Correct Option
i. b
ii. c
iii. a
iv. c
v. a,
vi. c
Analytical Corner
13. q
P
q
P
16.
17. x
P
18. QA = 6, QB
x
t<1
P = 41
Caselet 1
The Pure Joy of Monopoly
With a market share of roughly 99 percent, Intel, the Santa Clara, California-based processor giant,
has enjoyed a near-monopoly in the server chip market. Its x86 chips are the standard, and with almost
no competition from Advanced Micro Devices (AMD), the only other x86 chip makers, Intel has been
free to enjoy its dominance.
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Managerial Economics
Intel kept its prices high and people paid them. The other major products contributing to the growth of
the company include concrete stronghold over data centre compute processor and the desktop market.
Source:
https://www.theregister.co.uk/2017/04/27/intel_1qfy2017_results/
Case Question
1. This case proves that monopoly price is always high. Discuss.
Caselet 2
Is Government Monopoly also Harmful?
state-owned trading company to deal with the import, transportation, storage and distribution of
various petroleum products in the country. NOC is the sole organisation responsible for the import
all parts of the country. All the petroleum products consumed in Nepal are procured and imported
products in India. Earlier, Nepal used to import crude-oil directly from the petrol producing Gulf
million rupees, according to a statement issued by the NOC. The NOC operation is not transparent
and there are leakages in many sectors. A high-level commission has been constituted to reform the
NOC management.
Source:
www. Nepaloil.com.np,
.
Case Questions
1. It is a case of dual monopoly, where NOC is a monopoly in Nepal and can buy petroleum
products from IOC only. Comment on the situation and its fallouts.
2. If the Government of Nepal allows private players in competition with NOC, will that be
Monopoly and Monopsony
357
Discriminating all the Way: Indian Railways
Railway is the main source of transportation for majority of population in India because of its
Indian Railways, the largest monopoly in the country, has full control over ticket price and it makes
full use of this power. A glimpse would elaborate the categories of ticket price as charged by IR:
Indian Railways charges for every kilometre, which gets reduced as one travels longer distances.
Thus, a train ticket for Rajdhani 1st AC between Bengaluru to Delhi (`
`
of two 1st AC tickets one from Bangalore to Nagpur (`
valid passport, against which they can obtain reservations from any reservation office of Indian
the pass, which simply means customer buys more subsequent days of validity at reduced price.
Concessions are available to students, national level sports persons, differently abled, teachers,
unemployed youth traveling for interview, patients, etc.
Circular journey tickets are available for passengers intending for sightseeing or pilgrimage
trips. Such tickets provide consumer the benefit of telescopic rates, which are considerably lower
than regular point to point fares. They are issued for all journeys which begin and end at the same
station and can be purchased for all classes of travel.
Confirmed tickets can be booked on short notice by paying Tatkal charges fixed as a percentage
other classes subject to minimum and maximum charges.
6 percent freight concession was introduced for traffic booked from other States for stations in
Sources:
http://mbacase.blogspot.in/2012/05/economics-indian-railway-monopoly.html, accessed on
www.indianrailway.gov.in, accessed on
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Managerial Economics
Posers
1. Categorise the various methods of price discrimination by Indian Railways as given this case
practices this kind of discrimination? Why or why not?
3. Looking at the information given in the case, do you think Indian Railways uses in price
WalMart: Monopsony Power
WalMart was founded by Samuel Moore Walton in 1962. With its headquarters in Bentonville, Arkansas,
four retailers (USD 343.33 billion).
For past many years, WalMart has been the largest retailer in spite of upsurge of e-retailers, especially
low pricing strategy that Wal-Mart offers is extremely appealing. To keep prices low, the company has
been many claims that WalMart operates as a monopsonist in both the labour and supplies markets.
WalMart is the largest employer in the United States ofAmerica, who employs at or near minimum wage.The
strategy adopted is to hire people from rural markets from South because labour is cheap and has low bargaining
power. According to a research, WalMart lowers wages to such an extent that it could warrant attention from
anti-trust regulators in the US Department of Justice.
It is not only demand for labour that WalMart has monopsony power, but it also commands same
domestic retailers who have less bargaining power on the same suppliers. History shows that WalMart
reduces price to such an extent that suppliers are not able to cover their costs and often withdraw from
other retailer can match. Moreover, if they do not agree to sell at the price commanded by WalMart, the
latter would move to another supplier who is able and willing to offer the price WalMart wants. This
in turn forces suppliers to make efforts to reduce their costs to keep themselves in business. Hence,
suppliers, in order to maintain business relationship with WalMart, have to move production facilities to
China or India. Even there, WalMart pushes suppliers to further decease price, affecting local wages and
costs of production. The company website invites vendor partners who can provide quality products at
less factories are opened there, hence, levels of production decreases in world terms.
Monopoly and Monopsony
359
Sources:
http://www.academia.edu/8234797/Walmart_Monopsony_Power, accessed on
https://www.statista.com/statistics/195992/usa-retail-sales-of-the-top-50-retailers/ accessed on
http://www.wal-martindia.in,
Posers
Chapter
12
2. Analyse the pricing and output decisions of a monopolistically competitive firm in
the short run and long run.
3. Comprehend why a firm in monopolistic competition operates with excess capacity.
4. Understand the rationale behind advertising for the “unique” product of a
monopolistically competitive firm.
Chapter Objectives
1. Understand the nature of imperfect competition or monopolistic competition.
INTRODUCTION
Let us begin with a small mind game by recalling brands of toothpastes that are available in India, and
list down what uniqueness each brand offers. Colgate offers all round dental protection as a feature;
Dantkanti
the babool tree. These companies introduce wide variety to further differentiate the product. But the
Formal is not boring
In the previous chapters, you have learnt about perfect competition and monopoly. Now try to place
because there are many players but not as large as in perfect competition and each sells a differentiated
product exercising some
Monopolistic Competition
361
monopolistic competition or
two great economists,
The Theory of Monopolistic Competition and in the
The Economics of Imperfect Competition,
so these two economists can be regarded as the parents of the modern study of imperfect competition.
brief description may be relevant.
MONOPOLISTIC COMPETITION
heterogeneous
or differentiated
Monopolistic competition is a market
situation in which a relatively large number
of producers offer similar but not identical
products.
just like a monopolist
similar that later economists used the two terms alternatively for long. Somehow, over time, the term
not perfect.
To quote Chamberlin,
“Monopolistic competition is a challenge to the traditional viewpoint of economics that competition and
monopoly are alternatives……… By contrast it is held that most economic situations are composites of
both competition and monopoly.”
Features of Monopolistic Competition
Large Number of Buyers and Sellers
Heterogeneous Products
product homogeneity under perfect competition
understand product differentiation.
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Managerial Economics
eality
B ites
Monopolistic Attributes in Indian Secondary Education System
Uttar Pradesh Board of High School and Intermediate Education is the biggest examining body in
the world. The Board was set up in the year 1921 at Allahabad by an Act of United Provinces Legislative
governed by the Indian Council of School Education (ICSE) and Central Board of Secondary Education
(CBSE), though majority seeks recognition of the UP Board. Presently, there are more than 22,000
secondary schools recognised by the UP Board.
The Central Board of Secondary Education, established in 1929, enjoys the distinction of being the
second oldest Board of Secondary Education in India. The Board is an apex National Body, which
substantially upgrades educational standards and introduces innovations in secondary education.
and 211 schools in 25 foreign countries. So 1,118 Kendriya Vidyalayas
Jawahar Novodaya Vidyalayas and 14 Central Tibetan Schools
come under the aegis of the Board.
Source: http//www.upmsp.nic.in, http//www.cbse. nic.in,
www.upmsp.edu.in/AboutUs.aspx
www.cbse.nic.in
A product is differentiated if there are even
minor changes in the same generic product,
by which sellers can charge different prices.
customers that what they are selling is not the same as what their rival
differentiated product. Such differentiation can also be on the basis of
Companies producing oral care products offer different types of the same generic product, toothpaste
and tooth powder
for one of the products. These companies resort to advertisements to highlight this differentiation and
higher than the price established by the forces of demand and supply.
Now let us explain product differentiation under monopolistic competition. From the previous
paragraphs, you must have understood that a differentiated product enjoys some degree of uniqueness
in the mindset of customers, be it real, or imaginary. Whatever be the basis of differentiation, because
of such differences among their products, producers in monopolistic competition have some control over
A differentiated product enjoys some
degree of uniqueness in the mindset of
customers, be it real, or imaginary.
very similar to each other and are very close substitutes with very little
or nil switching cost on the part of the customer. In brief we can, thus,
say that the products of different sellers in monopolistic competition
cross elasticity of demand.
Product differentiation, however, is not restricted to monopolistic competition; it can also be practised
by oligopolists, which we would discuss in the next chapter.
Monopolistic Competition
363
Selling Costs
incentives. These are selling costs that must be considered along with production costs.
Independent Decision-Making
collusion, such
2
Imperfect Knowledge
Information about cost, quality, price, etc. is not uniformly available to all buyers and sellers in the
the imperfect market (monopolistic market) is
characterised by distortion of market conditions by the sellers.
Unrestricted Entry and Exit
eality
B ites
Unrestricted Entry: From Oligopoly to Monopolistic
ten years could see the number of companies increasing to 800 by the year 2000. The revenue per
Another booster dose was given to the sector by National Task Force and Software Development and
bring similar increase in revenue per capita, except for giants like TCS, Infosys, Wipro and HCL. India
also the biggest job creator in the organised sector. Despite occasional obstacles, the industry is pro-
Sources: Sheshagiri N. IT: Ambience for Growth, Yojana, November 2007.
https://www.ibef.org/news/it-export-to-grow-at-78-15l-jobs-to-be-created-in-fy18
2
364
Managerial Economics
IDENTIFICATION
OF
INDUSTRY
A product group comprises of products that
are “good”, but not “perfect” substitutes of
each other.
we identify groups
product group would ideally comprise
eality
B ites
The domestic retail industry in India has emerged as one of the most dynamic and fast-paced industries
into organised and unorganised sectors. Traditionally, the domestic retail industry comprised of large,
medium and small grocery stores and drug stores which could be broadly clubbed under unorganised
retailing. These are father and son shops, “kirana” shops and paan shops that have dominated the
economy before the “onslaught” of organised outlets which are cashing on a bigger and better stock
of commodities to meet the requirements of the modern consumer. This apart, with growth in Internet
Sources: http://www.icmrindia.org/casestudies/catalogue/Marketing/MKTG114.htm,
Roll, But… Investors India, November 2007, pp. 38–42.
https://www.ibef.org/industry/indian-retail-industry-analysis-presentation
, on a
In the service sector in India, institutions of primary and secondary education and organisations of
healthcare are good examples of monopolistic competition.
Monopolistic Competition
DEMAND
AND
MARGINAL REVENUE CURVES
OF A
365
FIRM
with a negative slope. The main reason behind the negative slope
Demand curve for a firm has a negative
slope as all firms sell products which are
close substitutes of each other.
substitutes of each other; the substitution effect results in the negative
may only attract its competitors’ most mercurial
customers; as larger and larger price reduction is
instituted, it may acquire more and more customers
from its rivals, by drawing on customers who are
less anxious to switch.
these curves are similar to those in monopoly with
the only departure that in monopolistic competition
the demand is highly elastic, and in monopoly it is
Price, Revenue
slightly, it will lose some, but not all of its customers; if it lowers the price slightly, it will gain some,
but not all
AR
MR
O
Quantity
Fig. 12.1
Demand and MR Curves of a Firm
to that in case of a monopolist.
PRICE
AND
OUTPUT DECISIONS
IN
SHORT RUN
of both perfect competition and monopoly. The monopoly aspect
The negative slope of the demand curve
under monopolistic competition is
instrumental for chances of monopoly
profits in the short run.
some
discretion over price, due to the existence of customer loyalty. We assume here that any representative
366
Managerial Economics
(i) Case of Supernormal Profit
E, with the equilibrium price at OPE and output at OQE. So the total revenue earned by
OQE at OPE is given by the rectangular area OPEBQE
To produce this equilibrium output OQE
area OAEQE
is given by the rectangular region AEBPE, because price PE is greater than average cost.
Price, Revenue, Cost
MC
AC
B
PE
E
A
AR
MR
O
QE
Quantity
Fig. 12.2
(ii) Case of Normal Profit
E
OQE
OQE is the rectangular area OQEBPE.
and price is OPE
Similarly, the total cost of producing OQE is also given by the area OQEBPE
E
367
Monopolistic Competition
MC
Price, Revenue, Cost
AC
B
PE
AR
E
MR
O
QE
Quantity
Fig. 12.3
(iii) Case of Loss (or Subnormal Profit)
MC
In the short run, a monopolistically competitive
A
this case is at point E, with equilibrium level
of output at OQE and price OPE
earns total revenue given by the rectangular
area OPECQE
cost of producing OQE level of output is given
by the rectangular area OABQE. Thus, the
total cost of producing OQE is more than the
revenue earned by selling OQE. The amount
Price, Revenue, Cost
revenue is less than average cost, or when the
AC
B
E
PE
C
AR
E
MR
O
QE
Fig. 12.4
Quantity
Loss in Short Run
area ABCPE.
PRICE
AND
OUTPUT DECISIONS
IN
LONG RUN
In the long run, the same situation would exist for monopolistic competition as in perfect competition,
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Managerial Economics
towards tangency, as at point B
E, with price PE and quantity QE.
LMC
Price, Revenue, Cost
LAC
B
A
PE
AR
E
MR
O
QE
Quantity
Fig. 12.5 Price and Output Decisions in Long Run
Let us clarify price and output decisions discussed so far with some numerical illustrations.
Q
Q2, and the demand equation for its product is given as P
Q
Solution:
P
fiQ
R(Q
C(Q
Q
Q2
d 2P
dQ 2
dP
dQ
P
Q
company is given as Q
Q2.
P.
Solution:
d
dQ
d TC
dQ
QfiQ
Q
Q
P
R(Q
C(Q
`
Q
Q2
Q
Q
Monopolistic Competition
MONOPOLISTIC COMPETITION
AND
369
ADVERTISING
We have already mentioned advertising as one of the ways of product
differentiation. In perfect competition, the product is homogeneous
and there is perfect information about the prevailing price, quality of
There is no need for advertising in perfect
competition and monopoly.
lowering the price of the product. In monopoly, however, there is no need for advertising as such, as
customers need to collect and process information on such large
It is more profitable for a monopolistically
competitive firm to attract customers
through advertising rather than by
lowering its price.
This type of advertising is prevalent in consumer goods industry;
5
general demand increasing effect of advertising is probably a major source of incentive for advertising.
The second broad incentive for advertising is to shift the demand curve of one
criticised by several economists, as it fosters advertising and helps build brands. This is for the reason
that advertising drives customers to spend more on purchasing products because of the name associated
with them rather than any other rational factor.
expenditure that adds perhaps no value to the product being offered, and leads to brand confusion in
Determination of Optimal Level of Advertising
on television, or radio, or print media, or promotion over mobile
phone, promotion and selling expenses constitute a major component
5
ibid
The optimal level of advertising is found
at the point where MR derived from
advertising is equal to MC of advertising.
370
Managerial Economics
principles would be applicable, the optimal level of advertising would be at that point where additional
equal to the marginal cost of advertising. In other words, optimal level of advertising is found at the
A
A
COMPARISON BETWEEN MONOPOLISTIC COMPETITION,
MONOPOLY AND PERFECT COMPETITION
A monopoly firm produces and sells less
than firms under monopolistic and perfect
competition.
We have already discussed in the previous chapter how a monopoly
excess capacity and have seen that perfect competition
ensures the most
evaluation of allocation of resources by monopolistic competition, perfect competition and monopoly.
perfect competition, the
second under monopolistic competition, and the third under monopoly
demand curve (DC
QC at price PC
a downward sloping demand curve (D
than PC
and produces an output QM (less than QC and Q
Q
(less than QC
P (more
DM, which is less elastic than D
PM (more than PC and P
QC QM, and also
QC
Q
A monopolistically competitive firm
produces (or sells) lesser output than a
perfectly competitive firm at higher price.
point EM and E
exclude monopoly practices from good economics.
substitutes, the demand
is homogeneous. Thus, the loss in welfare due to higher price and lower output is counterbalanced by
Monopolistic Competition
371
Price, Revenue, Cost
LAC
EM
PM
EMC
PMC
PC
EC
DC
DMC
O
DM
QM
QMC QC
Quantity
Fig. 12.6 Excess Capacity under Monopolistic Competition and Monopoly
SUMMARY
some
somewhere between the two extremes of monopoly and perfect competition.
imperfect competition
monopolistic competition
unrestricted entry and exit.
groups
Firms under monopolistic competition have a normal demand curve with a negative slope because
of substitution effect of heterogeneous products, which are close substitutes of each other. They
tomers must need to collect and process information on such large number of brands. Further, it
attract customers through advertising rather than by lowering the price.
372
Managerial Economics
good economics.
KEY CONCEPTS
QUESTIONS
Objective Type
I. State True or False
iii. Selling costs would be higher for monopolistic competition due to advertising costs.
iv. Product groups are formed by combining close substitutes from the same industry.
II. Fill in the Blanks
Monopolistic Competition
III. Pick the Correct Option
a. Brand image
c. Brand leverage
b. No change in the same generic product
c. Preference over any one product
b. Brand equity
d. Brand extension
373
374
Managerial Economics
c. Free movement of resources
d. Clubbing of close substitutes
a. No effect on customers
Analytical Corner
of monopoly.
examples of each basis.
its apparels as P
Q
Q
P
Q2
Q.
i. Find the inverse demand function of your product.
C
Q
Q2
Q
Monopolistic Competition
Q2
375
Q
P and its long run total cost equation is given as TC Q
Q, where Q is the amount of output per month. What is the long run equilibrium price
Hint: In long run P
Check Your Answers
State True or False
i. T
ii. F
iii. T
iv. T
v. T
vi. T
vii. T
viii. F
ix. F
x. T
Fill in the Blanks
i. brands
vi. mercurial
ii. customer loyalty
vii. imaginary
iii. left
viii. perfect
iv. substitution effect
ix. distortion
v. lose
x. uniqueness
Pick the Correct Option
i. a
ii. a
iii. b
iv. d
v. d
vi. b
vii. d
viii. b
ix. c
x. d
Analytical Corner
Q
Q
P
Q
ii. Q
2
P
P
Caselet 1
The Toy World
to the price-sensitive segment of consumers.
have got distributors who cater to retail complexes, whereas local manufacturers have a huge base
of wholesalers and distributors and their products are sold in a bigger way rather than their branded
counterparts.
376
Managerial Economics
served by players from China and Italy. Imports from both countries expanded at a compound annual
with changing consumer pattern, as customers buying online are more careful about brands and
quality, though price is still the major deciding factor in most cases.
Sources:
http://www.world-of-toys.org/india/toy-market-india/
Indian-toy-market.i696,
http://www.toyindustryjournal.com/?p=334,
Case Questions
Caselet 2
Booming Business: Indian Hotel Industry
way of joint ventures.
since the tax component of this segment are lower compared with the premium segment. The Budget
In the face of stiff competition, hotels in India have come up with ingenious ways to attract
customers. These hotels distinguish themselves with beds, bathroom, amenities and complementary
Monopolistic Competition
377
or other lifestyle facilities. The ongoing revolution in cuisine has been accompanied by innovations
such as free standing, and niche restaurants.
Source:
, http://www.
,
Case Questions
2. Comment on differentiation offered by hotels in India.
The Jewel in the Crown
The gems and jewellery sector is highly fragmented with more than 500,000 players. The gold
percent of the total players are family owned businesses. Besides, India is world’s largest cutting and
credit to the diamond industry.
delighting customers with the pleasure of buying branded jewellery. Increasing penetration of organised
investment in single brand retail outlets, which is attracting both global and domestic players to this
stabilisation of gold prices at lower levels is expected to drive volume growth for jewellers over short
how, as can be seen by introduction of new techniques to attract and retain consumers. The branded
378
Managerial Economics
manufacturers have also introduced advertisement to promote their products besides multiple types of
promotional schemes. The interesting part is that all such promotional actions are easily replicable and
Sources:
https://www.ibef.org/industry/gems-jewellery-india.aspx,
,
Posers
David Fights Goliath: The Nirma Story
The story of Nirma is a classic example of the success of Indian entrepreneurship in the face of stiff
completely on home-grown research and development, clashed head on with the giant multinationals,
and wrote a new chapter in the Indian corporate history.
INDIAN SOAPS
AND
DETERGENTS INDUSTRY
The Indian soaps and detergents industry is characterised by the co-existence of a number of small scale
featured mainly the premium segment dominated by big players, and small players restricted to a smaller
purchasing power, increased awareness about personal hygiene, responsiveness to brands offering
superior value and penetration of media.
Emergence of David
in the form of bars to most Indians; detergent powder was considered a luxury meant for the upper
Monopolistic Competition
379
`
`
developed product formulae. It did not contain any ingredient to improve the whiteness of fabric and the
Product Differentiation
toilet soap brand in India.
priced segment, by positioning Wheel against Nirma, by setting a price of `
Product
introduction of the detergent powder. Its success was almost a foregone conclusion. With the launch of
another brand, Nirma.
Price
process and raw materials.
380
Managerial Economics
Immediately after its launch, the lower priced product became a rage with the middle-income
an impact on upper middle income and higher income families, which used Nirma for washing their
inexpensive garments and linen.
powder and showed that Surf washed more clothes than the low-priced yellow washing powder—and
hence, it was economical to buy Surf.
The conclusion is that Nirma gave a new connotation to differentiation by creating a similar product
Sources:
http://www.citeman.com/price-oriented-marketing-strategy http://www.superbrand sindia.com/images/
,
,
,
,
,
http://www.citeman.com/segmenting-and-targeting-the-market,
,
,
Posers
Oligopoly
381
Chapter
13
2. Understand the indeterminate demand curve for a firm under oligopoly and look
into the various models of price and output decisions under oligopoly.
3. Comprehend the nuances of collusive oligopoly, with detailed analysis of its
various forms, including cartels.
4. Identify with the practice of price leadership by an oligopolist.
Chapter Objectives
1. Examine the nature of an oligopoly market.
INTRODUCTION
We had played a mind game in previous chapter; let us do another similar exercise here. Under which
category of market would you put a petroleum company like Reliance India, or an airlines company like
Go Air, a cement manufacturer like ACC, or an iron and steel company like TISCO, or a motorcycles
manufacturer like Bajaj India, or a bank like SBI? Under perfect competition, monopoly, or monopolistic
competition? You guessed it right! Neither. They are the examples of oligopoly. Oligopoly is the most
interesting among all the market forms. It is one of the most realistic types of markets and yet it is the
The word oligopoly is derived from the Greek word “oligo” meaning few and “polo” meaning to
sell; it means a market with a few sellers. Oligopoly consists of characteristics of various other markets;
let us see how. Normally, there are a small number of sellers (or producers) in such a market; however
there can be many sellers (just like in monopolistic competition) as well, with a few very large sellers
dominating the market. The products sold in an oligopoly may be homogenous or identical (like in
perfect competition), or may be differentiated (like in monopolistic competition). Entry is not restricted
382
Managerial Economics
OLIGOPOLY
Oligopoly is a market where a few
dominant sellers sell differentiated or
homogenous products under continuous
consciousness of rivals’ actions.
There is one aspect which differentiates oligopoly from all other market
forms and that is the
: no player
can take a decision without considering the action (or reaction) of
rivals. This continuous consciousness of rivals’ actions (or reactions)
is the main characteristic of oligopoly and often results in cut throat
in price rigidity, i.e., a single price prevails in the market just like perfect competition, but the difference
be cases where there is a very large number of small players (thus, making the market monopolistic) but
only few large players dominate and govern the market forces (thus, creating an oligopoly like situation).
For example, in India the newspaper industry is a market in which there are more than 8,000 newspapers
in circulation, but the market is typically ruled by few very large players, who have indulged in price
wars more than once to get hold of the market and keep small players to operate at local or regional level.
In a nutshell, it can be said that
When there is product differentiation among the sellers, the market is called differentiated oligopoly
or
product differentiation and in case of identical products, the market is called pure
oligopoly or
Let us now look at the main characteristics of this market.
Features of Oligopoly
Few Sellers
The word ‘oligopoly’ itself implies a market dominated by a few sellers, although the term
is
ambiguous and does not specify any particular number of players. However, any market in which a
example of oligopoly, where one can count the number of players. In Indian automobile industry, major
players like Maruti Suzuki, Honda, Toyota and Ford are examples of oligopoly since one can count the
number of players in this market. Indian Oil, IPCL and Hindustan Petroleum are another set of example.
In the case of cars, each seller tries to differentiate its product by name, shape and other features, whereas
in the second case, the product (petrol or diesel) is identical and the buyer is indifferent among all the
players. Hence, the case of car manufacturers represents differentiated oligopoly and that of petroleum
refers to pure
In FMCG sector, Coke and Pepsi represent an extreme case of oligopoly where
there are only
players, this situation is known as
Product
The product under oligopoly may be differentiated (like cars, motorbikes, televisions, washing machines,
and soft drinks) or homogenous (like petrol, cement, steel and aluminium). Thus, it is not a simple case
Oligopoly
383
Entry Barriers
There are no legal barriers as such to enter the market under oligopoly. However, at the same time there
Huge Investment Requirements
You would understand that it is not easy to collect such huge
Hence, this creates a kind of natural barrier to entry and thus, restricts the number of players.
Strong Consumer Loyalty for Existing Brands
Unlike other market forms, customers in an
customers, many took long to accept the concept and continued to be loyal to the sturdier Premier or
Ambassador cars. The extent of such loyalty can be translated to the fact that many of such products
have become generic brands by virtue of being pioneers in their respective categories. Examples include
Xerox for photocopying, Godrej for steel almirah and Jeep for SUV.
Economies of Scale
The existence of an oligopoly market is substantially dependent upon the
adopting a low price strategy. This creates a strong deterrent to new entrants as they may not be able to
sustain at such a low price. HP printers can be cited as an example, as they are sold at such a low price
that other players have become almost extinct. Domination of few newspapers as national dailies has
also been possible due to this reason. You will learn more about this aspect in the chapter on pricing.
Interdependent Decision-Making
product which is either a perfect substitute (homogenous) or a very close substitute (differentiated). Is it
possible that Hyundai changes the price of Verna without fear of retaliation by Honda City? Can Coke
introduce a different design or size of bottle without anticipating a counter move by Pepsi?
This
Even a new advertisement would attract counter strike by rivals. The advertisement war between cola
suit. If Virat Kohli and Ranbir Kapoor promote Pepsi, Ranveer Singh is roped in to promote Thums Up
extended to such heights that now people are talking of brand confusion. Same is the story with punch
Live your Style
Me Hai Hero’.
The price war between newspapers,
and
is also not a distant history,
and even
could not remain aloof of the media price war syndrome. When the national leader
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Managerial Economics
became pink, Financial Express too had to adopt the
same colour. To counter the onslaught of new and high tech models by multinational companies, Maruti,
which was established to produce a common man’s car, too had to introduce multiple versions of its car
in various segments, thereby creating rivals in house. At present, airlines are going through a phase of
tacit price war where a combination of pricing strategies is used including creation of a perception of
The reason for this interdependence is the nature of the product and the low cost of switching over to
perception.
changing waves of competition proved them so costly that they have become matter of history. Titan
swept the market by introducing style and fashion in watch making and the erstwhile leader HMT lost
its glory. In the Indian audio industry, Gramophone Company of India (GCI), with its HMV label,
dominated the market till the seventies. During seventies, the industry
A firm under oligopoly can ignore its rivals’
moves only at its own peril.
players such as Super Cassettes (from the T-Series stable), Venus,
Time and Weston.
peril. This interdependence brings out some other important dimensions to oligopoly market, like
non-price competition and an indeterminate demand curve; both these concepts have been dealt with in
eality
B ites
Newspapers up in Arms
According to media planners, the market of Delhi-NCR is extremely competitive, with two newspaper
dailies running neck-in-neck. This has resulted in several incidences of price war between the two major
contestants. Results of the contentious Indian Readership Survey (IRS) 2014 have announced that HT
Media Group’s English daily Hindustan Times (HT ) has remained the numero uno newspaper for the
fourteenth time in a row in Delhi-NCR, while it has further strengthened its position as the second most
popular daily in Mumbai. HT has more than 23 lakh daily readers in Delhi-NCR, extending the lead over
its nearest competitor, Times of India (TOI), to nearly 6.5 lakh. However, TOI has come up as the most
read English daily newspaper in the country, while HT, with around 4.5 million readership is the second
most circulated English newspaper across the country, followed by The Hindu at 1.6 million.
The battle between the two behemoths seems to be heated up subsequent to the launch of Delhi
edition of Zee Media’s DNA. Reports of October 2016 state that DNA will cost `10 (32 pages), almost
double of Hindustan Times (offering 46 pages at `5) and Times of India (34 pages at `4.50).
Sources: http://bestmediainfo.com/2015/03/irs-2014-ht-remains-top-english-daily-in-delhi-ncr/ accessed on
18/08/2017.
http://trak.in/tags/business/2015/03/30/top-publication-english-dailies-2015, accessed on 18/08/2017.
https://www.newslaundry.com/shorts/dna-is-out-with-its-new-edition-in-delhi-and-the-express-group-has-a-new-website, accessed on 18/08/2017.
Oligopoly
385
Non-Price Competition
enough, each of them avoids the incidence of a price war. What is a price war? Let us explain this concept
A and B, both are selling a homogenous product. Assume that at a point of time the prevailing price is
P1,
A, in an attempt to lure customers, lowers the price as shown by arrow below the price line.
A
B fears loss of its customers and retorts by lowering the price below that of
A. Firm A further reduces the price and this process continues, as shown by arrows on both sides of the
P2.
either of them and decide to end the war. With this, the price stabilises at P2.
D1
Price
P1
Price
D
P2
A
B
D
D1
O
Market Share of A
Fig. 13.1
Quantity
Market Share of B
Price War in Oligopoly
Fig. 13.2
Demand Curve of an Oligopolist
not
branding, and offering better service
packages. In fact, sometimes the government has to intervene to stop the price war in order to maintain
competition in the market because there is always an apprehension that the price war has been begun to
remove weak competitors.
The extreme case of non price competition is the formation of cartels or collusive oligopoly, where
Oil and Petroleum Exporting
Countries (OPEC) is an international cartel, in which all the suppliers of crude oil have openly declared
to charge a single price for the product all over the world. Firms may also tacitly agree to sell their
products in separate markets and/or at the same price, like in the case of soft drinks and cellular phone
services. The concepts of cartels and collusive and non-collusive oligopoly have been discussed in detail
Indeterminate Demand Curve
Once you have understood the incidence of non-price competition, it would be easy for you to comprehend
of competition.
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Managerial Economics
eality
B ites
Differentiation in Air
With the entry of a new competitor in the premium air services space, Vistara, a joint venture between
Tata Sons and Singapore Airlines, the war between Indian full-service airlines is being fought through
Flying Returns by
Air India, Jet Privilege by Jet Airways and Club Vistara by Vistara. Flying Returns by the state-owned Air
India brings the advantage of being a Star Alliance Partner. Jet Privilege has the advantages of multiple
Club Vistara has changed the rules of the game as far as the structure of rewards programmes is con-
and has introduced an online account which would help in marginally reduced costs.
Jet Airways has retaliated by introducing a new scheme whereby customers can upgrade to a higher
tier of the loyalty programme based on the value of ticket as well as the distance and frequency of travel.
Earlier accumulation of points was only linked to the miles travelled, irrespective of ticket price. Jet has
also doubled and tripled the number of miles its passengers earn on routes on which Vistara operates.
Needless to say in this new kind of war of differentiation, passengers shall gain immensely.
Sources: http://indianexpress.com/article/business/companies/full-service-airlines-go-full-tilt-at-loyalty-programmes/
accessed on 18/08/2017.
accessed on 18/08/2017.
https://www.jetprivilege.com/rewards-program, accessed on 18/08/2017.
In the previous sections, you have seen that an oligopolist’s demand is affected not only by its own
Price and output determination is a very
complex phenomenon in oligopoly, as each
firm faces two demand curves.
demand curves, this makes
price and output determination a very complex phenomenon. One of
these two demand curves is highly elastic and the other one is less
Oligopoly
387
the effect of a fall in price could not result in a proportionate increase in sales due to counter price
A increases
not react by a similar increase, in fact, they may either not increase the price at all, or increase it less than
A. Thus, because of
A’s product will become more expensive and
face a highly elastic curve.
DD) and the
other which is less elastic (D1D1), as shown in Figure 13.2.
DUOPOLY
Duopoly is a special case of oligopoly, with only two players in the
market. This may happen due to various reasons; it is possible that
Duopoly is a special case of oligopoly, with
only two players in the market.
two large players are competing neck to neck and have, thus, created a duopoly like situation. Pepsi and
establishment of Maruti Udyog Ltd. (MUL), the Indian auto industry too was a duopoly with Premier
and Hindustan Motors as the only two players. In Delhi,
and
have
created a duopoly like situation due to their dominance among newspaper readers. Before privatisation
All the characteristics of duopoly are same as those of oligopoly. In fact there is no difference between
duopoly and oligopoly, but for the number of players. It can be said that duopoly is that type of oligopoly
in which only two players operate (or dominate) in the market. The concept of duopoly has been used by
PRICE
AND
OUTPUT DECISIONS
resulting in price rigidity are some of the reasons which pose a major constraint in developing a model
by French economist Cournot, followed thereafter by various other models. Although these models refer
to the oligopoly situation but for sake of simplicity they have been developed around the assumption of
n
pricing. In the following sections, we shall discuss some important models including those by Cournot,
Stackleberg and Sweezy; we shall also talk about cartels, price leadership and
388
Managerial Economics
Cournot’s Model
context, may appear very simplistic, but it sets a precursor to more advanced models on oligopoly.
Assumptions of Cournot’s Model
(iii) Market demand is linear; hence the demand curve is a downward sloping straight line.
will continue to produce and sell the same amount of output in next period).
DD* and MRA is its marginal revenue curve. To maximise
A
produce OQA output and charge OPA price which is governed
A
Price, Revenue, Cost
Cournot’s model can be understood from Figure 13.3.
Firm A
D
A
PA
B
PB
O
D*
Q
Q
Quantity
A
B
OD*). Note further that point A is the mid point of DD*
MRB
MRA
curve.
Firm B
Fig. 13.3 Cournot’s Model
A is supplying to one half of the total market. It assumes that
A will continue to produce OQA and hence, decides to consider QAD* as the market available to it and
AD* as its demand curve. Thus, its MR curve will be MRB. Now B
QB
B will produce QAQB output and sell at price OPB. As an outcome of this process, A
supplies to half of the total market and B supplies to half of the remaining half. In other words, A and B
together supply to three-fourth of the total market, while one-fourth remains unattended.
Firm A
B’s entry by assuming that B will continue to serve one fourth of the market
A will supply to
Ê 1 3 3ˆ
one-half of three- fourth Á ◊
of the total market. In this period, B will assume that A will continue
Ë 2 4 8 ˜¯
Oligopoly
389
3
to supply to three-eighth of total market, and hence will take the remaining market, i.e., ÊÁ1 - ˆ˜ as its
Ë 8¯
È1 Ê
3ˆ ˘
5
of the total market demand.
domain. B will no produce Í Á1 - ˜ ˙
8 ¯ ˚ 16
Î2 Ë
A will continue
B
A and B, as follows:
Period 1:
Firm A
1
2
1
2
Firm B
1 Ê 1ˆ
Á ˜
2 Ë 2¯
1
4
Firm A
1 Ê 1ˆ
Á1 - ˜¯
4
2 Ë
3
8
Firm B
1 Ê 3ˆ
Á1 - ˜
2 Ë 8¯
5
16
Firm A
5ˆ
1 Ê
ÁË1 - ˜¯
16
2
11
32
Firm B
1 Ê 11 ˆ
Á1 - ˜
2 Ë 32 ¯
21
64
21ˆ
1 Ê
ÁË1 - ˜¯
64
2
43
128
43 ˆ
1 Ê
ÁË1 ˜
128 ¯
2
85
256
Period 2
Period 3
Period 4:
Firm A
Firm B
………
Period N:
Firm A
Firm B
1
2
1
2
Ê 1ˆ
ÁË1 - ˜¯
3
1
3
Ê 1ˆ
ÁË1 - ˜¯
3
1
3
Ê
Thus, it is clear that A’s output is declining progressively Á
Ë
increasing at a declining rate.
1ˆ
˜ , whereas B’s output is
4¯
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Managerial Economics
1
1
– 8
2 1- 1
4
A
1
4
B
1
4
3
4
1
14
1
1 8
2 3
4
1
3
8
24
1
3
Equilibrium output: 2 firms:
n
1
1
1
A = ; B = n firms: Â
n
3
3
+
1
i =1
Ê 1ˆ
ÁË ˜¯
3
1
portion of the total output,
n +1
Cournot’s model can be applied to n
and in this case the industry output will be
n
n
n +1
1
 n +1.
Let us now explain Cournot’s model with a numerical illustration.
Suppose the demand function of an industry is P
X
and B
A has a constant cost function CA
increasing cost function CB
X 2B.
A
B has an
XA
Solution:
A and B, therefore, it can be said that industry
demand function is P
XA + XB).
Firm A
PXA – 5 XA
XA + XB)]XA – 5XA
XA – 0.5XA2 – 0.5XAXB – 5XA
XA – 0.5XA2 – 0.5XAXB
XA – 0.5 XB
or
XA
XB
XA
XB
Hence:
Thus:
A)
B)
XB
XB)
XB
XB
XB
XA
P
Oligopoly
391
Stackelberg’s Model
German Economist H.V. Stackelberg developed his model, popularly
known as the Leader Follower Model, as an extension of the model of
In Stackelberg’s model, the sophisticated
firm determines the reaction curve of the
rival and incorporates it in its own profit
function.
reaction curve of
the rival, and is also able to incorporate it in its
own
Point E
Output of Firm B
like the one in Cournot’s model. Figure 13.4
illustrates the reaction functions of oligopoly
RA
b
X¢B
RR
Firm A’s reaction
function
E
Firm B’s reaction
function
selling at the same price. As per Stackelberg’s
A is the
a
operate within the area RAERA and will try to
XB
RR
RA
produce that output at which it can maximise
O
X¢A
XA Output of Firm A
a
A
will produce OXA and B will be contended with
Fig. 13.4 Reaction Functions of Duopoly
OXB
B will act as a follower
and accept the leadership of A
B is the sophisticated
RBERB
b, producing OXB. In this case,
A will act as the follower and accept B’s leadership, will produce only OXA
sophisticated? In that case, there will be a price war like situation and will either result in a cartel or in
RARA
E
A and RBRB
A is producing XA
B.
B is producing XB
is able to assess the other’s output correctly, and this is achieved after a series of changes in output by
392
Managerial Economics
Let us now explain this model with a numerical illustration.
A and B is P
Q. Assume that the
Find
the
reaction
curves of the two
B
A
Solution:
A and B, the industry demand function is P
– (QA + QB), where QA is the output of A and QB is the output of B.
Total revenue of A is TRA P.QA
Q)QA
QA + QB))QA
QA – Q A2 – QAQB
∂TR A
QA – QB.
Marginal revenue of A is MRA
∂Q A
MCA
A
A
Thus, 200 – 2QA – QB
A.
1
QB.
2
QA
Firm A
B. Similarly, Firm B
A
Firm A’s output reaction curve:
QA
1
QB.
2
Firm B’s output reaction curve:
QB
1
QA.
2
A, insert the level of output produced by B in
A’s output reaction curve. Do the reverse in case of level of output produced by B. Thus,
1
QB
2
Similarly, from B’s output reaction curve we get B
QA
Q
P
The
curve
two assumptions:
was done by
1
2
1 ˆ
Ê
ÁË 60 - QA ˜¯ fi QA
2
QB
QA + QB
Q
Oligopoly
393
eality
B ites
‘Nickel’ Coke
than 70 years. The case of Coca Cola is particularly interesting because during the 70-year period there
were major events like the two World Wars and the Great Depression, along with substantial changes
in the structure of the soft drink market, as well as numerous regulatory interventions, which led to
substantial changes in the demand and supply conditions. Yet the company insisted that the price
accompanied by equally long lasting Coca Cola quality rigidity.
Numbers: E12, E31; Last Revision: 11/08/2002.
Thus, an oligopolist faces an indeterminate curve, as you have seen in earlier sections. Taking this to
be the most distinct characteristic of oligopoly, Sweezy developed a model which is still considered to
and resort to non-price competition strategies like advertisement and sales promotion, and product
differentiation. Thus, the oligopoly price remains rigid at the same level. This is further explained by the
reduced its price does not get the expected advantage of price reduction and thus, faces a highly elastic
demand curve. A price reduction will give
The demand curve is more elastic above the
initially, but due to similar reaction by rivals, this increase in demand kink and less elastic below the kink.
will not be sustained. Consider now the case of increase in price by
D1
Hence, at current
price a kink is developed in the demand curve.
Have a close look at the demand curve of
at point K. The curve is more elastic above
the kink (current price) and less elastic
the kink. OP is the current price at which the
oligopolist can sell OQ output. D1K shows the
highly elastic portion of the demand curve due
to no reaction by rivals in the event of increase
in price; KD2 shows the less elastic portion,
This discontinuity in the demand curve (AR)
Price, Revenue, Cost
customers to rivals due to substitution effect.
MC1
K
P
MC2
A
S
T
O
B
D2
Q
Quantity
MR
Fig. 13.5
Kinked Demand Curve
394
Managerial Economics
between point A and B. Hence, the producer will produce the same amount of output (OQ), whether it is
S as well
operating on MC1 or MC2
as T
A and B
its price. It will change its output and price only if MC moves above A or below B.
characteristics of this market, such as price rigidity, indeterminate demand curve, non-price competition
is price determined. Sweezy’s explanation is also criticised on the ground that he fails to explain the
Let us wrap up the concept of a kinked demand curve with the following illustration.
Smooth Wheels Pvt. Ltd. belongs to the oligopolistic market for automobiles. The demand
functions for price increases and price decreases for the company are given respectively as: Q1
1 2
P1 and Q2
P2
Q + Q + 50. Derive
4
the MR1, MR2
What are the upper and lower limits of the MR curve? Prove that MC falls in the MR gap.
1
From the demand functions we get, P1
Q1, P2
Q2.
4
1
1
TR1
Q1 – Q 12 fi MR1
Q1.
4
2
1
Q2 – Q 22 fi MR2
Q2
Q.
TR2
2
Oligopoly
395
At the kink the two demand curves would intersect. To get this point of intersection, we
consider Q Q1 Q2 at the kink.
1
Q
4
QfiQ
The upper and lower limits of MR are: MR1
Q
1
Q
4
P
1
◊
2
2
1
◊
2
COLLUSIVE OLIGOPOLY
“People of the same trade seldom meet together, even for merriment and diversion, but the conversation
ends in a conspiracy against the public, or in some contrivance to raise prices.”
Adam Smith
An important characteristic of oligopoly is collusion, in which rival
such as price, market share, etc. Firms may either openly declare
their decision of collusion, or may collude tacitly. Basic oligopoly
When a number of producers (or sellers)
enter into a formal agreement, it is an
explicit collusion.
all. Give it a thought, it does make sense that companies come together in order to get better control over
market. We have explained the process of tacit collusion further with the help of game theory in Chapter
14. When a number of producers (or sellers) enter into such an agreement formally, it is called collusion;
on the other hand, collusion which is not overt is known as tacit collusion. The most commonly found
form of explicit collusion is known as cartels. The aim of such collusion is to reduce competition and
creates monoply like situation and make various laws to identify and break up cartels. This has lead to
Cartel
A cartel
A cartel is a formal (explicit) agreement
occur where there are a small number of sellers and the product is among firms on price and output.
usually homogenous. Thus, an oligopoly market provides a great
opportunity for such collusion. Formation of cartel normally involves agreement on
total industry output, market share, allocation of customers, allocation of territories, establishment
cartelisation is a hike in price and a reduction in supply.
Cartels can be of two types: centralised cartels and market sharing cartels. Let us give you a brief idea
of each of these types now.
396
Managerial Economics
Centralised Cartel
A centralised cartel is one in which cartelisation is perfect. It is an
arrangement by all the members, with the objective of maximising
. In such type of arrangement, the product is essentially
homogeneous and a centralised body decides on the pricing of the
product. The working of a centralised cartel can be understood from Figure 13.6, which assumes that
A and B operate in the market. Firm A’s marginal cost curve is MCA
B’s marginal
cost curve is MCB.
price determination, the sum of their marginal cost (SMC) will be the industry marginal cost; the cartel
will face one demand curve (AR) and its corresponding marginal revenue curve (MR). OQ
SMC.
Price is determined by demand curve, hence OP
MC
SMC
A centralised cartel is an arrangement by
all the members, where a centralised body
decides on the pricing.
MCA
OQA is
the output of A and OQB
B. As you can see
from Figure 13.6, the total output OQ
sum of individual outputs OQA and OQB, where OQA
is greater than OQB
A is more
B and hence, is able to sell more
than B. You should understand that the same logic can
in the industry. In a centralised cartel, price will be
determined by association, on the basis of summation
Price, Cost, Revenue
B
P
MR
O
Q
Q
Q
AR = D
Quantity
Fig. 13.6 Price and Output Determination
in Centralised Cartel
thus, just a price taker. You would now surely understand and agree with the statement we had made in
the beginning of this chapter, that oligopoly is a combination of a perfectly competitive market and a
price and thus,
other members.
Market Sharing Cartel
A market sharing cartel is an arrangement
by all the members to divide the market
share among them and fix the price
independently.
market segment.
It is that form of collusion in which members decide to divide the
because they are producing a homogenous product. They agree
to sell the product in the allotted market segment and to not enter
in its respective
Oligopoly
397
A and B have agreed to
Price, Cost, Revenue
understand the price and output determination of the
A and
A and ARA
B). You can see that
MRB and ARB
A is able to sell
B
PA
PB
(since OQA > OQB).
ARA
MRA
MRB
O
total output (OQ) is the sum of OQA and OQB. You
must be wondering as to how much of OQ will be
A. You should understand that this
will depend upon the terms of agreement. The two
AC
MC
QB Q A
ARB
Output
Fig. 13.7 Price and Output Determination in
Market Sharing Cartel
A being larger, it may insist upon supplying two-third of the total market,
leaving one-third for B. Firm B being smaller, it may agree to this condition.
very unstable.
Let us further explain the working of a cartel with the following numerical illustration.
A and B selling PDAs in India decide to form a cartel. The manager
of the newly formed cartel estimates the demand function for PDAs as P
Q. The total
2
2
cost functions of A and B are TCA
QA + Q A and TCB
QB + Q B
Solution:
P.Q
MCA
In order to add MCA and MCB
QA
Solving for
Setting
For
For
S MC we get S
S
Q
Q
Q
QA and MCB
Q – 5Q2
Q.
B.
SMC, we solve for QA and QB. Thus,
1
1
MCA, QB
MCB.
2
2
Q + 3.
Q
QfiQ
P
Q
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Managerial Economics
Setting MCA and MCB
Thus
4 + 2QA
Q
fi QA
QA + Q B
QB
fi QB
You have seen from the above discussion that in either type of cartel sustainability is uncertain. Thus,
it is important to unerstand as to what determines the life of a cartel. The members of a cartel always
sustain in the long run. Empirical studies have shown that the mean duration of cartels is from 5 to 8
. Whether the members
of a cartel will choose to cheat on the agreement will depend on short-term returns from cheating and
long-term losses from the possible breakdown of the cartel.
The most prominent and world’s largest cartel, OPEC, which is based on agreement on common pricing
the agreement during tough times.
Among the many factors, it is primarily the ability of cartel members to coordinate on various aspects
coordination (for example on a common price) is much harder. Establishment and enforcement of cartels
an explicit collusion. Therefore, it is important to understand the following factors which determine the
formation and sustainability of cartels:
1. Number of Firms in the Industry
for the members of the cartel to monitor the behaviour of other members.
2. Nature of Product Cartels are generally formed in markets with homogenous goods rather than
differentiated goods, because it is easy to arrive at common price in case the goods are homogenous. But
by cheating, i.e., by lowering the price.
Oligopoly
399
3. Cost Structure
different cost structures, then each will have a different maximising behaviour and therefore, will have
4. Characteristics of Sales
You have seen that short-term gains from cheating (relative to long-
undercut the price in order to gain greater market share.
In most countries, cartels have been declared illegal and several laws have been made to prohibit
antitrust laws declare cartels as illegal. Japan and South Korea also take stringent measures to restrain
companies from collusion. In India, Monopolies and Restrictive Trade Practices (MRTP) Commission
is entrusted with the task of keeping an eye on any form of collusion that may distort market forces.
eality
B ites
It is Costly to go for Cartelisation
sellers, distributors, traders or service providers who, by agreement amongst themselves, limit, control
or attempt to control the production, distribution, sale or price of, or, trade in goods or provision of
services”. If the Competition Commission of India is convinced that there exists a prima facie case
of cartel, it is empowered to direct the Director General of the Commission to cause an investigation
therein and furnish a report.
cement manufacturers during 2001–02, the industry has been generally considered as an oligopolistic
market. However the Cement Manufacturers Association (CMA) was continued to be watched for
any collusive activities. In 2012, the Director General of Competition Commission of India inter alia
members of the CMA. The Commission also established that in addition to similarity in pricing, there
was capacity under-utilisation and production and dispatch parallelism amongst them. Consequently,
the Commission concluded that market forces alone did not determine price and that price rise was not
`6,300 crore on cement manufacturers
liable for collusive price setting.
Sources: http://www.competition-commission-india.nic.in/advocacy/CARTELS.PDF, accessed on 18/08/2017.
http://www.indialawjournal.org/archives/volume6/issue-2/article4.html, accessed on 18/08/2017.
https://www.lexology.com/library/detail.aspx?g=3a5a4a8a-ce0d-42c4-9b88-d1e317aa5841, accessed on
18/08/2017.
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Informal and Tacit Collusion
In a tacit or implicit collusion firms do not
declare a cartel, but informally agree to
charge the same price and compete on
non-price aspects.
Collusion normally results in higher price and lower output and
provides sellers an advantage similar to that of monopoly. Therefore,
governments make efforts to ensure that companies do not collide
will automatically come under scrutiny, therefore, they do not
compete on advertising and image, it is a
oligopoly to enter into an agreement with all rivals to charge the same price and to compete on the basis
agreement invloves division of the market among the players in such a way that they may charge a price
skilled human resource. Many companies enter into “no poaching” agreement, whereby each agrees
not to attract others’ workforce by offering better salaries or higher position.
PRICE LEADERSHIP
going rate or the price
charged by the largest or the most sophisticated player. Such kind of price determination is known as
price leadership. What is this going rate? It is the price which prevails in the market and existing players
Dominant Firm
A dominant firm is a leader in terms of
market share, or presence in all segments,
or just being the pioneer in the particular
product category.
one may be the largest player. There can be numerous such examples,
Google among search engines, Intel in the micro chips market, and
Maruti in cars and Godrej in steel furniture. The highlight of this
What can be the basis of such dominance? Let us explore.
Oligopoly
401
just being the pioneer in the particular product category. Normally, the leader is very large in size and
earns economies of scale; it produces optimum output at which it is able to maximise returns. This
A benevolent leader
higher cost of production may also survive. There are two major
A benevolent leader allows other firms to
exist by fixing a price at which small firms
may also sell.
leadership. However, there is one limitation of this aspect and that is, the success of this type of
leadership exists on the assumption that others will follow the leader. However, there may be a possibilty
that another rival takes advantage of the benevolence of the leader and
An exploitative leader fixes a price at which
charges a lower price. This will pose a challenge to the dominant
exploitative
not survive and thus, it gains large share of the market.
small inefficient players may not survive
and thus, it gains large share of the market.
Barometric Firm
Some markets may be such that no single player is so large to emerge
A barometric firm has better industry
intelligence and can preempt and interpret
its external environment in an effective
manner.
better industry intelligence and can preempt and interpret its external
environment in an effective manner. For example, if the Indian Rupee
is appreciating against U.S. Dollar, how will it affect the market of a particular good, say television? A
on the demand for the product or on the general price index. If the appreciation of Rupee is likely to
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Managerial Economics
RECENT GLOBAL TRENDS
livestock. Although collusion is termed illegal in different countries including the U.S., Canada and EU,
implicit collusion after many years like it happened in case of Indian cement industry which was blamed
ing markets among them.
- Major League Baseball that operates North American professional baseball’s two major leagues,
been amended several times, the most recent being in July 2005.
an agreement on market division and output determination.
- The Organisation of the Petroleum Exporting Countries (OPEC) is the largest international cartel
aimed at safeguarding the interests of members by price stabilisation and regulating market
Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela.
like the Gulf of Mexico and North Sea, the opening of the USSR and market modernisation. OPEC
2005, allowing them considerable control over the global market.
SUMMARY
Oligopoly is a market with a few sellers, it consists of characteristics of various other markets. Its
features include few sellers, differentiated or homogenous product, interdependent decision-making
rivals’ actions (or reactions) is the kingpin of this market.
When there is product differentiation among the sellers, the market is a differentiated oligopoly
or oligopoly with product differentiation and in case of identical products, the market is called a
pure oligopoly or oligopoly without product differentiation.
Duopoly is a special case of oligopoly, in which only two players operate (or dominate) in the
market. All the characteristics of duopoly are same as those of oligopoly.
Oligopoly
403
of price war resulting in price rigidity are some of the reasons which pose a major constraint in
developing a model to explain oligopoly.
Ê 1ˆ
ÁË ˜¯ and at the same price.
3
stick to the current price. Thus, the oligopoly price remains rigid.
elasticity.
price, market share, etc. Collusion may be open or tacit. The most commonly found form of
explicit collusion is known as a cartel.
A centralised cartel is an arrangement by all the members, with the objective of determining a
pioneer in the particular product category. A leader can be benevolent or exploitative.
environment in an effective manner.
In spite of serious legal restrictions, collusions are not uncommon globally.
KEY CONCEPTS
Oligopoly
Price rigidity
Kinked demand curve
Cartel
Duopoly
Interdependence
Collusion
Price leadership
QUESTIONS
Objective Type
I. State True or False
i. The objective of cheating in cartels is to earn short-term gains.
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Managerial Economics
iv. The reason for interdependence among oligopolists is high cost of switching over to other
vi. Supply of the product increases when a cartel is formed.
function.
ix. The demand curve in oligopoly is less elastic above the kink and more elastic below the kink.
II. Fill in the Blanks
ii. Cartels are a form of ________collusion.
v. In a centralised cartel, price is determined by ______.
ix. A
x. Firms in Cournot’s model ignore ________ as a basic feature of oligopoly.
III. Pick the Correct Option
i. All the following EXCEPT one pose a constraint in developing a model to explain oligopoly:
c. Formation of cartel
ii. Sweezy’s model fails to explain:
d. Fear of price war
b. Indeterminate demand curve and price rigidity.
c. Non-price competition.
d. Interdependent decision-making.
iii. Find out the only incorrect statement about cartels from the following:
b. Cartels are generally formed in markets with differentiated goods.
c. Similar cost structures make it easier to coordinate.
d. Short-term gains encourage members to indulge into cheating.
iv. The portion above the kink on the demand curve of an oligopolist is:
a. Less elastic
b. More elastic
Oligopoly
405
EXCEPT:
a. Market share
b. Presence in all segments
c. Indeterminate demand curve
d. Pioneer in the particular product category
vi. Celebrity brand endorsement in an oligopolistic market is an example of:
b. Indifference of buyers among products available
c. Indeterminate demand curve
X and Y, we have:
a. Share of both X and Y declining
b. Share of both X and Y increasing
c. Share of X (or Y) increasing and share of Y (or X) declining
d. Share of X (or Y) remaining constant and share of Y (or X) increasing
viii. The extreme case of non-price competition in an oligopoly is:
a. Formation of duopoly
b. Formation of cartels
c. Interdependent decision-making
d. Attaining of economies of scale
ix. A collusion is tacit when:
b. Firms engage in price war
c. Firms do not document their agreement to collude
a. One would act as the follower of the other
b. Firms would engage in a price war
Analytical Corner
conclusions:
c. Exploitative leader
d. Cartels
3. To what extent does the kinked demand curve help in explaining price rigidity under oligopoly?
4. Compare the characteristics of an oligopoly with those of a perfect competition, monopoly and
monopolistic competition.
6. There are two fast food outlets in the city of Bhopal. Experience tells that they have tried to engage
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Managerial Economics
not illegal?
8. What is the role of non-price strategies like advertising in oligopoly? Why are they important?
10. You have read about a multi-plant monopolist and a cartel that acts like a monopoly. Assume that a
your answer.
curve P
Q, where P is the price and Q is the total output in the market. Also assume that
Find the reaction curves of the two
A
B
demand function for the product is 2P
Q, where P is the price in hundreds of Rupees and
Q is the output in thousands. The total cost functions of the members are TC1
Q1 + 2Q 12 and
2
TC2
Q2 + 2Q 2
and has a linear demand curve P
Q, where P is the price in Rupees hundred and Q is the
with MCA
B
of output.
14. The market for steel in India is considered to be oligopolistic. Hard Core Pvt. Ltd., a major
producer of steel faces a kinked demand curve. The demand functions for price increases and
price decreases for the company are given respectively as, P1
Q1 and P2
Q2. The
Q2 – 2Q + 550.
i.
ii.
iii.
iv.
Derive the MR1, MR2
Determine the price and output at the kink.
What are the upper and lower limits of the MR curve?
Prove that MC falls in the MR gap.
Check Your Answers
State True or False
i. T
ii. T
iii. T
iv. F
v. F
vi. F
vii. T
viii. T
ix. F
x. F
Fill in the Blanks
i. sophisticated
vi. exploitative
ii. explicit
vii. elasticity
iii. two-third
viii. monopolist
iv. consumers
ix. pure
v. association
x. interdependence
Oligopoly
407
Pick the Correct Option
i. c
ii. a
iii. b
iv. b
v. c
vi. d
vii. c
viii. b
ix. c
x. b
Analytical Corner
1
QB
2
A: QA
12. Q
P
Q1, MR2
1
QA, Q
2
P
Q2
Q1
1
QB
2
A: QA
14. (i) MR1
B: QB
Q2
B: QB
Q – 2. (ii) Q
1
QA, Q
2
P
P
Caselet
Battle in the Domestic Skies
This comes close to the airline announcing a steep fare cut from 1 May 2011. Its lowest fare for the
summer season is 15 percent less than what the low cost carriers are charging.
Passenger Loading Factor (PLF). Between April 2010 and February 2011, the international PLF
Source:
Case Questions
1. Do you see the beginning of a price war in domestic air travel? If yes, who will be the ultimate
gainer?
2. Could Air India think of some non-price aspects to improve its market share? Discuss.
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Managerial Economics
Jio: The New Samurai in Telecom Battle
RIL chairman Mukesh Ambani’s new venture Reliance Jio launched its tariff plans on 1 September
2016. It offered free voice and data services for its users till 31 December 2016, in order to capture the
market. Immediately Bharti Airtel `12,000 crore in market capitalisation eroded and Idea Cellular Ltd.,
lost its market value by `2800 crore.
Reliance Jio new venture of conglomerate Reliance Industries Limited has recently appealed to TRAI on
group’s Idea Cellular and UK based Vodafone’s Indian subsidiary – for using unfair means to retain
customers using number portability to exit their networks and join services of Jio.
Lot of analyst now believes that Reliance Jio’s entry with such kind of offers of free voice calls,
roaming and probably world’s cheapest data plans will kick start the telecom industry consolidation and
will push smaller mobile service providers such as Aircel, Telenor India, Tata teleservices and Reliance
Communication towards exiting the industry. Bharti Airtel, the country’s largest mobile operator, along
with Vodafone and Idea reacted in September itself, by launching unlimited voice plans bundled with
it only to `
`50 per GB, which Jio had also
promised on its launch. Airtel had also introduced free-voice plans on some of its existing premium
plans by then. Even state-owned BSNL announced a counter-attack by offering free-voice calling
Jio’s plans is only available to 4G users.
Days after Jio extended its offer, Airtel came out with two prepaid offerings, including a `145 pack
with free unlimited Airtel-to-Airtel local/STD calls along with 300 MB 4G data, and a `345 pack that
offers unlimited free local/STD calls to any network in India and 1GB of 4G data. Both packs were
complimentary data and voice from April for three months, against a month’s recharge of minimum
`
`
`
allegations. Bharti Airtel moved fair trade regulator CCI (Competition Commission of India) with the
has been alleged to bind a customer to free voice calls and minimise competition from smaller players
in the telecom market, to gain a higher market share. Airtel also alleged that Reliance Jio is abusing its
dominant position. Jio has, in turn, accused Airtel for misleading consumers through advertisements
The Advertising Council of India has ruled against Airtel, and asked it to modify or withdraw the
Oligopoly
409
advised Jio to withdraw its summer surprise offer and the company has agreed to comply, while assuring
that all customers who have already subscribed to the offer prior to its discontinuation shall “remain
eligible for the offer”.
Another change shaping up is the proposed merger of Vodafone India and the Kumar Mangalam
Birla-owned Idea-Cellular. This merger would not only create the country’s biggest phone company in
terms of number of subscribers, dislodging the 15-year long leadership stint of Bharti Airtel, but will
also be the second worldwide, after China Mobile.
Sources:
,
Posers
1. When companies enter into price war, consumer is the ultimate gainer. Discuss in light of telecom
industry price war.
2. Explain Stackelberg model using the information given in this case.
3. Do you think regulatory authorities should intervene in the matter of market? Why? Why not?
Duopoly in Air
There have been few rivalries in business as spectacular as that between Boeing and Airbus. This
rivalry not only puts bottom lines and stakeholder returns at stake, but also national pride and supremacy
of the skies. These two corporations have been battling it out for more than four decades.
A350 plane and has also enjoyed several years of extended sales of its venerable A330, a medium-sized
long-haul jet with a great reputation for reliability and a modest sales tag. This has allowed Airbus to
move ahead of its rival last year in the wide-body market where Boeing has been a leader since long,
upgrade. Overall Airbus outsold Boeing (1,503 versus 1,355), but Boeing is still ahead in the number of
planes delivered, which is the result of several good years of sales. The remarkable thing is that between
list prices.
Both companies are currently aiming to change existing models to prolong their life and deliver better
fuel consumption that airlines desire. Airbus in particular has a huge challenge to cling on to its narrow
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Managerial Economics
Meanwhile, both the companies are anticipating the much-hyped about challenge of new entrants to the
big-jet market from Brazil, Canada, China and Russia. Three new competitors, Canada’s Bombardier,
China’s Comac and Russia’s United Aircraft Corporation (UAC), are preparing to enter in the critical
battle for single-aisle jets seating more than 100 passengers.
European and US manufacturers are notching up large orders for planned new versions of their
Comac and UAC out of the market during this decade. The immediate threat to Airbus and Boeing is
further reduced because some of the new aircraft makers are not focused, at least initially, on their main
market. Japan’s Mitsubishi Aircraft Corporation is developing a narrow-body aircraft, but it would
widespread support. So far, Bombardier has orders for 138 C Series aircraft, which will have between
by which time they will be edging towards brand new narrow-body aircrafts, enabling another major
Sources:
,
,
,
Posers
1. Can the duopoly of Boeing and Airbus be called a technological cartel?
2. Why have potential entrants not been able to pose a real threat to this duopoly?
Choice Under Uncertainty and Game Theory
411
Chapter
14
2. Explain the relevance of game theory in economic theory.
3. Discuss dominated and dominant strategies.
4. Determine Nash equilibrium, minmax and maxmin strategies.
5. Illustrate the application of game theory concepts in models of economics.
Chapter Objectives
1. Understand the intricacies of risk and uncertainty in economic decision-making.
INTRODUCTION
There is one thing that everyone has done at some point of time in life, i.e., play games. As children you
played Paper, Scissors and Rock, and then you played ball games, chess or Poker or any other game
that interested you. Grandmaster Vishwanathan Anand enthralls his audience by making very strategic
moves in a chess tournament. You surely have spent endless hours playing games on your computer;
Counter Strike or Age of Empires must be like staple diet to you! And you must be surprised to know that
even the corporate world is very fond of playing games, albeit very different in nature and magnitude.
Mergers, acquisitions, joint ventures and strategic alliances are all outcome of such corporate games.
PepsiCo knows that any move it makes would be countered by Coca Cola, and with this perspective it
launches a new package or a new flavour.
The most interesting and yet critical aspect of games is that there is no certainty of outcome of any
of the games, whether among individuals or corporates. Howsoever, intelligent and strategic moves
one may take, outcome still remains unpredictable. Hence, there is always an element of risk of losing
the game.
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Managerial Economics
So, what to do then? Only if you could predict some of the outcomes of moves by you and your
opponents. As businesses became more and more complex and competition became tougher, a need
for analytically predicting outcomes was felt, and drawing lessons from games people play, a scientific
field of analysis has been developed in the name of Game Theory. Game theory is highly mathematical
in nature, and calls for a sound knowledge of probability. However, we shall make the description more
lucid and simple for you, so that you can appreciate this amazing area of knowledge.
RISK
AND
UNCERTAINTY
IN
DECISION-MAKING
Risk and uncertainty go hand in hand in business. You have learnt in the previous chapters that a firm
has to operate in the framework of uncertainty; you have also learnt that the entrepreneur earns profit for
bearing uncertainty and taking risk. In fact, until Knight distinguished between risk and uncertainty, these
two concepts were taken to denote the same aspects of decision-making. In the chapter on input pricing
you would see that Knight has distinguished between the two, saying that risk refers to situations in which
the decision maker (say an individual or a firm) can assign mathematical probabilities to the randomness
which it is faced with, and thus, can insure against such risks. On the other hand, uncertainty refers to
situations when this randomness cannot be expressed in terms of specific mathematical probabilities,
and thus, it cannot be insured against.
However, this was just the beginning of the debate on defining risk and uncertainty. Many scholars
dispute this distinction, arguing that Knightian risk and uncertainty are one and the same thing. They
have argued that in Knightian uncertainty, the problem is that the agent does not assign probabilities, not
that he/she cannot assign probabilities. In other words, uncertainty is really a problem of “knowledge” of
the relevant probabilities, not of their “existence”. Some economists further argue that there are actually
no probabilities out there to be “known”, because probabilities are really merely subjectively assigned
beliefs, and have no necessary connection to the true randomness of the world, whatsoever at all.
Nonetheless, some economists have argued that Knight’s distinction is crucial. In particular, they
propose that Knightian “uncertainty” may be the only relevant form of randomness for economics. In
contrast, Knightian risk, they argue, has no connection to the murkier randomness of the “real world”
that economic decision makers usually face. In these situations, mathematical probability assignments
usually cannot be made.
The “risk versus uncertainty” debate is far from resolved. We shall not dwell upon it any further. We
will use the term uncertainty in broader context and very often will combine it with risk. However, some
form of this distinction may still be useful, in that it permits to roughly divide theories between those
which use the assignment of mathematical probabilities and those which do not make such assignments.
Thus, risk refers to any situation in which there can be more than one possible outcome, and the
probability of each such outcome is known. One big reason behind emergence of risk is lack of
information. Recollect our discussion on asymmetric information in Chapter 2. You should be able to
recall that in any principal agent setup, the principal cannot directly observe the activities of the agent,
and the agent may also know some aspect of the situation, which may
Risk refers to a situation in which there
be unknown to the principal, all because of asymmetry in information.
can be more than one possible outcome,
and the probability of each such outcome
What can be the consequences of such asymmetry? Yes, you could
is known.
remember it right: adverse selection and moral hazard!
Choice Under Uncertainty and Game Theory
413
Risk bears the seeds of uncertainty mainly because of the fact Uncertainty refers to a situation which may
that the possible outcomes are unknown. All decisions taken under have more than one possible outcome and
such circumstances have an element of uncertainty. Individuals face the probability of each outcome cannot be
uncertain incomes and threat of losses; businesses face uncertain costs ascertained.
and revenues; governments face uncertain economic and political
environments. What is uncertainty after all? Let us go round the way and define uncertainty in terms of
certainty. Certainty would refer to a situation in which there would be only a single possible outcome
to any situation and such an outcome is known beforehand. Uncertainty would, thus, be a situation
which may have more than one possible outcome and the probability of each such outcome cannot
be ascertained apriori. Recall learning from oligopoly that competitors are never certain about the
move by rivals. If A increases price will B follow suit or not? Uncertain! If A increases advertisement
expenditure will sales increase, i.e., will consumers respond positively? Uncertain! And the situations
are innumerable. We only want to highlight that business world is replete with situations imbibed into
uncertainties especially when at least two parties are involved and still players have to take decisions
under assumptions of calculated risks.
A major breakthrough in decision-making under conditions of interaction and uncertain results was
made when young mathematician John von Neumann published an article introducing game theory
to the world of knowledge. In 1944, John von Neumann and his collaborator Oskar Morgenstern
published their book Theory of Games and Economic Behaviour, in which they further developed and
refined the earlier results of Neumann. Neumann is credited for the formal incorporation of risk and
uncertainty into economic theory. If we go strictly by Knight’s definition, game theory will fall in the
category of analysing risk, as through this method mathematical probabilities are assigned to situations.
Now that you have got a fair taste of risk and uncertainty, next you need to fasten your seatbelts while
we take you on a roller coaster ride into the mazes of game theory.
GAME THEORY
Game theory is a method of analysing strategic interaction. It analyses
Game theory is a mathematical tool that
the way in which two or more interacting parties choose strategies that helps to study strategic situations in which
jointly affect each participant in some way. In the first place, what is players optimise a variable not only on the
a game? Game, the name itself hints at mysteries and challenges of basis of their own preferences, but also on
unknown moves and unanticipated outcomes. A game between two other players’ decisions and reactions.
or more players is a formal example of a strategic situation, in which
players optimise their maximum gains, depending on the response of other players. Game theory is a
mathematical tool that helps to study strategic situations in which players optimise a certain variable
not only on the basis of their own preferences, but also on the other players’ decisions and reactions. It is
that branch of applied mathematics that formally structures a situation in the form of a game and studies
the behaviour of conflict (competition) and cooperation (collaboration) between players.
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Managerial Economics
Games are characterised by a number of players or decision makers who interact, and even “threaten”
each other, and at times establish coalitions and take actions under uncertain conditions. As an outcome,
these players receive some benefit (or even loss) or reward (or punishment). The different types of
moves taken by different players in various games are systemetically and structurally used by economic
theorists and mathematicians to explain economic analysis in a distinct branch of economics, known as
game theory.
eality
B ites
The Pizza Game
The beginning of 1960s saw emergence of two major brands of pizza in USA: Pizza Hut and Domino’s
Pizza. Since then the two have been engaged in tough competition, joined by a subsequent entrant,
Papa John’s Pizza, in mid 1980s. Adopting expansion as their dominant strategy, they embraced
franchise opened in 1960 in Topeka, Kansas. Domino’s Pizza Inc. started operations in 1961, and the
against it by the Karnataka Rajya Raitha Sangha, a farmers’ association and some pro-vegetarian
.
http://www.livemint.com/Industry/rNr0KLPI8EE6iMWsyDZwbI/KFC-Pizza-Huts-Q3-sales-rise-despite-demonetisa.
http://www.livemint.com/Companies/jChCarxfXopS8iiI5X4E7H/With-Sapphire-Foods-franchisee-Yum-reorganizes.
.
The idea of theorising games to explain economic and human behaviour dates back to the study of
a duopoly market structure by Augustin Cournot in 1838. You have already learnt about the Cournot
duopoly model in Chapter 13. Incidentally, its limitations inspired the path breaking work by John von
Neumann and Oskar Morgenstern in Theory of Games and Economic Behaviour that marked the formal
establishment of game theory as a means of explaining economic theory. Further, in 1950, John Nash
demonstrated the idea of an equilibrium situation in which all players in a game choose strategies or
actions which are the best for them, given the opponents’ choices.
Although game theory has significantly contributed to the understanding of many economic situations
like duopoly, oligopoly, and stock market, yet its application is not restricted to economics; it is applied
Choice Under Uncertainty and Game Theory
415
to a plethora of disciplines like biology, psychology, sociology, philosophy, law, computing science,
mathematics, and politics. Game theory received special importance with the Nobel Prize being shared
by John Nash, John C. Harsanyi and Reinhard Selten in 1994 and William Vickey and James Mirrlees
in 1996, for their contributions to the theory. You can understand the amount of interest it has created in
society that a film “A Beautiful Mind” (2002) was made inspired from the life of John Nash, which also
won several Academy Awards.
Assumptions
Game theory provides a mathematical process for selecting an optimum strategy in the face of opponents
who have their own strategies. In game theory, one usually makes the following assumptions:
i. Each decision maker (or player) has two or more well specified choices or sequences of choices
(plays).
ii. Every possible combination of plays available to the players leads to a well defined end state (win,
loss, or draw) that terminates the game.
iii. A specified payoff for each player is associated with each end state (zero sum, constant sum or
non-zero sum).
iv. Each decision maker has perfect knowledge of the game, including the rules of the game as well
as the payoffs of all other players.
v. All decision makers are rational, that is, each player, given two alternatives, will select the one
that yields him the greater payoff (or which minimises the losses).
Structure of a Game
In order to understand game theory it is essential to first understand the structure of a game. For this, you
need to be conversant with the various concepts associated with a game.
Players
They are the participants in the game; they may include individuals, firms, or even the government with
some policy variables. The underlying assumption is that the player is rational and chooses the strategy
or action which provides the most preferred outcome, conditioned on what its opponents are anticipated
or expected to do.
Strategy
It is the precise course of action with clearly defined objectives, either having complete knowledge about
the other player, or predicting its behaviour. A strategy fully determines the player’s behaviour. Various
types of strategies are discussed in subsequent sections.
It is a set of strategies for each player that fully specifies all the actions in a game.
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Managerial Economics
Payoff
The “payoff” of a strategy is the net utility or gain to a player for any given counter strategy of the other
player. This gain is measured in terms of the objectives of the player, and is generally denoted by a
number. If, for example, the objective of the firm is to maximise profit, then the payoff of the strategy
will be measured in terms of the profit it earns. If the goal is optimising market share, then the payoff
will be measured by the shares that the strategy will yield to the firm opting for it.
Payoff Matrix
Given the strategies of all the players in a game, the payoff matrix
will represent the set of outcomes for the game. It is a table showing
the payoffs accruing to player owing to each possible combination of
strategies adopted by him/her and the other players. You will learn
more about payoff matrix in subsequent sections.
Given the strategies of all the players in a
game, payoff matrix will represent the set
of outcomes for the game.
Outcome
It is the end result accruing to different players by opting for different strategies of the game.
Equilibrium
A specific outcome is regarded as equilibrium if no player in the game can take any action to make its
payoff any better, and when all the other players continue to follow their optimal strategies.
Pure and Mixed Strategies
When a strategy specifies one and the same particular action at each
decision point in a game, it is a pure strategy. You know that Jasprit
Bumrah is a pacer with unorthodox action. His yorkers usually dip
very late and his slower deliveries are hard to deal with by batsmen
in aggressive mode. If Bumrah bowls all yorkers in an over, that would be an example of a pure
strategy! However, it may also be possible that a player would avoid being predictable, and would
prefer randomness in actions at various decision points in a game. Such a strategy would be a mixed
one. Bumrah had bowled 10 yorkers in the Australia–India Twenty20 International series, giving only
four runs and taking two wickets! Obviously that must have kept the opponent batsmen wondering what
would be his next ball, a Yorker, or a short pitch one, or one on the leg stump! You got it right, a mixed
strategy would always keep the rival player alert and wondering about the next move of a player!
The study of games is based on two principles:
i. Choices of the players are motivated by their own well defined preferences, and
ii. Players take their preferences into consideration in relation to the choices of other players.
A pure strategy specifies one and the same
particular action at each decision point in
a game.
Or stated differently, players act strategically, taking decisions with well stated objectives, and also
with the perception of the expected behaviour of other players. Therefore, these concepts of game theory
are applied only when the actions and strategies of the players are interdependent. These concepts are
used to formulate, structure and analyse distinct strategic situations of different players and consequently
the possible outcomes derived from the game.
Choice Under Uncertainty and Game Theory
417
Dominant and Dominated Strategy
So far it must be clear to you that in a game the players, being rational, Dominant strategy is the optimum strategy
take those actions that result in their preferred outcome, contingent taken by a player which maximises player’s
on what their opponents do. Suppose, in a game a player has two outcomes, whatever is the strategy
strategies A and B available to it. Suppose also that given all possible of opponents.
combinations of strategies of the other players, the outcome derived
by a player from strategy A is better than that of strategy B. This implies that strategy A dominates
strategy B; in other words, strategy A is the dominant strategy and B is the dominated strategy. A rational
player will always choose the dominant strategy, no matter what the strategies of other players are.
Thus, the dominant strategy is the optimum strategy taken by a player which maximises its outcomes,
whatever is the strategy of its opponents. This strategy yields the best payoff, no matter what the
strategies other players choose.
If one player has a dominant strategy in a game, then all other strategies are dominated strategies. A
dominant strategy equilibrium is one in which all players have a dominant strategy.
Maxmin Strategy
Maxmin strategy is one that maximises among the worst case payoffs
Maxmin strategy maximises among the
of a player in the situation where all the other players happen to play worst case payoffs of a player.
the strategies which cause the greatest harm to this player. A player
who takes the maxmin strategy usually believes that all the other players would inflict maximum harm to
him/her. The maxmin value (or safety level) of the game for a player is that minimum amount of payoff
guaranteed by a maxmin strategy.
Minmax Strategy
A minmax strategy is one in which a player minimises the best case A minmax strategy is one in which a player
payoff of its rivals. It is that strategy that is the worst among the best minimises the best case payoff of its rival.
outcomes of the opponents. Check this out, the psychology of this
player is to cause maximum loss to its opponent, or rather to punish the opponent. The minmax value of
the 2-player game for player 1 is that maximum amount of payoff that other player could achieve under
player 1’s minmax strategy.
THINK OUT
OF
BOX
Can there be only dominated strategies in a game, without any dominant
strategy?
In order to understand the different aspects of games, we would build a model of a duopoly industry.
Suppose that only two mobile phone service providers operate in India, namely Ring and Tone, each
deciding on its own advertising drive to enhance the percentage of market share. Both Ring and Tone
have two strategy options: to advertise, or not to advertise. The possible strategy combinations in such
a game are as follows:
a. If both Ring and Tone advertise, Ring gets a market share of 50, and Tone gets a market share
of 20.
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Managerial Economics
b. If Ring advertises and Tone does not advertise, then Ring gets a market share of 60, and Tone gets
a market share of 10.
c. If Ring does not advertise and Tone advertises, then Ring gets a market share of 40, and Tone gets
a market share of 30.
d. If both Ring and Tone do not advertise, then Ring gets a market share of 55 and Tone gets a market
share of 25.
Let us formally organise the above payoffs in a normal form game structure. Table 14.1 gives the
payoff matrix of the two players, where the first number within brackets shows the payoff of Ring and
the second number shows the payoff of Tone. As you can see the strategies taken by the both companies
are two (i.e., to advertise or not to advertise), hence, the payoff matrix will include 2 ¥ 2 = 4 payoffs for
each company.
Table 14.1
Payoff Matrix
Tone
Advertise
Ring
Do not Advertise
Advertise
Do not Advertise
You must be confused at the very first look at this payoff matrix, as to which of these strategy
combinations would the mobile phone service providers take. The answer is very simple. It is assumed
that each company is rational and would want to enhance its market share, or would like to move to
a better payoff. Thus, from Tone’s point of view, if Ring advertises, Tone will choose the strategy of
advertising (payoff 20), instead of not advertising (payoff 10). This is because advertising provides a
better payoff (i.e., 20) than not advertising (i.e., 10). But, if Ring does not advertise, Tone will advertise
(payoff 30), because advertising provides a greater market share than not advertising (payoff 25).
What can you infer from this? Simply that Tone will always advertise, whether Ring advertises or not.
Therefore, “advertise” is a dominant strategy for Tone.
Let us now look at Ring. If Tone advertises, it is better for Ring to advertise, because it gets a greater
market share by advertising (payoff 50) than by not advertising (payoff 40). However, if Tone does not
advertise, it is better for Ring to advertise, because it provides a better payoff (60) than by not advertising
(payoff 55). Thus, it is always better for Ring to advertise, irrelevant of what Tone does. What can
you infer from this? Yes, you got it right, Ring will always advertise, whether Tone advertises or not!
Therefore, “advertise” is a dominant strategy even for Ring.
So what will be the equilibrium in this game? Since advertisement is the dominant strategy for both
Ring and Tone, therefore (Advertise, Advertise) provides the equilibrium in dominant strategies. Given
the various strategy combinations, the best optimal strategy for both Ring and Tone is to advertise, in
order to enhance their respective market shares. You can see that each player’s optimal strategy does not
depend on the action of the other player. Consequently, the outcome or end result of this game becomes
easier to interpret, since both companies have dominant strategies.
Let us look at this advertising game to explain the maxmin strategy. In this case, the players try to
maximise the worst case payoff for them. Each company tries first to figure out the worst that can happen
to it, given both the choices or strategy options it takes, and then it takes the best possible strategy out
of these worst strategies.
Choice Under Uncertainty and Game Theory
419
You can see that the worst that can happen to Ring if it advertises is 50, whereas if it does not
advertise, it is 40. It is, thus, obvious that Ring would like to take that strategy that would give it the best
out of these two worst possible outcomes, hence, Ring would advertise.
Similarly, if Tone advertises, the worst that can happen is a payoff of 20 and if Tone does not advertise,
the worst that can happen is a payoff of 10. To choose the best among these worst payoffs is that Tone
advertises and gets a payoff of 20. You can, thus, infer that the maxmin strategy of both the players in
this game is to advertise.
We would now explain minmax strategy; as you know in this case each player calculates the best that
can happen to its opponent for each move the player takes, and chooses that strategy which minimises
among these best payoffs of the opponent. Thus, when Ring advertises, the best strategy outcome of
Tone is 20 when it advertises. If Ring does not advertise, then Tone gets a payoff of 30 if it advertises,
and 25 if it does not advertise. Thus, when Ring does not advertise, the best strategy outcome for Tone
is to advertise and get a payoff of 30. Therefore, Ring will choose that strategy which causes maximum
damage to its opponent and hence, it will advertise to keep Tone’s payoff minimum.
Similarly, if Tone advertises, the best outcome for Ring is a payoff of 50 when Ring advertises. If
Tone does not advertise, then the best outcome for Ring is a payoff of 60 when it advertises. Therefore,
Tone would choose the strategy that would cause maximum loss to Ring, and thereby would advertise.
Therefore, the minmax strategy of both the players in this game is to advertise.
NASH EQUILIBRIUM
In 1951, John Nash developed the equilibrium concept which is known
Nash equilibrium is the optimal collective
by his name. Nash equilibrium proposes a strategy for each player such strategy in a game involving two or more
that no player has the incentive to change its action unilaterally, given players, where no player has anything to
that the other players follow the proposed action. It is the optimal gain by changing his strategy.
collective strategy in a game involving two or more players, where
no player has anything to gain by changing his/her strategy. Let us explain this with the same example
given in the previous section. The only difference is in the payoff of Ring, when both Ring and Tone do
not advertise.
It is assumed here that when both Ring and Tone do not advertise, Ring gets a payoff of 65 and Tone
gets a payoff of 25. The new payoff matrix is given in Table 14.2. The new assumption here is that Ring
uses an expensive advertising agency, and would shift the burden of increased cost to the consumer by
increasing the price of the product; so the company gets a lesser market share when it advertises, as
compared to when it does not advertise. Thus, if Tone does not advertise, then it is better for Ring not to
advertise and get the larger share of the market.
Table 14.2
Pay off Matrix
Tone
Advertise
Ring
Advertise
Do not Advertise
Do not Advertise
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Managerial Economics
As per Nash equilibrium, both the players would try to take the best possible action given the
opponent’s action; hence Ring would try to speculate Tone’s action and Tone would anticipate Ring’s
action. Since Ring presumes that Tone will advertise, it is better for Ring to advertise (payoff 50) than
not to advertise (payoff 40). Similarly, Tone knows that Ring will advertise because it is in its interest,
therefore, Tone will also advertise (payoff is 20) because if Tone does not advertise given that Ring
advertises the payoffs are less (10).
Therefore, the Nash equilibrium in this advertising game is that both companies advertise. Why?
Because it represents a set of strategies for both Ring and Tone, in which neither the players would
benefit anything by changing its strategy, while its rival kept its strategy unchanged. As you can see it
is a suboptimal equilibrium, which is so due to lack of communication and cooperation between the
players.
Let us again play this advertising game with a little change in the payoffs. The change is that if both
Ring and Tone do not advertise, then Ring gets a payoff of 65 and Tone gets a payoff of 35. The new
payoff matrix is given in Table 14.3.
Table 14.3
Pay off Matrix
Tone
Advertise
Ring
Do not Advertise
Advertise
Do not Advertise
In this case, if Ring advertises, Tone will advertise, because it gets a better payoff by advertising
(payoff 20) than by not advertising (payoff 10). But if Ring does not advertise, Tone will not advertise,
because advertising leads to a lesser preferred (payoff 30) than not advertising (payoff 35). Therefore,
Tone advertises when Ring advertises and Tone does not advertise when Ring does not advertise. We
can easily conclude that the decision of Tone to advertise or not depends on whether Ring advertises or
not. In other words, Tone does not have a dominant strategy in this game.
Let us now consider the other player. From Ring’s point of view, as in the previous game, if Tone
advertises, it is better for Ring to advertise, because it gets a greater market share by advertising (payoff
50) than by not advertising (payoff 40). However, if Tone does not advertise, it is better for Ring not
to advertise, because it provides a better payoff (65) than by advertising (payoff 60). Thus, it is always
better for Ring to advertise when Tone advertises, and not advertise when Tone does not advertise. You
can infer quite easily that Ring does not have a dominant strategy in this example; Ring’s action depends
on what Tone does in this case.
Let us now summarise, both Ring and Tone do not have dominant strategies. What would happen to
the equilibrium outcome in this case? This situation is a little complicated. In this case, there are two
Nash equilibriums: the first Nash equilibrium occurs when both of the companies advertise; the second
occurs when both do not advertise. Now, each firm is better off if it plays the same strategy as the other
firm, and both the Nash equilibriums occur when both the firms simultaneously play the same strategy.
We can also say conclusively that
. A minmax
.
Choice Under Uncertainty and Game Theory
421
PRISONER’S DILEMMA
In 1984, Axelrod gave a new dimension to game theory by presenting “Prisoner’s Dilemma” which
talks of importance of cooperation. The two players in the game can choose between two moves, either
“cooperate” or “defect”. The idea is that each player gains when both cooperate, but if only one of them
cooperates, the other one, who defects, will gain more. If both defect, both lose (or gain very little) but
not as much as the “cheated” cooperator, whose cooperation is not returned.
The game of Prisoner’s Dilemma needs a bit of story telling! This is a story of two prisoners; they
are two criminals who have been arrested for stealing a car but the attorney suspects that they were
also involved in a big bank robbery. However, the evidence is not adequate to make the robbery charge
stand unless one or both confess. Now car stealing is comparatively a lesser offence, and hence has less
punishment as compared to bank robbery. Thus, the attorney keeps these two prisoners in separate cells
so that no communication is possible between them. Each prisoner is told that if he and his accomplice
confess, their imprisonment will be only five years, but if only one confesses and the other remains
silent then the one who confesses will get only one year of jail whereas the other will get 10 years.
The prisoners know that if both of them keep silent they will get only two years of jail which is the
punishment for car stealing for which they have been caught.
Table 14.4 is representing the payoff matrix, where the two prisoners are the players and the years of
imprisonment are the payoffs. Each of the players is having two strategies, either to betray and confess,
or not to confess and remain silent. Thus, the outcome of each choice depends on the choice of the
accomplice. But neither partner knows the choice of his accomplice. You know that each of them would
try to minimise their jail term, but neither player has any means of knowing that his accomplice will
not betray.
Table 14.4
Prisoner’s Dilemma
Prisoner B Stays Silent
Prisoner A
Prisoner B Confesses
A serves 10 years
Win-Win
B serves 1 year
A Loses, B Wins
Prisoner A
B serves 10 years
A serves 1 year
Lose-Lose
A Wins, B Loses
(NASH EQUIIBRIUM)
By your understanding of game theory and Nash equilibrium, you can easily infer that both the
prisoners would confess and thus, would serve five years imprisonment. This is because each of the
prisoners knows that the dominant strategy of the opponent is to confess; hence each will confess,
while his accomplice keeps his strategy intact.
Similarly, if either A or B adopts maxmin or minmax strategy, the outcome in both the cases would
be the same.
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Managerial Economics
TYPES
OF
GAMES
There are different ways in which games are categorised such as, on basis of relation between players,
strategies or outcome.
Cooperative and Non-Cooperative Games
Cooperative games are essentially those which entail cooperation among the players. In real business
world, such cooperation is considered to be illegal; you have learnt this in Chapter 13. Non-cooperative
games are ones in which there is no possibility of a tie up among the players like in case of cut throat
competition.
The normal form game systematically lists
each player’s strategies and the possible
outcome they derive, given the strategy of
the opponent.
Normal Form and Extensive Form Games
The normal form game systematically lists each player’s strategies
and the possible outcome they derive from each strategy, given the
strategy of the opponent. An outcome is revealed by the payoff matrix,
Ring, Tone
Advertise
(50, 20)
Tone
Advertise
Do not
Advertise
(60, 10)
Ring
(40, 30)
Do not
Advertise
Advertise
Tone
Do not
Advertise
Fig. 14.1
Extensive Form Game
(55, 25)
Choice Under Uncertainty and Game Theory
423
and each player’s payoff is denoted by a number to measure the utility or gain it derives from each
strategy taken. The games we have so far discussed are all examples of normal form.
An extensive form game (or a game tree) gives the complete plan of action of the players over a period
of time. The game tree gives the chronological order in which players take their action at that particular
point of time, dependent on what they know at that point. The advertising game we have discussed before
can be represented in the extensive form structure, as in Figure 14.1.
Two Person Games and n Person Games
This classification is on the basis of the number of players. As is apparent from the respective names, two
person games are played by only two persons like the one we have discussed above; n person games are
played by any number of persons, and are obviously more complicated than two person games.
Simultaneous Move Games and Sequential Move Games
In a simultaneous move game, both players act at the same time. In such games, even if the players do
not act at the same time, the second player is uninformed of the first player’s move, thus, making it
effectively a simultaneous move. This type of game theory approach is used by economists to understand
behaviour of oligopoly firms. The Cournot model of oligopoly is an example of a simultaneous
move game.
On the other hand, in a sequential move game one player acts,
In a simultaneous game, both players act at
followed by the other. The second player knows the move adopted by the same time; in a sequential game, one
the first player, and takes its decision contingent on that taken by the player acts, followed by the other.
first player. This type of game is used to explain oligopoly markets
in which a firm takes the first move, and then the other firm tries to take a move to optimise its returns,
depending on the move taken by the first firm. The Stackelberg model of duopoly or the leader follower
model is an example of a sequential move game.
Constant Sum, Zero Sum and Non-zero Sum Games
The extent to which the goals of the players coincide or conflict is another basis for classifying games.
Thus, on the basis of the extent of rivalry and outcomes, games can be classified as: (i) constant sum,
(ii) zero sum, and (iii) non-zero sum games.
In constant sum games, the total benefit of the players, given each
In constant sum games, the total benefit
strategy, is a constant and the players have to share the profit. Constant of the players, given each strategy, is a
sum games are games of total conflict, which are also called games constant and the players have to share
of pure competition. Poker, for example, is a constant sum game, the profit.
because the combined wealth of the players remains constant, though
its distribution shifts in the course of play. You can, thus, follow intuitively that in such a game, if the
share of Player A increases, that of Player B must decrease, and vice versa.
In zero sum games, the total benefit of the players, given each strategy, is equal to zero. It can be said
that a zero sum game is a special case of constant sum game in which all outcomes involve a sum of all
player’s payoffs of zero. Hence, a gain for one participant is always equal to the loss of another, such as
in most sporting events. In other words, whatever is gained by one player is lost by the other player;
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Managerial Economics
thereby the sum of gain and loss is zero. For example, the total market size being given, a 20 percent
increase in market share of one firm would mean equivalent decrease in market share of other firm hence,
sum of gain and loss is zero. Take another example, an increase in salary of employees would mean an
equivalent increase in cost to employer.
There can be another set of outcome where a player wins without
In case of a non-zero sum game, the total
a
loss
to another player, for example in a growing unsaturated market
benefit of the players added together,
there
may
be place for many players. In case of a non-zero sum game,
given each strategy, is more than zero or
the
total
benefi
t of the players added together, given each strategy,
the constant.
is more than zero or the constant. This entails a situation in which
both the players A and B end up in a win-win (or lose-lose situation), like in strategic alliances or joint
ventures. Or in the above example of increase in salary, if with increased salary employees perform
better, the increase in cost will be offset by increase in productivity. Hence, such games are also called
positive sum or variable sum games.
Symmetric and Asymmetric Games
Symmetric games are those in which the payoffs do not depend on the
players of the game, but on the strategies of the game. In such games,
the strategies are such that if the players are interchanged without
changing the payoff matrix, the game remains the same. These are
symmetrical games. Prisoner’s Dilemma is an example of symmetric games.
Asymmetric games do not have this property; they usually do not have identical strategies for both
set of players. And even if they have identical strategies for both the players, they are asymmetric. The
Market Entry Game is an example of asymmetric games.
In symmetric games, the payoffs do not
depend on the players of the game, but on
the strategies of the game.
APPLICATIONS
OF
GAME THEORY
IN
ECONOMICS
By now you have understood various aspects of game theory and would be ready to understand its
application in economic analysis. This concept of games is widely used to explain economic behaviour
of markets. The application of game theory in economics is mostly established in explaining price and
output determination in oligopoly structure of markets; it can also be used to analyse case of monopoly
firm facing the threat of a new entrant.
eality
B ites
The Success in Safal Game
Safal
Safal
Contd.
Choice Under Uncertainty and Game Theory
425
Safal
`
Safal had even announced a sharp price cut to stay ahead in competition. With the entry of
Safal
accessed
Market Entry Game
Let us begin with the game of entry of a potential competitor firm in an industry which already has a
monopoly firm. The competitor (or incumbent) has to decide whether to enter the market or to stay out.
The monopolist, on the other hand, has two options: either it colludes, or fights with the entrant firm.
Let us now design the payoff matrix for the incumbent. If the entrant decides to stay out, then the
profit it earns is zero. In that case, the incumbent firm earns monopoly profits and its payoff is 100. If,
however, the entrant enters the market, the monopolist is faced with the decision to collude with the
entrant, or fight by competing forcefully. The competitor has to pay an entry cost of 10 for entering the
ENTRANT, INCUMBENT
(40, 50)
Collude
INCUMBENT
Fight
Enter
(–10, 0)
ENTRANT
(0, 100)
Stay out
Collude
INCUMBENT
Fight
(0, 100)
Fig. 14.2 Market Entry Game
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Managerial Economics
market. Therefore, if it enters and the incumbent fights then market profit equals zero. Since the entrant
has an entry cost, its payoff is –10 and that of the incumbent is 0. But if the entrant enters the market
and the existing firm colludes with this new player, then they divide the profits; in this case the entrant’s
payoff is 40 and the incumbent’s payoff is 50. The normal form of the game is given in Table 14.5.
Table 14.5
Pay off Matrix
Incumbent
Collude
Fight
Stay Out
This normal form game is represented in an extensive form, incidentally this is also a sequential
move game.
Given this structure of a monopoly game, what do you think would be the strategy of a rational
monopolist? If the entrant does not enter then the monopolist under usual conditions earns monopoly
profits. But if the entrant enters, it becomes a better option for the incumbent to collude than to fight.
This is because the objective of the monopolist is to maximise profits. Fighting with the entrant results
in zero profit, while colluding with it leads to positive profits. Thus, Nash equilibrium occurs when the
entrant enters and the incumbent firm colludes with it.
Cournot Model
The Cournot model of oligopoly is one where firms choose output
on the basis of the assumption that the rival firms would not
change its output. The Cournot model has already been dealt with in
Chapter 13. Here we would explain it with game theory approach.
The Cournot game is a simultaneous move game where the firms strategically choose outputs such as
to maximise profits. The firms know that their choice of quantity is dependent on what the rival firms
choose. Once the quantities are chosen, then prices are determined.
If both firms fight with each other, then they earn duopoly profits. If they form a cartel, each firm earns
greater profits but given the structure of the game and the players’ rivalry, they end up in a suboptimal
equilibrium.
The Cournot game is a simultaneous move
game where the firms strategically choose
outputs such as to maximise profits.
Bertrand Model
Joseph Bertrand in 1883 developed a model in which, unlike the Cournot model, the firm chooses prices
instead of quantities in an oligopoly market, considering that the prices of its competitors are fixed. Like
Cournot, this is a simultaneous move game where the firms choose prices simultaneously. Suppose one
firm sets its price higher than the other firm’s price. Then the higher priced firm will not get a single
buyer since both the firms are selling homogeneous products. The low priced firm will get the entire
market share and thus, enjoy maximum profits. Each firm has the incentive to cut prices and hence, at
equilibrium all the firms must have a same price equal to the marginal cost of production.
Now, is there Nash equilibrium in this game? Yes. There is exactly a single Nash equilibrium, where
both the firms set their price at marginal cost.
Choice Under Uncertainty and Game Theory
427
Let the market demand curve be D(P). Since firms can choose different prices, demand faced by the
firm ‘I’ is given by Di (Pi, Pj). Let each firm have a cost function given as:
C(q) = cqi
…(1)
This implies that the demand for the product depends not only on the firm itself, but also on the price
of its rival firm, say j. Therefore,
Ï D ( Pi ),
if Pi < Pj
Ô
Ô1
Di(Pi, Pj) = Ì D( Pi ), if Pi = Pj
Ô2
Ô 0,
if Pi > Pj
Ó
…(2)
This implies that if the opponent firm j charges a higher price, firm “i” gets the entire market. If j
charges a price equal to i then both the firms equally share the market. Also, if firm “j” charges a price
lower than i then the demand for the product of firm i is zero.
Each firm wants to maximise profits, given what it predicts the other firms will do. Therefore, profit
for firm “i” is given as:
Ï D( Pi )( Pi - c),
if Pi < Pj
Ô
Ô1
p i = Ì D( Pi )( Pi - c), if Pi = Pj
Ô2
Ô 0,
if Pi > Pj
Ó
…(3)
The Nash equilibrium is where Pi = Pj = MC.
Why is it Nash equilibrium? You can understand this by seeing the possible cases of profits earned by
each firm for each price it chooses along with its rival as stated below:
1. If Pi < MC and Pj > Pi, then firm “i” earns negative profits, because price is less than marginal cost
and firm “j” earns zero profits. In this case, i would like to increase price.
2. If Pj > Pi > MC, then firm “j” earns zero profits and firm “i” earns positive profits. In this case,
firm “j” will reduce the price.
3. If Pj = Pi < MC, both the firms earns negative profits, and both the firms would like to increase
their prices.
4. If Pj = Pi > MC, both the firms earn positive profits. But each of them would like to reduce their
price to get a larger share of the profit in the market. Undercutting of prices by both firms will
continue.
5. If Pj > Pi and Pi = MC, both the firms earn zero profits, and firm “i” would slightly increase its
price to earn positive profits, because if price equals marginal cost, profits are zero.
Therefore, in all the cases, each or both firms would unilaterally want to change the price. If Pj = Pi
= MC, both the firms earn zero profits, but none of them would like to increase or decrease the price.
This is a unique Nash equilibrium in pure strategies. The Nash
Nash equilibrium in Bertrand Game is the
equilibrium in the Bertrand Game is the same as the equilibrium under same as the equilibrium under perfect
perfect competition, where price equals marginal cost.
competition.
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Managerial Economics
Since oligopolistic markets are characterised by some degree of product differentiation, firms generally
choose prices than quantities. Let us illustrate this with an example. Suppose each of the duopolists has
a constant cost c and the same demand function, where demand depends not only on the price of its own
product, but also on the prices of the slightly differentiated products of other firms. The quantity that
each firm sells decreases with the rise in its own price, but increases when the opponent charges a higher
price. The demand function takes the form:
Di(Pi, Pi) = a – bPi + Pj
a > 0 and b > 0.
where
…(4)
Therefore, the profit function for the ith firm is given as:
pi = PiDi(PiPj) – c = Pi[a – bPi + Pj] – c
…(5)
Let us illustrate the Bertrand game with a typical game theory approach. Continuing with the two
mobile phone service providers Ring and Tone, we can draw the payoff matrix as given below, for
decisions regarding price determination:
Table 14.6
Price Determination
Tone
Maintain Price
Cut Price
Ring
Price of Tone (Pi)
The payoffs denote the profits earned by each company, given the strategy of the company itself and
the strategy taken by the rival company. Thus, if Ring maintains its price, Tone will cut price, because
this strategy brings it higher profits. If however, Ring cuts price, Tone will also cut price to earn more
profits. Thus, “cut price” is a dominant strategy for Tone. Similarly, if Tone maintains price, Ring will
cut price because it gives Ring a better payoff. Again, if Tone cuts price, then cutting price would be a
profitable strategy for Ring. Therefore, “cut
price” is the dominant strategy for Ring.
Collusive
Thus, the Nash equilibrium is that both the
Equilibrium
players cut price. If these companies colluded
90
to maintain price, both the companies would
have earned larger profits. But since the firms
are rivals and undercutting of price takes
place continuously, both the firms end up
50
Nash
selling their product at a lower price earning
Equilibrium
lesser profits. This game is similar to the
Prisoner’s Dilemma.
The profits earned by each firm when they
colluded are also more than that if firms act
O
90
50
as rivals choosing prices independently. This
Price of Ring (Pi)
is drawn in Figure 14.3.
Fig. 14.3 Price Determining Game
Choice Under Uncertainty and Game Theory
429
Stackelberg Game
The Stackelberg game is a sequential move game different from the
The advantage of the leader of setting a
Cournot or the Bertrand game. Like the Cournot game, the firms higher quantity of output and earning
choose outputs in this game. But first, one firm known as the leader more profits than the follower firm is called
chooses the output. The second firm observes the first firm’s quantity the “first mover” advantage.
and then chooses its own output. The second firm is the follower firm.
These games are known as Follow the Leader games. Once the two firms choose respective quantities,
prices are determined. You have learnt Stackelberg model in Chapter 13. You know that the leader firm
sets a higher quantity of output and earns more profits than the follower firm. This advantage of the
leader is often called the “first mover” advantage.
The method in which equilibrium is determined in the Stackelberg model is known as backward
induction in the game theory. The technique first considers the optimal strategy of the player and its
best response which takes moves that are last in the game. Thus, predicting the future action of the last
player, the second last player proceeds taking the best move and the process continues backwards in time
determining for each player best response, until the beginning of the game is reached.
Table 14.7 illustrates the comparative analysis of equilibrium price, quantity and profits under three
models and that of monopoly.
Table 14.7
Summary of Price, Output, and Profit under different Models
Bertrand
Stackelberg
Cournot
Monopoly
c
a
a
a+c
c
c
a-c
b
a-c
b
a-c
b
0
a-c
16b
a-c
9b
a-c
b
a-c
b
eality
B ites
Pantaloons: The First Mover
Contd.
430
Managerial Economics
the recent past.
Sources: https://www.ibef.org/news/indias-organised-retail-market-presents-a-whopping-us-75-billion-opportunityaccessed on
accessed on
Let us further understand these three most prominent oligopoly models with the help of a numerical
example.
The demand function is given by p(Q) = a – bQ = a – b(q1 + q2) where the total output is divided
by the two firms as q1 and q2. Here a = 130 and b = 1. Therefore, the demand function is p(Q)
= 130 – Q = 130 – (q1 + q2). The total cost is constant at c = c1 = c2 = 10. Given this, find the
equilibrium price, equilibrium quantity and profits in the Cournot, Bertrand and Stackelberg
models? Compare these results with monopoly equilibrium.
Solution:
In the Cournot model, the equilibrium quantity for each firm is (a – c)/3b = 40
The total equilibrium quantity of output produced is (40 + 40) = 80. The equilibrium price is
P = 130 – (40 + 40) = 50. The equilibrium profit of each firm is (a – c)2/ 9b = 1600. The total
profit in the Cournot model is (1600 + 1600) = 3200
In the Bertrand model, the equilibrium price is equal to marginal cost. Therefore, P = c = 10.
The total output produced in the Bertrand model is Q = 120. Since, price equals marginal costs,
the Bertrand market like the competitive markets earn zero profits.
In the Stackelberg model, the equilibrium output produced by the leader firm is (a – c)/2b =
60. The equilibrium output produced by the follower firm is (a – c)/4b = 30. The total output
produced in the market is (60 + 30) = 90. The equilibrium price is P = 130 – 90 = 40
The profit earned by the leader firm is pL = pqL – cqL = (40 ¥ 60 – 10 ¥ 60) = 1800. The profit of
a-c
ˆ
the follower firm is pF = pq F – cqF = ÊÁ
40 ¥ 30 - 10 ¥ 30˜ = 900. Therefore, the total profit
Ë 2b
¯
in the Stackelberg model is (1800 + 900) = 2700
(Contd.)
Choice Under Uncertainty and Game Theory
431
The two firms colluded to form a cartel or behaved like a monopoly, the equilibrium output is
(a – c)/2b = 60. The equilibrium price P = 130 – 60 = 70. The profit of each firm is (a – c)2/ 8b
= 1800. Therefore, the total profit of the firm is (1800 + 1800) = 3600
A comparative study of all these models reveals that the prices (10 < 40 < 50 < 70) and profit (0
< 2700 < 3200 < 3600) are minimum in the Bertrand model and then increase in the Stackelberg
followed by the Cournot model. The prices and profits are maximum for a monopoly. On the
other hand, equilibrium outputs are maximum (120 > 90 > 80 > 60) in the Bertrand model
followed by the Stackelberg model and then followed by the Cournot model and ultimately
by monopoly.
SUMMARY
According to Knight, risk refers to situations in which the decision maker can assign mathematical
probabilities to the randomness which it is faced with, and thus, can insure against such risks.
Uncertainty refers to situations when this randomness cannot be expressed in terms of specific
mathematical probabilities, and thus, it cannot be insured against.
Risk connotes a situation in which there can be more than one possible outcome, and the
probability of each such outcome is known. Risk emerges due to factors like lack of information.
Game theory is a mathematical tool that helps to study strategic situations in which players
optimise a certain variable not only on the basis of their own preferences, but also on the other
players’ decisions and reactions.
As per Knight’s definition of risk, game theory falls in the category of analysing risk, as through
this method mathematical probabilities are assigned to situations.
Games are characterised by number of players or decision makers who interact, and even “threaten”
each other, and at times establish coalitions and take actions under uncertain conditions. As an
outcome, they receive some benefit (or even loss) or reward (or punishment).
The “payoff” of a strategy is the net utility or gain to a player for any given counter strategy of the
other player.
A pure strategy specifies one and the same particular action at each decision point in a game; a
mixed strategy would have randomness in the actions of the player at various decision points in
a game.
Dominant strategy is the optimum strategy taken by a player which maximises its outcomes,
whatever is the strategy of its opponents. If one player has a dominant strategy in a game, then all
other strategies are dominated strategies.
Maxmin strategy maximises among the worst case payoffs of a player. A minmax strategy is one
in which a player minimises the best case payoff of its rival.
Nash equilibrium proposes a strategy for each player such that no player has the incentive to
change its action unilaterally, given that the other players follow the proposed action. It is the
optimal collective strategy in a game involving two or more players, where no player has anything
to gain by changing his strategy.
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Managerial Economics
“Prisoner’s Dilemma” is a celebrated game that talks of the importance of cooperation. Each
player gains when both cooperate, but if only one of them cooperates, the other one, who defects,
will gain more.
Cooperative games entail cooperation among the players; in non-cooperative games there is no
possibility of a tie up among the players.
The normal form game systematically lists each player’s strategies and the possible outcome they
derive from each strategy, given the strategy of the opponent; an extensive form game (or a game
tree) gives the complete plan of action of the players over a period of time.
In a simultaneous game, both players act at the same time; in a sequential game one player acts,
followed by the other.
In constant sum games, the total benefit of the players, given each strategy, is a constant and the
players have to share the profit; in zero sum games, the total benefit of the players, given each
strategy, is equal to zero.
The Cournot game is a simultaneous move game where the firms strategically choose outputs such
as to maximise profits. Once the quantities are chosen, then prices are determined and the firms
end up in a suboptimal equilibrium.
The Bertrand model is a simultaneous move game where the firms choose prices simultaneously.
There is exactly a single Nash equilibrium, where both the firms set their price at marginal cost.
The Stackelberg game is a sequential move game different from the Cournot or the Bertrand game.
Equilibrium determined in this model is known as backward induction in game theory.
KEY CONCEPTS
Risk
Payoff
Nash equilibrium
Maxmin Strategy
Prisoner’s Dilemma
Uncertainty
Strategy
Dominant and Dominated Strategies
Minmax Strategy
Zero Sum Games
QUESTIONS
Objective Type
I. State True or False
i. The leader follower model is an example of a sequential move game.
ii. Players of a game cannot make binding agreements on each other.
iii. A strategy is dominant for a player if the player has another strategy at least as good as or better
than this strategy.
iv. A game tree gives the complete plan of action of the players over a period of time.
v. Asymmetric games have identical strategies for both set of players.
Choice Under Uncertainty and Game Theory
433
vi. Uncertainty is a problem of existence of relevant probabilities.
vii. In dominant strategy equilibrium, one player has a dominant strategy and the other has a
dominated strategy.
viii. Constant sum games are games of pure competition.
ix. The Nash equilibrium in Stackelberg game is similar to equilibrium in perfect competition.
x. In zero sum games, whatever is gained by one player is lost by the other player.
II. Fill in the Blanks
i.
ii.
iii.
iv.
v.
vi.
vii.
viii.
ix.
x.
In _______ games the payoffs depend on the strategies of the game.
________games need decision-making at regular intervals.
Gain to a player for any given counter strategy is measured by the __________of the player.
Both players are in a “win-win situation” in _________ games.
In ______ strategy the player is pessimistic by nature.
Behaviour of firms in an oligopoly can be explained with ________ games.
The dominant strategy of the opponent in Prisoner’s Dilemma is to ________ .
A player’s behaviour is determined by a ________.
Game theory assumes all decision makers to be ________.
If an entrant decides to stay out in a market entry game, its profit earned is equal to ________.
III. Pick the Correct Option
i. Cournot game is an example of a:
a. Simultaneous move game
b. Sequential move game
c. One shot game
d. Zero sum game
ii. A player who takes the maxmin strategy is:
a. A conservative pessimist
b. One who believes that other players would inflict maximum harm to him/her
c. One who tries to impose the maximum damage on its partner
d. Both a and b
iii. If players make their moves in a particular order over time, then the game is:
a. Normal form
b. Strategic form
c. Extensive form
d. Constant sum
iv. Which of the following statements is NOT correct about zero sum games:
a. Total benefit of the players is equal to zero b. Both players lose
c. One player’s loss is the other’s gain
d. Sum of gain and loss is zero
v. Find out which one among the following statements is always correct about Nash equilibrium:
a. Any player has the incentive to change its action unilaterally.
b. It is a suboptimal collective strategy.
c. There can be two equilibriums when both the firms simultaneously play the same strategy.
d. No player has anything to gain by changing its strategy.
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Managerial Economics
vi. None of the following is valid for asymmetric games EXCEPT:
a. All outcomes involve a sum of payoffs equal to zero.
b. Both players act at the same time.
c. There is no possibility of tie-up among the players.
d. These games usually do not have identical strategies for both players.
vii. Which of the following distinguishes Stackelberg game from Cournot and Bertrand models:
a. Firm chooses opponents in this game
b. It is a sequential move game
c. It is a simultaneous move game
d. Firms assume their choice of quantity depends on choice of rival firms
viii. The set of outcomes for a game is determined by:
a. Equilibrium
b. Payoff
c. Payoff matrix
d. Strategy profile
ix. Backward induction is the method by which equilibrium is determined in:
a. Cournot model
b. Bertrand model
c. Stackelberg model
d. None of the above
x. There is no possibility of a tie- up among the players in:
a. Extensive form games
b. Normal form games
c. Cooperative games
d. Non-Cooperative games
Analytical Corner
1. Give examples from the business world of each of a constant sum game, zero sum game, and a
non-zero sum game.
2. Establish a relationship between Cournot equilibrium and Nash equilibrium.
3. Explain the relevance of game theory in an oligopolistic market.
4. Explain how can we arrive at Nash equilibrium in a game of incomplete information like
Prisoner’s Dilemma?
5. ‘The distinction between risk and uncertainty is uncalled for.’ Comment.
6. Can we apply game theory to explain the behaviour of firms in perfect competition or monopoly
or monopolistic competition? Give logic to support your answer.
7. Imagine two cola majors Simply Cola and Only Cola are vying for greater market share in
Mumbai. They have roped in two celebrities as their brand ambassadors and are planning to
advertise their products with these celebrities. The only concern that is holding them back is the
reaction of each other. The following table gives their payoffs in terms of market share:
Simply Cola
Advertise
Advertise
Do not Advertise
i. Determine the dominant strategy for each company.
ii. What would be Nash equilibrium?
Do not Advertise
Choice Under Uncertainty and Game Theory
435
iii. Let us consider a different payoff matrix for the cola companies given below. Determine the
dominant strategy for each company. Also calculate Nash equilibrium.
Advertise
Do not Advertise
Advertise
Do not Advertise
iv. How is your answer of (iii) different from those of (i) and (ii)?
8. What if cartels were not illegal? Comment.
9. Consider Prisoner’s Dilemma. Are the convicts risk averse or risk lovers? Is it a dominant strategy
game? Give arguments in support of your answer.
10. What is the “first mover advantage”? Discuss this in connection with the Stackelberg model.
11. ‘Prisoner’s dilemma leads to a suboptimal equilibrium.’ Explain.
12. Suppose there are two players. Player 1 is an internet service provider and player 2 is a potential
customer. The internet service provider has to decide between two levels of quality of service,
High or Low. The customer also has two options, either to buy or not to buy the contract. But for
the customer a high quality service is more valuable than a low quality service, whereas for the
firm the high quality service is difficult and costly to provide than a low quality service. If the firm
supplies a high quality service and the customer buys it, then both have a payoff of 3. If the firm
provides a high quality service and the customer does not buy it, then the firm’s payoff is zero
and the customer’s payoff is 1. If the firm provides a low quality service and the customer buys
it, then the firm has a payoff of 4 and the customer has a payoff of zero. But if the firm provides
a low quality service and the customer does not buy it, both have a payoff of 1.
i. Draw the payoff matrix of this quality game.
ii. Determine the equilibrium in this game.
13. Suppose a game is similar to the game in question 12, except that when the firm provides a low
quality service and the customer buys it, then the firm has a payoff of 1 (instead of 4) and the
customer’s payoff is zero. Given this game structure, answer the following questions:
i. Draw the payoff matrix of this quality game.
ii. Determine the equilibrium in this game.
iii. Is the equilibrium same as in the case with question 12?
14. Suppose there are two ice cream producers and each firm can produce a high as well as a low
quality product. The payoff matrix which indicates the profits for the two firms is given as:
Firm B
Firm A
High
Low
High
Low
40, 40
50, 70
60, 45
30, 30
i. What is the Nash equilibrium in this case?
ii. If both the firms followed a maxmin strategy what would be the outcome?
436
Managerial Economics
15. Let us consider a market entry game. Suppose, a firm like Tata tries to introduce a new small
car, where Maruti currently is the only provider of small cars. In the game, Tata can enter or not
enter and Maruti can advertise or not advertise to maintain its market share. If Tata does not enter,
Maruti gets the entire market. It is assumed that Maruti gets a profit of 6 if it does not advertise
and a profit of 4 if it advertises. If Tata does not enter, its profit is zero. If Tata enters and Maruti
doesnot advertise then the profits are 3 for Maruti and 1 for Tata. If Tata enters and Maruti
advertises, Maruti keeps some of its customers but at the expense of an advertising cost and hence,
the profits are 1 for Maruti and –1 for Tata. Assume that each firm knows its own payoff, as well
as its rival’s.
i. Draw the payoff matrix in the normal form.
ii. What is the Nash equilibrium in this case?
iii. Draw the game structure in the extensive form.
iv. What is the Nash equilibrium in this case?
16. Suppose we consider a symmetric duopoly where each firm has a unit cost of c = 10. The
demand for good 1 is given by q1 = 20 – p1 + 1 p2. The demand for good 2 is given by
2
q2 = 20 – p2 + 1 p1. Find the Bertrand Nash equilibrium with the help of a diagram.
2
17. Suppose the market demand for a product is p(Q) = 60 – Q = 60 – b(q1 + q2), where q1 and q2 are
the quantities supplied by the two firms in the market. The cost function is C(q).
i. Find the Cournot Nash equilibrium.
ii. If the firms colluded, then what would be the equilibrium profit for each firm?
Check Your Answers
State True or False
i. T
ii. T
iii. F
iv. T
v. F
vi. F
vii. F
viii. T
ix. F
x. T
Fill in the Blanks
i. symmetric
vi. sequential
ii. repeated
vii. confess
iii. objectives
viii. strategy
iv. non-zero sum
ix. rational
v. maxmin
x. zero
vii. b
ix. c
Pick the Correct Option
i. a
ii. d
iii. b
iv. b
v. d
vi. d
viii. c
x. d
Analytical Corner
7. i. Dominant Strategy: Advertise, ii. Nash equilibrium: Advertise, Advertise iii. Nash equilibrium: Advertise,
Advertise
12. ii. Equilibrium: Low quality, Does not buy
13. ii. High: Buy Low: Do not Buy, iii. Two Nash equilibrium
Choice Under Uncertainty and Game Theory
14.
15.
16.
17.
437
i. No Nash equilibrium in pure strategies, ii. Maximum Strategy: High, High
ii. Tata enters, Maruti does not advertise, ii. Tata enters, Maruti does not advertise
P1 = P2 = 13.33
i. 1 = 2
Caselet
Winning over the Winner
Ghari took birth when Nirma was at its peak. Launched in 1987, it took almost 15 years for Ghari
to hit `500 crore in sales. But the next 10 years saw it adding another `1,700 crore. Murlidhar
Gyanchandani, the co-founder of Nirma told Economics Times that they were inspired by the success
of the Nirma model. As of December 2010, Ghari became the second largest brand in home and
personal care industry. Ghari had almost doubled its market share, as of December 2010, taking it
up to 13.5 percent in the detergents segment. It left behind the original winner Nirma with a share of
7.9 percent, a far cry from the 35 percent it once had. Wheel still leads with over 17 percent, but the
gap is slowly but surely narrowing. “Ghari did a Nirma on Nirma. So far Ghari’s gain has come from
Nirma and smaller regional brands because it is definitely a better product in comparison,” says a
former HUL senior executive, who was directly involved with HUL’s operation STING (Strategy To
Inhibit Nirma’s Growth) in the late eighties.
One glaring difference between Nirma and Ghari is that, Ghari took the bold step of pricing at a
10 percent premium over HUL’s Wheel and Nirma—`35 a kg as against `30. “It’s a brilliant gap that
Ghari has found. It is priced above mass brands like Wheel and Nirma but much below mass premium
brands such as Tide and Surf,” says Jagdeep Kapoor, Chairman Samsika Marketing.
The biggest challenge, however, would be if consumers, whose aspirations are shifting, decide to
leave behind a bucket–wash brand like Ghari and move on to a more urban–type washing machine
product. The Gyanchandanis will have to be careful that other brands do not do to Ghari what it did
to Nirma.
Case Questions
The Herbal Strategy
438
Managerial Economics
DantKanti
DantKanti
`300 crore (`
company sources, the target is to achieve a turnover of `500 crore (`
DantKanti, with
`
revenue comes from toothpaste segment (`
new entrant DantKanti
Sources:
https://www.techsciresearch.com/news/686-patanjali-is-dominating-the-oral-care-market-eating-themarket-shares-of-colgate.html,
http://www.rediff.com/business/special/special-now-patanjali-is-giving-toothache-tocolgate/20160210.htm,
Posers
DantKanti
Part
5
Pricing Decisions
Pricing intrigues everyone, be it those who fix the prices of goods and services or those who have to
pay such price. You have understood price and output determination under various market forms in
Part 4. Now we introduce you to a wide variety of pricing strategies which producers/sellers adopt
in real world. This part of the book deals with pricing and a brand new topic on externalities, public
goods and role of government. The first two chapters of this part are dedicated to pricing of goods
and inputs respectively. The following chapter introduces you to the realms of externalities and
public goods, thus, preparing a firm background for you to move to the macroeconomic aspects of
managerial decisions covered in Part 6.
CHAPTERS
15. Product Pricing
16. Input Pricing
17. Externalities, Public Goods and Role of Government
Chapter
15
2. Understand cost based, value based and perception based pricing strategies.
3. Relate product life cycle stages as well as different phases of business cycles with
pricing decisions.
4. Learn the effect of administered pricing on general pricing policies.
5. Understand dumping and its impact.
Chapter Objectives
1. Introduce the rationale behind different pricing decisions of a firm.
INTRODUCTION
Price denotes two aspects, on one hand it is revenue to the seller and on the other it is the perceived value
of the good (or service) to the buyer. So the basic question is what is the right price for a product? A
simplistic answer is that the right price is one which keeps all stakeholders happy; consumers feel happy
that they got value for their money; sellers are happy because they could sell the desired volume; and
we would expose you to some other dimensions of pricing decisions.
At the outset, we would like to apprise you that all pricing strategies, methods, techniques and
types that we would discuss in this chapter are outcomes of an imperfect market. You have already
are few players and a product is differentiated, thereby competition is tough. Another very important
and opportunity.
442
Managerial Economics
Before we take you to various pricing strategies, it is important that you understand the situations
identify the factors upon which pricing decisions depend.
new product would obviously need
to decide upon its price; sellers of a
product would also have to decide about
its price. You would agree that models of cars in a new colour scheme are available at higher price.
new market or a
new market segment, in order to suit the different dimensions of the market structure, such as degree of
competition, pricing of competitors’ products, consumers’ buying capacity, and so on. Objective of the
Another equally important factor is cost
some
hence, cost creates the bottom line for price. Therefore, with any change in cost of production
in demand would also require change in pricing; refer to the chapter on demand and supply analysis
in this context. Market structure also affects pricing decisions, you have seen in previous chapters that
cannot ignore the actions of its rivals, hence, any change in competitor’s strategy
decide on appropriate action. Remember the slash in price of all models by Maruti on the eve of launch
Elasticity of demand of a product also has to be considered in determining price.
Last but not the least, a change in government policy regarding taxation, subsidies and administered
prices would also lead to change in existing prices. The relation between government policies and
sugar under the ambit of stock holding limits imposed on dealers. This decision empowers State and
and is likely to bring down and maintain sugar prices at a reasonable level.
would require reviewing its price. With this understanding in the backdrop, we take you to a detailed
discussion of various
Product Pricing
443
COST BASED PRICING
Under cost plus pricing, price of the product
is the sum of cost plus a profit margin.
of price should be the cost of production with some margin. Hence, the
term cost plus pricing
next obvious question is which
consider total cost, it is a case of cost plus pricing and if we take variable cost based pricing, the term
used is marginal costing.
Cost Plus or Mark up Pricing
Price = AC + m
Pricing or
and determine a mark up, depending upon various considerations such as target rate of return, degree of
competition, price elasticity and availability of substitutes. The price arrived at would, thus, be:
m
…(1)
where m is the percentage of markup. Let us explain the concept further with a small example.
Technologies Pvt. has invested `10 crore in plant and machinery, with a capacity to produce
10,000 units of television per month. Total variable cost is estimated at `
expects a return of 20 percent on total investment. What should be the price of television if we
Solution:
`15 crore
Margin = 20% of 15 = 3 crore.
`18 crore
Price =18,00,00,000/10,000 = `18,000 per television.
break-
used cost plus pricing because it was essentially a seller’s market; however with the onset of economic
444
Managerial Economics
eality
B ites
Capping Margins
Sources: www.pharmabiz.com/ArticleDetails.aspx?aid=92965&sid=3,
http://pharmaceuticals.gov.in/industry-news/pricing,
accessed on
Marginal Cost Pricing
When demand is slack and market is highly competitive, full cost pricing may not be the right choice;
method remains same except that only variable cost is considered
instead of total cost for the purpose of price determination. Marginal
cost pricing is also known as incremental cost pricing. You would
see here that the base price (i.e., cost) is less than in case of full cost
pricing, hence, price would be highly competitive.
Let us extend the previous example of Technologies Pvt. Ltd. to explain marginal pricing.
Undermarginal cost pricing, price of the
product is the sum of variable cost plus a
profit margin.
Determine price of television on basis of marginal pricing:
Solution:
`5 crore
`8 crore
Price = 8,00,00,000/10,000 = `8,000 per television
`6 crore
Price = 6,00,00,000/10,000 = `6,000 per television
Product Pricing
445
Thus, you can see that the highest price by using marginal cost pricing method would be `8000 when
the company charges a margin on variable cost, the price would be further lower, namely `6000.
The only limitation of this method is that it cannot be adopted as a long-term strategy as it ignores the
Target Return Pricing
This is similar to other cost plus pricing methods but with one difference Under target return pricing, a producer
that in other methods the mark up may be decided arbitrarily, whereas rationally decides the minimum rate of
in this method the producer rationally decides the minimum rate of return that the product must earn.
return which must be earned by the product. The methodology of
price determination is the same as the previous ones but for the fact that the margin is decided on the
basis of target rate of return, determined on the company’s experience, consumers’ paying capacity, risk
involved, and similar other factors.
These three methods of pricing can also be understood with the help of an example illustrated below.
Let the demand function of shampoos by Herby Shampoos Pvt. Ltd. be P = 20 – 2Q. The
manager of the company estimates the total cost per month of production to be C
Q–
Q2, where Q represents bottles of shampoo in thousands.
level.
Solution:
P = R(Q) – C(Q) = 4Q – Q2 – 5
dP
= 0,
dQ
d2P
= –2 < 0. fi Q = 2, P = 16.
dQ 2
then it will consider marginal cost:
TR (R) = 20Q – 2Q2
dR
= 0,
dQ
fi
for marginal costing.
d 2R
= –4 < 0.
dQ 2
Q = 5, P = 10.
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Managerial Economics
PRICING BASED
ON
FIRM’S OBJECTIVES
is a complicated process and cannot be directly linked with pricing.
Profit Maximisation
determination of price and hence, will adopt mark up pricing. The above example also shows that the
Sales Maximisation
would have to adopt competitive pricing; one such method could be marginal costing. You can see that
COMPETITION BASED PRICING
been devoted to various market structures categorised on the basis of competition and to determination
of price and output under each category. Thus, you have learnt how perfectly competitive price would
be the lowest and monopoly price would be the highest. You have also gained knowledge of the cases
we shall talk about pricing strategies adopted for entering a new market, as well as for creating hurdles
Penetration Pricing
charge a low price, even lower than the ongoing price. This price is called penetration price. Reliance
was dominated by BSNL. Similarly, Air Deccan had entered the civil aviation market with its low cost
air travel opportunity. Nirma is another example of success of this strategy in entering a market largely
catered by big brands like HLL and P&G. You would be wondering as to how to determine penetration
Product Pricing
447
price? The principles of marginal costing may be used for this purpose. However, this method is also
short term in perspective, and its success largely depends upon the price elasticity of demand of the
product because in the long run ultimately factors other than price may become important.
Entry Deterring Pricing
may be created by a large player to eliminate or reduce competition, by keeping the price low, thus,
making the market unattractive for other players.
Under entry deterring pricing the price
is kept low, thus, making the market
unattractive for other players.
the other hand, existing small players may not be able to survive at this
price due to higher average cost. Thus, this practice is also known as Limit Pricing.
Such pricing is also prevalent in oligopoly markets.
economies of scale
and hence, can afford to charge low price.
When price is high, there is possibility of increase in competition. Let us take you back in time to
clearance, there has been a continuous increase in competition, coupled with attractive price offerings.
it would have acted as a limitation to new entrants. For example, the
Under going rate pricing, most of the
players do not indulge in separate pricing
but prefer to follow the prevailing
market price.
Going Rate Pricing
using the going rate pricing strategy. This strategy is adopted when most of the players do not indulge
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Managerial Economics
prevailing market price. Thirdly, the products sold by the players are very close substitutes, hence, their
cross elasticity is very high.
Going rate pricing strategy is popular in monopolistic and oligopoly markets where product
is mostly adopted when the product has reached maturity and has become generic to the extent that
consumers ask for a good soap or soft tooth brush instead of a particular brand.
PRODUCT LIFE CYCLE BASED PRICING
Every product passes through many stages starting from introduction, going through growth and
maturity and leading to saturation and ultimately reaches decline. Each phase is unique in itself, with
varied features. Moreover, a product faces different demand patterns and competition levels under
different stages; hence there is a need for revising its price as it passes
Product life cycle based pricing refers to
different pricing for a product at different
stages of its lifecycle.
all these stages would amount to less than optimum revenue for the
goods (or services) in their introduction stage. When these goods were introduced their prices were very
and white televisions, cassette players and pagers have reached decline stage, and there are no buyers
for these goods.
The most popular strategies under this category are price skimming, product bundling and perceived
value pricing. Figure 15.1 depicts the various stages of the life cycle of a generic product, say colour
Under price skimming, producers charge a
very high price in the beginning to skim the
market and earn super margins on sales.
introduction stage due to the novelty of the product. This is the stage
and may charge a high price and skim the market by creating high
value perception on account of the novelty factor. Now have a look at the growth stage, the product has
already created its own market. Firms would charge lower price from residual consumer.
When the product reaches its maturity, sellers try to woo the consumers by advertisements, product
bundling, discounts, buyback offers, etc. This is also the stage when elite consumers aspire for some
the segment.
Now that you have a fair idea about the phases, let us discuss the pricing strategy in each of these
phases in detail.
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449
Sales (`)
Sales Revenue
Curve
Decline
Growith
Introduction
Maturity
Saturation
Time
Fig. 15.1 Product Life Cycle Stages
Price Skimming
Producers know that there is a segment of consumers who have deep pockets, and who would like to
latest product. These consumers have very low price
elasticity of demand and are mostly governed by the status symbol factor and not by the intrinsic value
of the product. Hence, producers (or sellers) charge a very high price in the beginning to skim the market
stage, the mark up on cost is normally very high.
lower price for the same product to attract larger number of consumers who have lower paying capacity
consumer surplus is
Price skimming strategy deals with a complete pricing
package suitable for different life cycle stages of a product,
i.e., high price at the time of introduction and lower price
during maturity. Nokia has been successfully using this
strategy for its products. You can experience the impact of
this strategy whenever you buy the ticket of a movie on the
Price
taken away by the seller.
D1
D2
A
P1
settle down pay almost half of what you had paid. Figure
15.2 shows the behaviour of a
Let us continue with the example of movie tickets to
B
P2
D1
O
Q1
Fig. 15.2
Q2
D2
Quantity
Price Skimming Strategy
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Managerial Economics
curve D1D1
movie theatre) charges OP1 price from these viewers. Naturally, there would not be too many of them,
therefore, the total demand at price OP1 is OQ1
price to OP2 and thus, allows others who have a demand curve D2D2 to see the movie at lower rates. This
Total sale of tickets would be equal to the sum of OQ1 and OQ2 and Total Revenue (TR) is equal to the
sum of areas OP1AQ1 and OP2BQ2
Product Bundling (or Packaging)
as a double edged weapon, for propagating a new product, as well as for selling a product in its stage
Under product bundling two or more
products are bundled together for a single
price.
during growth and maturity. When a product is new and needs to be
popularised, sellers adopt packaging of various products together and
charge one price for the same. This method has several advantages:
consumer gets the satisfaction of the additional good (or service) at no extra cost. This strategy may also
be adopted gainfully during the maturity stage, when the product starts losing its attraction of novelty
and its demand starts falling. A packaged product helps regain customers in this phase. For example, a
tourist agency would charge only airfare for a holiday destination which would include hotel stay, sight
in ticket. Most hotels provide free breakfast or drinks as part of room tariff.
eality
B ites
Bundling at Big Bazaar
`
`
`
Sources:
http://economictimes.indiatimes.com/industry/services/retail/big-bazaar-outlets-to-launch-eight-day-discount-
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451
Perceived Value Pricing
goods for different consumers depends upon their perception of utility
of the good. Therefore, the price a consumer is willing to pay would
According to perceived value pricing, value
of goods for different consumers depends
upon their perception of utility of the good.
that higher the price, better the quality; hence they would be willing
Psychological Pricing. Smart sellers
identify the perceived value of the good on the basis of their knowledge of market forces and charge a
price commensurate with the perceived value. Thus, they can take away consumer surplus to the extent
of their understanding of the perceived value of consumers. An interesting aspect of this method is that
the consumers.
Perceived value pricing is normally adopted during the growth and maturity stage so as to differentiate
the product from that of competitors’ and retain the quality conscious customers. Titan watches, Philips
to perceived value pricing by creating hype about high quality. Here the price of the good is not at all
governed by the cost of production.
eality
B ites
The Timeless Titan
`
`
`
`
`
452
Managerial Economics
Value Pricing
A variant of perceived value pricing is value pricing, in which sellers try to create a high value of
the product but keep the price low. The assumption is that price should represent value for money to
consumers, in other words, the price charged should be lower than
perceived value of product for the consumers. Thus, in this method of Under value pricing sellers try to create
a high value of the product and charge a
pricing the seller allows some consumer surplus to the buyer. This is low price.
a strategy suitable for the maturity and saturation stage when demand
can be maintained by keeping focus on higher quality and lower cost. Koutons brand of men’s wear is
a very good example of this strategy. They keep the price tag high to create brand perception and then
allow heavy discounts to bring the price at a very low level. Thus, the customer gets the satisfaction of
buying a big brand at the price of regional brands. This becomes possible due to large scale of production
and operations.
Loss Leader Pricing
An interesting strategy adopted by companies which produce and/or sell multiple products is to sell one
product at a low price and compensate the loss by other products. The assumption is that buyers would
Under loss leader pricing multi-product
firms sell one product at a low price and
compensate the loss by other products.
this strategy largely depends upon a combination of goods which are
complementary in nature and one product cannot be utilised without
the other product. There can be numerous such examples: pen and ink,
printer and cartridge, photocopier and toner, etc.
printer and photocopier) and high price for the product which is consumable and has low value and hence,
has recurring demand (say ink, cartridge and toner). HP has resorted to such practice as it charges low price
high priced. Thus, the printer is the loss leader, whereas the cartridge compensates for the loss.
Here one thing should be kept in mind that the term loss leader does not necessarily mean loss on cost of
production of the good but sometimes loss may be in terms of margin, which could otherwise be earned.
CYCLICAL PRICING
recession of economic activities. Economic conditions do not remain stable over a long period of time
as economies pass through stages of expansion and recession. These ups and downs when represented
in a graph create wave like movements; hence they are referred to as business cycles or trade cycles. You
Rigid pricing suggests that firms should
follow a stable pricing policy irrespective of
the phase of the economic cycle.
will encourage more production of these goods hence employment
will increase, income will increase and thus, demand for other goods
will also increase. The reverse of this happens during recession.
Product Pricing
453
phase of business cycle, or should they adopt different strategies across the phases? So far there is no
satisfactory answer to this critical question. However some attempts have been made to identify pricing
strategies at each phase.
Rigid Pricing
According to this approach, companies should follow a stable pricing policy irrespective of the phase
of the economic cycle. The argument in favour of this approach is that be it a recession or expansion,
reduces its price during recession to attract demand, consumers may wait for further fall in price as they
can postpone their purchase. This is what happens in case of
would not eat less if there is recession nor would they eat more if their income rises. The same argument
has never helped in meeting the issues of recession, instead she had insisted that emphasis should be on
costing and quality.
eality
B ites
The Rigid Apple
Sources:
http://www.zdnet.com/article/apples-enterprise-push-will-depend-on-more-than-just-hard-
Flexible Pricing
during recession prices should also be reduced in view of the declining Under flexible pricing, firms keep their
prices flexible to meet the challenges of
income (or paying capacity) of consumers, whereas when income change in demand.
rises prices can also be raised to take advantage of higher demand,
especially in case of agricultural goods which have a less elastic supply curve.
basis of impact of business cycles on the demand for its product.
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Managerial Economics
MULTI-PRODUCT PRICING
So far we have been talking as if producers (or sellers) are producing (or selling) independent products.
produces intermediary goods again has three options: it may either use these goods entirely internally for
intermediary goods for own use as
Here you should note that we shall not talk about those multi-product companies which are producing
unrelated goods. Let us give an example to clarify this point. Tata Sons produces goods (and services)
There can be three types of
interdependence between products:
● demand interdependence
● supply interdependence
● input output relationship
neither have demand interdependence nor supply interdependence.
The reason is that although all of these goods (and services) are
produced by one company, but their production is independent of each
other. Hence, pricing strategies of only those
which produce goods with some kind of interdependence is important
where steel is used as input; thus, pricing of these two goods is interdependent.
understand the possible relationships among the products of the same company. The interdependence
and (3) input output relationship. Now we shall help you learn the pricing strategies of companies dealing
in products with some kind of interdependence, but before that a look at nature of interdependence will
be useful.
1. Demand Interdependence
and Alto K10) or
Product Pricing
●
455
substitutes, the optimal output for each good would be less than when there was no
demand interdependence. The reason is obvious, since these goods compete with each other in the
cannot sell maximum of either of these products. Similarly, if price of one commodity is increased
it will push its customers to the substitute (remember the substitution effect in demand analysis).
Hence, the seller must treat its own products on the same pattern as those of competitors. Such a
of perceived value pricing as in case of Surf Excel (premium segment) and Surf (economy
●
it is very common to publish newspapers in two or more languages. For example, HT Media
Ltd. publishes Hindustan Times in English and Hindustan in Hindi. These two versions have
different market segments but still are substitutes; hence while pricing the two versions company
going rate or
combination of cost based pricing strategies.
complements, an increase in demand for one product increases demand for the other as
well; therefore optimal output is greater than when there was no demand interdependence. Here
an increase in price of one good would result in fall in demand of both the goods. For example,
be either product bundling or loss leader
conditions.
2. Supply (or Production) Interdependence
full costing
for the primary product and marginal costing for the joint product. Alternatively, for the primary product
it can adopt any of the other pricing strategies depending upon the market structure or life cycle stages
of the product.
Another case of production interdependence is when the same equipments and technology are used
stable. These are produced with the same plant and machinery; overheads are distributed and the same
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Managerial Economics
strategies by categorising its own products under different segments on the basis of the stage of product
life cycle, consumers’ perceived value, distribution of costs, and so on.
Kadimbini and Nandan. All of these products have some common costs (like
products as per demand supply conditions.
Ramsay pricing, discussed ahead in the chapter.
3. Input Output Relationship
each other. There may be the case when a company undertakes all the stages of production involved
produces iron and steel; it also manufactures cars, trucks and other vehicles. Steel is produced in a
input output relationship; pricing in this case is called transfer pricing, which is explained separately in
the following section.
Ramsay Pricing
According to Ramsay pricing, price
deviations from marginal cost should be
inversely proportional to price elasticity of
the product.
Economist Frank Ramsay gave a model for taxation which became
that the government should levy high tax on the goods which had
low price elasticity (because a large increase in price would bring
a small decrease in demand) and low tax on goods which had high
price elasticity.
equal to marginal cost for all its products then how would
the total cost be recovered? Answer to this question is found in Ramsay pricing, according to which,
should charge substantial margins for the product with low elasticity. Stated otherwise, price deviations
from marginal cost should be inversely proportional to price elasticity of the product.
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457
Transfer Pricing
company to which it is related as its subsidiary or sister concern.
where one product is an intermediary for the other, i.e., it is vertically
Transfer prices are the charges made when
a company supplies goods, services or
financials to its subsidiary or sister concern.
called transfer pricing.
Transfer pricing is used in large organisations for transaction between various divisions, i.e., internal
pricing as opposed to external market. These divisions are semi-autonomous as far as governance is
concerned.
company to subsidiary or from one subsidiary to another and most often these units are in different
rights from the parent to a subsidiary or from one subsidiary to another. The price of goods etc.,
pricing so that corporates may not evade tax payments.
Transfer pricing helps related entities to reduce global incidence of tax by transferring higher income
other hand in a high tax country they earn less and pay less tax. However, governments of different
countries do not appreciate that companies manage to transfer income from their country to another
country through this mechanism. Hence, strict regulations have been made against manipulated transfer
prices. Table 15.1 shows the chronology of transfer price regulations in different countries.
Table 15.1
International Regulations on Transfer Pricing
USA
Australia
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Managerial Economics
Table 15.1 clearly shows that all the countries
have taken cognisance of the need for transfer
pricing regulations around the same time as the
inception of
that the transfer prices should be fixed at
‘arm’s length price’, that is, the same price
should be charged whether the product is
transacted between related parties or with a
Parent
Transfer
Price
Subsidiary
Fig. 15.3
=
Arm’s Length
Price
Unrelated
Transfer Pricing
charged a transfer price different from the price they charge from an independent customer,
i.e., if different from ‘arm’s length price’. Figure 15.3 elaborates the implication of ‘arm’s
length price’.
Problem arises when there is no unrelated customer and the product is only transacted between
‘comparable uncontrolled price method’, ‘resale price method’, ‘cost plus method’ and ‘transactional
net margin method’.
The transfer pricing law requires that a company should submit details of its own transactions with
this is that comparable information of this nature from unlisted companies is not available in the public
of inadequacy of databases, most enterprises adopt the transactional net margin method to determine
controlled transaction is compared with the net margin it makes from an uncontrolled one.
involved in transfer pricing.
PEAK LOAD PRICING
Under peak load pricing, different prices
are charged for the same facility used
at different points of time by the same
consumers.
This is a kind of price discrimination in which consumers are
segregated on the basis of time segments; different prices are charged
for the same facility used at different points of time by the same
Product Pricing
459
peak load and off peak load, consumers using the product at
peak load time pay a higher price (say, mark up price) and users at off peak period pay a lower price
(say, incremental pricing).
You would agree that this strategy can be adopted when the product is used at different time periods
and the various segments of consumers have different demand characteristics. For long BSNL had used
differential pricing on long distance calls for different times of the day. You would recall that during
working hours (from 9 am to 6 pm) phone tariff was much higher than in evening and night hours. This
could not be postponed, i.e., calls which had to be made during peak load time. There can be numerous
other examples of such pricing. Airlines provide various discounts on tickets purchased at different
points of time; consumer durables industry extensively uses this strategy by providing off season
discount to encourage purchase of air conditioners, refrigerators, etc., during winter, which is normally
a bleak period for these goods.
SURGE PRICING
surge pricing. At the onset we would
like you to recall two pricing decisions discussed in previous sections, i.e., discriminatory pricing and
as that used in peak period pricing. That is, increasing prices during periods of peak demand to bring
and peak load pricing are variants of dynamic pricing. However, it is important to understand that the
periods of time without any change. Moreover, price differentials themselves are also set in advance
changes many times a day depending upon demand-supply situations. Advent of technology has enabled
companies to process large amounts of data and information at an aggregate level quickly and react to it
on the ground, making surge not only a possibility, but also much more responsive to actual situations,
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Managerial Economics
eality
B ites
Uber’s Surge Pricing
“Uber rates
increase to ensure reliability when demand cannot be met by the number of drivers on the road”.
Sources:
html
elasticity of demand on price and revenue. You have already understood that the producer/seller charges
high price when price elasticity is low and reduces the price when price elasticity for a commodity is
different hours of the day especially resulting from demand supply gap. For example, you need a taxi at
midnight, when availability of taxis is low. You would be willing to pay much higher price than the day
pricing for premium trains but so far the results are not promising. A communiqué has even said that
Railways might reconsider the use of surge pricing.
Having said this, you should understand that surge pricing may not be used effectively in all conditions
and for all products, which is why it has to be seen only with reference to price elasticity of demand for
consumption schedule where they can defer their consumption till prices are normal or low. They can
also switch over to a competitor product when price difference between the two products reduces due
to surge pricing. For example, when passengers have faced surge pricing by railway they preferred air
travel due to reduced price difference.
SEALED BID PRICING STRATEGY
There is a separate market in which the buyer does not prefer an open market price but demands that the
sellers provide their rates in sealed form, commonly known as tenders.
their offer under sealed cover. This may be considered as a case of limited monopsony.
Product Pricing
461
is a relative term; hence there is no certainty of getting the order of supply. To take on sealed bid pricing
lower rate. Normally mark up strategy is adopted for deciding the price, but how much margin should be
very low price and gets the order but is not able to execute the same because the price was unrealistically
low. Therefore a very good understanding of all aspects of the order is must for succeeding in this type
of pricing condition. All the works in government departments including construction, procurement of
for large variety of purposes and thus, is the largest single buyer in the country.
RETAIL PRICING
Marketing channel categorically consists of at least two sections: wholesalers and retailers. These two
would normally have different pricing considerations because they face different market conditions.
There are various stages in determining retail price:
determination by the producer);
(ii) The product then goes to the wholesaler, who is allowed some commission on the company price;
(iii) Finally the retailer gets the product and charges a price that includes its own commission as well.
Thus, it is the retail price that is actually paid by consumers.
Under EDLP a low price is charged
throughout the year and none or very
few special discounts are given on special
occasions.
upper limit known as MRP (Maximum Retail Price), which consists
of the retailer’s commission; hence it has a limited choice to decide
on the price. However, there is large number of other items such as
groceries, where a retailer has a wide choice of charging any price. Here mostly the rules of monopolistic
competition apply. Some of the popular techniques followed are discussed in this section.
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Managerial Economics
Every Day Low Pricing (EDLP) Strategy
As per EDLP, a low price is charged throughout the year and none or very few special discounts are
strategy and has emerged quite successful.
High-Low Pricing
This method involves high prices on a regular basis, coupled with temporary (or occasional) discounts
but on discount days it is lower than EDLP. Thus, on these days the retailer snatches the customers from
cannot afford every day low pricing. An announcement by Tanishq, a leading brand, offering discount
Value Pricing
This method has been discussed earlier in detail, but is being referred to here again to highlight that some
retail stores also adopt this method of pricing.
ADMINISTERED PRICING
The term administered prices initially related to prices charged by a monopolist and therefore, determined
by considerations other than marginal cost. However, now the term is used for prices which are statutorily
determined by the government. The government as a measure of social
Administered prices are those that are
statutorily determined by the government.
available to all the sections of consumers and producers, irrespective
administered pricing. These include petroleum products, sugarcane, steel, fertilisers and coal.
and operations and hence, fails to absorb any increase in cost which results in loss to the producer. For
control on pricing.
EXPORT PRICING
We all know that markets are not limited to the boundary of one country. Every country engages in
international trade whereby goods are bought and sold to people (or companies) of other nations, i.e.,
the domestic market are known and predictable and the medium of exchange (one currency) is stable;
Product Pricing
463
whereas in foreign market the demand function is unknown and competition is unpredictable plus the
exchange rate determination are beyond the scope of this book; hence readers are advised to refer to
collect information about the income level, taste and preferences of the consumers of the country(s) to
in the same market. Remember that these sellers may come from various countries, and so it is not an
easy task to identify them. Finally, the seller should also know the exchange rate between the home
currency and the foreign currency. Price may be determined by any of the methods discussed above as
custom duties on the product as admissible. Tariffs make the product more costly for the target market
the players, irrespective of the country of origin.
INTERNATIONAL PRICE DISCRIMINATION
AND
DUMPING
because the market conditions are not similar. The international price is either higher than domestic price
or lower, depending upon market forces. At the same time, companies
may charge different prices in different countries using discriminatory Dumping is a strategy adopted by a country
of that particular country’s paying capacity and price elasticity of
where a product is exported in bulk to a
foreign country at a price which is either
below the domestic market price, or below
the marginal cost of production.
which is a strategy adopted by a country where the product is exported
in bulk to a foreign country at a price which is either below the domestic market price, or below the
marginal cost of production. As such it is a kind of predatory pricing which is aimed at gaining monopoly
in a foreign country or at disposing of excess inventory in order to avoid reduction in home price and
thereby help in reduction in producers’ income. Dumping is often referred to a pricing which is below the
fair value of the product.
counteract such a policy if the affected country can prove that dumping has taken place and is harming
antidumping measures, ranked third after Turkey.
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Managerial Economics
eality
B ites
The US Dumping Duty Math Fails WTO Test
investigation against imports of a consumer good item, including imports of dry cell batteries, sports
Antidumping and Allied Duties. The case against toys was dismissed after initiation.
SUMMARY
◆
Price denotes two aspects: it is revenue to the seller, and it is the perceived value of the good (or
◆
Pricing decisions are equally important for a new product and an existing product, for entering
◆
policy, etc.
Among the various pricing strategies cost plus pricing is one in which price of the product is the
pricing, a producer rationally decides the minimum rate of return that the product must earn.
◆
◆
◆
cost of production for determination of price and hence, will adopt mark up pricing. Those which
maximise sales would adopt competitive pricing like marginal costing.
When a new entrant charges a low price, in a new market dominated by existing players, the price
market unattractive for other players.
Going rate pricing strategy is adopted when most of the players do not indulge in separate pricing
but follow the prevailing market price.
Product Pricing
◆
465
Product life cycle based pricing refers to different pricing for a product at different stages of
maturity, two or more products are bundled together for a single price.
◆
price and compensate the loss by other products.
◆
of change in demand.
◆
another company to which it is related as its subsidiary or sister concern.
◆
sealed cover.
◆
◆
or very few special discounts on special occasions; High-Low pricing involves high prices on a
regular basis, coupled with temporary (or occasional) discounts as promotional activity.
Administered prices are statutorily determined by the government on commodities like petroleum
products, sugarcane, steel, fertilisers and coal.
◆
◆
also identify all the competitors who supply the same product in the same market.
Dumping is a strategy adopted by a country where a product is exported in bulk to a foreign
country at a price which is either below the domestic market price, or below the marginal cost
of production.
KEY CONCEPTS
Multi-product Pricing
Export Pricing
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Managerial Economics
QUESTIONS
Objective Type
I. State True or False
i. Dumping is often referred to as a pricing which is less than the fair value of the product.
elasticity.
iii. Rigid pricing is in favour of agricultural products.
iv. When a product is in its introduction stage, the mark up on cost is normally very high.
vi. Price skimming is third degree of price discrimination.
viii. Perceived value pricing is usually adopted in the introduction phase of a product.
II. Fill in the Blanks
_______ the optimal output is greater than when there was no demand interdependence.
iii. Marketing channel categorically consists of at least two sections _________and retailers.
iv. Dumping is a kind of ______pricing.
vi. Marginal costing may be used to determine the level of _______ price.
viii. Loss leader refers to loss on cost of production and also on _______.
x. Entry determining pricing is also known as _______ pricing.
III. Pick the Correct Option
a. Price skimming
b. Product bundling
a. Transfer pricing
c. Product bundling
b. Going rate
d. Full costing
b. The retailer can avail economies of scale
c. The retailer has very low overhead expenses
d. The retailer has very high overhead expenses
Product Pricing
467
iv. When demand is slack and market is highly competitive, the following method of pricing may
be adopted:
a. Full cost pricing
b. Peak load pricing
c. Marginal cost pricing
d. Penetration pricing
v. The transfer pricing law requires that a company should submit:
a. Details of transactions with related parties b. Sealed bid
c. Tariff and custom duties on the product
d. Mark up on the cost of production
a. Peak load pricing
b. Sealed bid pricing
c. Ramsay pricing
d. Transfer pricing
vii. Which of the following pricing strategies may be adopted for agricultural products:
a. Loss leader pricing
b. Rigid pricing
c. Multi-product pricing
d. Flexible pricing
viii. Which of the following is an example of product bundling:
a. Printer and computer
b. Jewellery and watches
d. Pen and paper
ix. As per Ramsay pricing, price deviation from marginal cost should be inversely proportional to:
c. Price elasticity of demand
d. Promotional elasticity of demand
a. Paying capacity of buyers
c. Experience of the company
b. Risk involved
d. Experience of the rival companies
Analytical Corner
How?
2. Are you in favour of dumping? Why or why not? Draw your conclusions on basis of recent cases
used by each:
i. Shoppers Stop
iii. Pantaloon
4. You are working for a large automobile manufacturer who is facing low sales in recent past. You
have been asked to design a pricing strategy for such situation. What will you do?
or not? Explain.
6. ‘Price discrimination is not limited to domestic market but spread over international markets’. Do
you agree with this or not?
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Managerial Economics
Therefore, all prices should be left to market forces’. Discuss.
9. While working for a computer manufacturing company you have developed a software for supply
chain management. The company has agreed to market the product, which pricing strategy would
be most suitable and why?
durable good.
based pricing.
12. What is ‘transfer pricing’? Why do governments make regulations to monitor transfer pricing
13. Discuss the following:
i. Arm’s length price
ii. Perceived value price
under retail market?
P = 10 – 2Q and cost function as C
Q
2
Check Your Answers
State True or False
i. T
ii. F
iii. F
iv. T
v. F
vi. F
vii. T
viii. F
ix. F
x. T
Fill in the Blanks
i. complements
vi. penetration
ii. reduce
vii. mark-up
iii. wholesalers
viii. margin
iv. predatory
ix. marginal
v. durable
x. limit
vii. d
ix. c
Pick the Correct Option
i. c
ii. b
iii. d
iv. c
Analytical Corner
15. i. Q = 1, P = 8, ii. Q = 2.5, P = 5
v. a
vi. b
viii. c
x. d
Q
Product Pricing
469
Caselet 1
Multiplex Pricing
or a holiday are charged the maximum, while during weekdays, when prices are kept lower, the
risk of broadening their network to the non-metros. But the game in non-metros is slightly different
to their affordability factor, taste and preferences. During weekdays, the prices of tickets vary from
`150–`200 in the metros and soar up during the weekends making the tickets available at `200–`250.
The morning shows are priced at `60.00, `80.00 or `100.00 attracting the school and college folk.
The price of tickets in non-metros varies from `80.00 to `
these towns would not have the capacity to pay upwards of `100 for a ticket, hence, we have entered
Source:
pp. 41–46.
Case Questions
1. What type of pricing strategy do you see in case of multiplexes? Evaluate on the basis of various
pricing categories.
Caselet 2
India the Dump-yard for China
order to protect domestic manufacturers from cheap in-bound shipments. This measure follows
recommendation by the Directorate General of Antidumping and Allied Duties (DGAD) that steel
antidumping duty equivalent to the difference between landed value of steel products and $499 per
other producers, antidumping duty would be the difference between landed value and $538 per tonne.
470
Managerial Economics
Sources:
,
http://www.business-standard.com/article/markets/anti-dumping-duty-imposed-on-chinese-steel,
Case Questions
1. How does dumping affect domestic business?
Caselet 3
From Xiaomi to Mi
are price sensitive and hence, they launched Mi3 having features similar to Nexus 5 of Google at
a price of `
off the shelves within minutes and seconds.
Source:
http://eminencejournal.com/images/pdf/MA4.pdf
Case Question
Indian Railways: Surging Ahead or Backwards?
in September 2016. The underlying formula is that, fares would increase by 10 percent with every 10
percent of the tickets sold in these premium trains, translating into a fare hike of up to 50 percent. The
Product Pricing
471
`1,000 crore every year through this scheme.
2016 had declined by `232 crore as compared to the previous year. Analysts expect that returns for
Express were vacant during December and January, occupancy being hit by 15 to 20 percent.
Some experts refuse to consider this fare system as a type of surge pricing on the ground that surge
back to its original level, which, however, is not the case with railways.
is much cheaper, with airline companies offering tickets to destinations like Goa, Kochi and Mumbai at
prices as low as `
compared with train tickets under the system.
Shatabdi trains, Ministry of Railways has sought a review of the scheme, in order to make it more
passenger-friendly. The review exercise has highlighted that revenue of Railways has increased at the
last-minute passengers.
Sources:
,
Posers
Chapter
16
2. Explain the nuances of determination of wage and backward bending supply curve
of labour.
3. Understand the determination of rent and interest.
4. Illustrate the different theories of profit.
Chapter Objectives
1. Introduce different factors of production and their pricing.
INTRODUCTION
In the previous chapter, you have read about pricing of products in detail and you must have developed
a fair idea about how the price of a product is determined under different conditions. So far you have
factor inputs
return households provide factor inputs. You would learn more about this in Chapter 18. Here you should
understand that as there is a
of inputs which minimises its cost. Input pricing bears resemblance with commodity pricing; therefore
demand and supply. In Chapter 8, you have seen that production is the process of converting inputs into
Input Pricing
473
output; you have also read about the different types of these inputs, their characteristics, and how can
labour are termed as wages
to land as rent and to entrepreneurship as
.
capital as interest,
the determinants of demand and supply of each. However, essentially demand for factors of production
is a
price of human resource, capital and funds, land and building, and last but not the least, return to the
entrepreneur. So here we introduce you to factor pricing, so as to help you understand business decisions
their relationship with each other. In fact, entrepreneur employs all the factors of production, i.e., the
land to produce something of value, and thus pays wages to the labour, interest to the capital owner and
WAGES
Benham
is the basic difference between wages and all other input prices; wages are the remuneration to a person
474
Managerial Economics
Wages are remuneration to a person who
works for someone else; they may be paid
on the basis of hours, days, months, or
even year.
to man hours. Wages may be paid on basis of hours, days, months, or
even year. You may note that the modern system of mentioning salary
annual package.
for the purpose of payment.
wages are price of labour. You should understand that in economic
Labour has derived demand.
ultimately by the forces of demand and supply. Now we have to see what determines the demand for
labour and supply of labour.
labour cannot be ignored.
iii. Its demand depends upon the goods it can produce, i.e., it has derived demand.
from mere subsistence theory and standard of living theory to broader aspects of human resource
management, and wages and salary are now clubbed as compensation. We shall discuss here the most
prominent among these theories, namely the marginal productivity theory. We would also try to capture
Wage and Salary
Wage refers to payment to unskilled labour,
while salary is payment to skilled labour.
You must have noticed that we are using two terms, wage and salary,
wage and salary, by putting wage as the price of labour and salary as
Input Pricing
Wage usually refers to payment to
475
salary is a
payment to
you would be remunerated with salary. We would, however, use the two terms interchangeably. Most
eality
B ites
Compensation: the Mixed Bag
A compensation package is considered to be the most visible expression of the employment
relationships in any organisation. Compensation is the remuneration employees receive in return for
salary, which is the price paid for contribution made by labour (human resource). Same terminology is
used in accounting, i.e., wages for direct labour and salary for indirect labour. Now an obvious question
may arise that why ‘compensation’ is used as an expression for payments made to labour and why
not wage and salary?
terms like wage and salary are narrower in purview, compensation provides a wider spectrum of all
types of payments (monetary, non-monetary, tangible, intangible, direct and indirect) made for the value
important for purchasing power of an employee. However, compensation goes beyond this, as it affects
a person economically, sociologically and psychologically. It also compensates for the opportunity cost
Demand for Labour
Demand for labour is dependent principally
upon its price, types of goods that are in
demand, and required skill sets which
determine the quality of labour.
wage determination is the marginal
marginal productivity of labour as the single most important factor.
demand will naturally be determined by the goods it can produce. Hence, which type of labour would be
other important determinants of labour demand.
476
Managerial Economics
Supply of Labour
Supply of labour
Supply of labour would be
governed by the prevailing wage rate in the
market and preference of labour for leisure.
preference of labour for
earn to meet their needs, which may include basic necessities of food,
clothing and shelter, education, and health and entertainment of self and dependents. It would, thus, be
supply of labour. Due to this, the supply curve of labour is not normally upward sloping, but is backward
bending
determinant of supply of
portion SP of the curve is the normal supply curve; on this
is shown by the portion PS1 of the labour supply curve. You must
substitution effect”. When wage rate
reaches a very high level, people would choose to reduce their
income effect” of a
Fig. 16.1 Supply Curve for Labour
Putting the two effects together, we can infer that once wage
Supply curve of labour is backward
bending.
wage rate; beyond a certain point, he would reverse this behaviour,
S1S slopes upwards till wage rate w*; the segment SP of the
curve is upward sloping. If wage increases beyond w
PS1 of
the curve has a negative slope. It shows that beyond w
prefer more hours of leisure.
Marginal Productivity Theory
One of the most prominent of neo-classical theories, the marginal productivity theory is most widely
associated with
Marshall, Jevons and
The marginal productivity theory
postulates that demand for labour is
determined by the value of output of an
additional worker.
is basically developed as a theory of distribution, and can be applied
to any factor of production, although it has been most prominently
used to describe determination of wages. It rests on the assumptions
of employers.
477
Input Pricing
than the marginal productivity of the factor. Due to perfect competition, no factor input would be willing
MRPL
MPL
MRQ
I
MRPL =
referred to as the
value of
∂R
∂Q ∂ R
¥
=
= MPL ¥ MRQ
∂L
∂ L ∂Q
VMP
VMPL
In a perfectly competitive market, the
optimal level of labour used will be
determined by VMPL = MRPL.
VMPL = MPL ¥ PQ
where PQ is the price of the product.
PQ = MRQ
VMPL = MRPL
If we assume w to be the price of labour, when w is less than MRPL
w
w is more than MRPL
of employment will be attained only when w
MRPL.
It would be an incomplete discussion on the marginal productivity theory if we do not highlight its
discuss some of the other theories of wages now.
478
Managerial Economics
Bargaining Theory of Wages
set with a number of different assumptions, i.e., there are two parties, labour and employer and both have
in a game theory problem.
Efficiency Wage Hypothesis
holistic view of wages.
eality
B ites
Trends in Compensation
Annual salary increase is expected to be between 6 to 15 percent across all sectors overall in 2017,
while average is expected to be around 9.5 percent, as per an estimate. Startups are likely to offer a 10
company could be higher with the inclusion of stocks. Switching between similar organisations brings
a 15 to 25 percent increase, depending on seniority level. For an average performer, this year the hike
is going to be one of the lowest, just as for top performers it would be among the highest. For over a
decade, India has been leading the average salary increase percentage, followed closely by China
and Philippines. In developed nations, average salary increases have been in the range of 2–4 percent
in compensation has been projected by the Banking and Financial Services sector, while the Energy
Sector projected the minimum decrease. Average variable pay projection has increased from 15 percent in 2016–17 to 15.4 percent in 2017–18, indicating that organisations are shifting towards paying
for performance. Banking and Financial Services reported the highest variable pay component.
accessed on 15/08/2017.
accessed on 15/08/2017.
accessed on 15/08/2017.
Input Pricing
479
INTEREST
Marshall
Entrepreneurs need capital for investment, and for this they have Interest is the price which the borrower of
to borrow money from others and pay interest to the capital owner. capital has to pay to the lender of capital.
Normally, interest is shown as percentage return on capital borrowed
and is referred to as rate of interest. It will be worthwhile to elucidate, at this point, on two important
terms related to interest, namely gross and net interest. Gross interest is the payment made to the creditor
for using its funds. It would include
payment made for using the services of only the capital borrowed.
savings as there are people who do not want to spend
converted into capital and the owner of savings earns interest as a return for parting away from savings
Time Preference Theory
consumption in preference to
deferred consumption. Suppose you have `
whole amount today with friends, or spend a part of it today with
Your decision will depend upon how much you value your present
As per time preference theory, if an
individual reduces present expenditure,
he/she should get more compensation for
future expenses as interest.
i. Higher preference to present consumption than future consumption.
ii. Uncertainty attached to future, higher the uncertainty greater the preference for present.
480
Managerial Economics
Loanable Funds Theory
Loanable funds are demanded by firms for
investment, by households for consumption
and hoarding, and by governments to
finance their expenditure.
Loanable funds theory is the neo-classical theory of interest, developed
by
for the use of capital and it depends on the demand for and supply of
funds is normal downward sloping, implying that the higher the rate of interest, the lesser would be the
ii. savings of households
iii. dishoarding by way of offering past accumulated saving and idle cash balances
According to the loanable funds theory,
rate of interest is the price paid for the use
of capital and it depends on the demand
for and supply of loanable funds.
Liquidity Preference Theory
theory by
Motive for holding money to bridge the
time gap between receipts and payment is
transactions motive.
or compensation would be in the form of interest.
i. Transaction Motive:
though they receive money income at intervals, e.g., you receive your salary on a particular date,
Input Pricing
481
ii. Precautionary Motive:
but not on interest.
iii. Speculative Motive:
on the basis of such estimation, they can decide about the amount of money to hold in the form of idle
cash balance. Let us clarify this further. When the price of bonds falls, the attraction of holding them
r
high, and demand for cash is less. Consider the converse case, in
which the present value of bond is high; an individual would buy less
Speculative demand for money depends
inversely on expectation about the rate of
interest of bonds.
the preference for cash.
speculative demand for money
demand for money bears an inverse relation with rate of
r is high, individuals would
hold less money, and when r is low, they would be motivated
to hold more money. On this basis, the demand for money,
When rate of interest rises from r1 to r
demanded of money falls from M1 to M
Interest
bonds; the higher the rate of interest, the lesser would be the
demand for cash balance, and vice versa.
L
r2
r1
O
Fig. 16.2
M2
L
M1 Quantity of money
Demand Curve for Money
eality
B ites
Sources of Liquidity
can always raise cash by pledging their future earnings in return. Both funding and market liquidity
from the capital market by selling bonds or shares to savers.
482
Managerial Economics
Determination of Interest
Rate of interest is determined by demand and supply in a competitive situation, at the intersection
of demand and supply curves of money. You have already seen that the demand curve for money is
downward sloping. Now, the supply of money is given by monetary authorities; hence supply of money
Fig. 16.3
Demand Curve for Money
Fig. 16.4
Equilibrium Rate of Interest
E
r* is the
L1L1
r1. Consider
LL
would now fall to r .
RENT
demand. Rent or economic rent is the payment made for use of any
factor of production. In common parlance, rent is the income earned
by landowners from the users of land, it is also called contract rent. In
surplus, i.e., the amount a factor of production earns over
and above the minimum amount it needs to remain engaged in its present occupation. In fact, economic
Rent (or economic rent) is the payment
made for use of any factor of production.
payment for own services.
Input Pricing
483
Rent occurs only when the factor of production has less than perfectly elastic demand, because under
therefore, return for
any use of land is called a rent.
are also believed to be earning rent as their supply is practically inelastic.
Ricardian Theory of Rent
rent owes its origin to the high price of corn in England; it was argued that corn was priced high because
of high rent of land charged by landlords to the farmers, who were, thus, compelled to sell corn at high
David Ricardo, who attributed it as the payment made for
of rent by introducing different types of land on the basis of fertility, assuming that the total supply of
land; no rent would accrue to this plot at the beginning. However, when demand for corn increased, this
goes on increasing, more and more infertile land is brought under cultivation, and the more fertile land
d
eality
B ites
The Reality of Real Estate
th
position in JLL’s 2016 bi-annual Global Real Estate
Foreign Direct Investment (FDI) regime, because of which India is now more attractive to both global
(
)
484
Managerial Economics
and Indian investors. According to National Housing Bank (NHB), out of 50 cities which are monitored,
27 have witnessed improvement in prices in the quarter ending March 2017 as against that of December
where prices rose included Mumbai, Gurgaon, Chandigarh, Kanpur and Bhubaneshwar, while Noida,
and Kolkata saw major drop in prices.
Shri Venkaiah Naidu, (then) Minister for Housing and Urban Affairs, said while releasing the
is a major constraint in rapid expansion of affordable housing, the
has planned to bring
important in context of low-rent housing for accommodating migrant population, but without creating
slums. Affordable housing would get the much-coveted infrastructure status. One crore houses are
help bring land prices down.
accessed on 15/08/2017.
accessed on 15/08/2017.
accessed on 15/08/2017.
the product is assumed to be given, hence AR = MR
which is greater than PBBEBRB
Fig. 16.5 Ricardian Theory of Rent
PBAEARA,
Input Pricing
485
Modern Theory of Rent
With passage of time, the Ricardian concept of rent has been
Modern theory of
rent encompasses all factors of production, including land, and has
According to the modern theory of rent,
economic rent is the amount an input earns
over and above its transfer earnings.
earnings. If we assume that an input can be put into more than one uses, then the amount of money that
that this transfer earning is the minimum amount that must be paid in the form of return to a factor, in
input is the amount it earns over and above its transfer earnings. If it earns any less than this minimum
economic rent.
Quasi Rent
introduced by
perfectly inelastic supply in the short run, but elastic supply in the long
Quasi rent is rent earned by a factor when
there is a sudden increase in its demand.
rent. It refers to the entire income earned by a factor when there is a sudden increase in the demand of
capital cannot be increased in the short run to meet the increased demand for capital. Needless to say,
rent accrues to other factors of production, the supply of which can be increased in the long run.
PROFIT
responsible for bringing together all the different inputs and organise them to generate desirable outputs.
we mean by uncertainty
486
Managerial Economics
supernormal
and describes the opportunity cost of time and resources applied by entrepreneur; whereas supernormal
Normal profits are referred to as the
opportunity cost of entrepreneurs.
eality
B ites
Accounting for nearly 7 percent of India’s Gross Domestic Product (GDP) and employing around 19
million people, the Indian auto-components industry has been experiencing healthy signs over the last
responsible for such performance include improved consumer sentiments with increased purchasing
Original Equipment Manufacturers (OEM), higher component content per vehicle and rising exports.
According to the Automotive Component Manufacturers Association of India (ACMA), this industry is
expected to register a turnover of US$ 100 billion by 2020, mainly because of strong exports, ranging
between US$ 80–100 billion by 2026.
However, automobile part makers are recently facing the heat of rising commodity prices and price of
copper and rubber have also increased. All this implies higher input costs, translating into higher
2016, when raw material costs fell sharply to 56.8 percent of sales, the operating margin had widened
to 15.9 percent.
accessed on 15/08/2017.
accessed on 15/08/2017.
Accounting vs. Economic Profits
Gross Profit = Net Sales
Revenue – Cost of goods sold
Net Profit = Gross profit – Indirect
expenses + Indirect receipts
excess of revenue over
explicit costs
concept of opportunity cost into consideration while ascertaining
Input Pricing
between
Best Jewelers
Best Jewellers
salary of `
could easily fetch annual rent of `
an interest of `
Table 16.1
Profit and Loss Account of Best Jewellers
`
`
15
By Sales
By Closing stock
80
50
113
18
113
50
1
0.6
0.8
5
4
2.6
15
50
50
`
`
`
Add:
Less:
Interest on capital
`
`
`
`
`
487
488
Managerial Economics
`
Gross and Net Profits
during the course of business. Hence,
Importance of Profit
but the underlying factor determining long-term success of a business entity is its capacity to generate
discusses this concept in details.
Input Pricing
489
theories have evolved. We shall discuss some of them here.
Innovation Theory
Innovators make supernormal profits in
the short run till other firms enter into the
industry.
innovators
innovator.
Reward for Uncertainty Bearing
amidst uncertainties. He clearly distinguishes between insurable risk
and uninsurable uncertainty.
According to Knight, uninsurable
uncertainty gives rise to profit.
and thus, can be insured with an insurance company by paying insurance premium; such as risk of loss
of assets
risk of theft, robbery etc. Non-insurable
1. Competition Risks
competitors.
Market Risks
and recession.
Risks of technological changes
from the possibility the discovery of new and better technology.
Risks of public policy
490
Managerial Economics
bought a bond, you earned interest and when you bought a share, you earned dividend, which is actually
Monopoly Theory of Profit
a certain degree of monopolistic power in setting its own price. Such
any control over price.
SUMMARY
◆
inputs is derived demand.
◆
◆
◆
Wages are payment for services rendered to someone else as per certain terms and conditions,
measured against time.
Economists designate wage as price of labour and salary as that of organisation. In accounting,
usually refers to payment to un-
◆
bending.
Input Pricing
491
◆
labour employed.
◆
amount it needs to remain engaged in its present occupation.
◆
an input earns over and above its transfer earnings.
◆
◆
of the income earned by a factor when there is a sudden increase in its demand.
Interest is the price which the borrower of capital has to pay to the lender of capital.
◆
◆
interest depends on the demand for and supply of loanable funds.
Motive for holding money to bridge the time gap between receipts and payment is transactions
motive. Demand for money to meet unforeseen events is termed as precautionary demand;
◆
about the rate of interest of bonds.
Rate of interest is determined by demand and supply in a competitive situation, at the intersection
of demand and supply curves of money.
◆
uncertainty borne by the entrepreneur.
◆
◆
revenue during the course of business.
◆
KEY CONCEPTS
Marginal productivity of input
Loanable funds
492
Managerial Economics
REFERENCES
AND
FURTHER READINGS
Economics for Managers
Microeconomics: Theory and Applications
th
Microeconomics: Theory and Applications
Hill Education Pvt. Ltd., New Delhi.
QUESTIONS
Objective Type
I. State True or False
iii. Interest is the compensation for a sum of money lent.
v. When the present price of bonds is low, an individual would be interested to hold less cash
in hand.
present consumption.
II. Fill in the Blanks
ii.
iii.
iv.
v.
vi.
moving out of the business.
Loanable funds are demanded by households for consumption and ________.
Economic rent is the amount a factor earns over and above its _______ earnings.
Keynes suggested that interest is a purely _________ phenomenon.
_______ refers to the income earned by a factor when there is a sudden increase in its demand.
Demand for factor inputs is _______ demand.
_______ _______.
for _______.
Input Pricing
III. Pick the Correct Option
i. Divergence in costs of production can be brought about by all the following
c. Changes in technology
d. Change in amount of capital
a. Reward for management of loanable funds
b. Payment made for using the services of only the capital borrowed
d. Reward for inconvenience
a. It is given by nature
c. It is the only factor input
b. It has a single use
d. It varies in degrees of fertility
a. Labour
b. Capital
c. Cannot be insured against
d. Can be insured against
a. Wage
b. Interest
493
494
Managerial Economics
Analytical Corner
9. Draw a comparison between all the factors of production in terms of their characteristics so as to
Give logic for your answer.
Check Your Answers
State True or False
Fill in the Blanks
i. normal
ii. hoarding
Pick the Correct Option
iii. transfer
iv. monetary
Input Pricing
495
Caselet 1
Government Revises Minimum Wage Rate
construction or maintenance of roads, runways or in building operation and underground cabling
in sweeping and cleaning.
category of cities.
Sources: Times of India, 01/05/2011.
Case Questions
Caselet 2
The Interesting Interest Rates
th
496
Managerial Economics
Source: http://www.tradingeconomics.com/india/interest-rate,
www.tradingeconomics.com/india/interest-rate,
Case Question
JSW: Expanding with Grits of Steel
`17,917 crore from `
`
`
highest ever in the history of the company.
`
`
Post this encouraging performance, JSW has made couple of announcements; including a series of
`
`
`
`
will not be increasing debt, but we may end up decreasing it depending on whether we are able to use
any other method of putting in funding.”
Source:
Economic Times, Lucknow, 18/05/2017, p. 11.
Input Pricing
497
Posers
From Wages to Packages: the Journey of Software
Organisations across all industries are undergoing a shift in emphasis from tangible resources to valuable,
rare and inimitable human resource in order to attain competitive advantage. Many leading organisations
have started adopting an investment perspective towards their employees by moving from a traditional
strategic goals, and gaining control over labour costs.
Wage and salary system bear a strong relationship with the performance, satisfaction and attainment
Dimensions of Compensation
Compensation affects a person economically, sociologically and psychologically. It also compensates
to performance appraisal to enhance motivation, and hence productivity. Compensation may also
employee to perform better.
Compensation in Software
of wage and salary administration. It is software that has introduced compensation as a multi-dimensional
new facades to compensation.
498
Managerial Economics
`
country to `
such parameters of compensation strategies should be directed towards providing the ability to
reinforce desired behaviours, and also serve the traditional functions of attracting and maintaining a
Sources:
Ghosh, P. (2005), Human Resource Strategies: An Analysis with Special Reference to the Indian
Info Tech Industry, Doctoral Thesis (unpublished), School of Management Studies, Motilal Nehru
National Institute of Technology, Allahabad.
http://www.citeman.com/salary-and-wage-management.
Rajawat, K. Y., Branding People, Businessworld, 04/02/2008, p. 64.
Posers
arguments in support of your logic.
Chapter
17
2. Differentiate between positive and negative externalities.
3. Differentiate between consumption and production externalities.
4. Understand the nature of public goods.
5. Analyse the impact of externalities on market forces.
6. Comprehend the role of government in reducing externalities and in providing
public goods.
Chapter Objectives
1. Introduce the concept of externalities.
INTRODUCTION
There are many things which happen to us, even though we are not actually responsible for them. At
smokers themselves, but also others who might be passively inhaling smoke from air. This is the basis of
an economic concept known as externalities.
500
Managerial Economics
public goods
Here we must realise that the role of government
externalities, public goods
role of
government
EXTERNALITIES
spillover
effects or side effects
external cost or external diseconomies
external economies. You
Externalities, Public Goods and Role of Government
TYPES
OF
501
EXTERNALITIES
negative
positive
Negative Externalities
social cost is equal to the sum of private cost and
external cost.
Negative Production Externalities
eality
B ites
‘Airpocalypse’
(Contd.)
502
Managerial Economics
.
social marginal cost is more than
Negative Consumption Externalities
external diseconomies of consumption or external costs of consumption,
demerit goods, such as
Externalities, Public Goods and Role of Government
503
Positive Externalities
merit goods.
Positive Production Externalities
external economies of production.
learnt about
private
returns are smaller than social returns.
technology spillovers
very shape of business organisations.
eality
B ites
The Evolution of Internet
(Contd.)
504
Managerial Economics
.
Positive Consumption Externalities
Technical Externalities
bargaining is
unlikely to be a feasible solution.
Externalities, Public Goods and Role of Government
EXTERNALITIES
AND
505
MARKET EFFICIENCY: NET WELFARE LOSS
ownership issues. Now who owns
market failure
as the welfare perspective
in net welfare loss.
marginal cost to society of a particular economic activity
ROLE
OF
GOVERNMENT
IN
CONTROLLING EXTERNALITIES
506
Managerial Economics
rivers, then government intervention is the only
corporate social responsibility
are some of such incentives.
eality
B ites
Social Forestry
.
PUBLIC GOODS
The Pure Theory of
Public Expenditure.
Externalities, Public Goods and Role of Government
507
form a subject matter of environmentalists.
PUBLIC GOODS
AND
OTHER GOODS
¥
Table 17.1
Categories of Goods
Rival Goods
Non-rival Goods
Private Goods
Common Goods
Public Enterprise Goods
Public Goods
private goods
clear property rights, or their
rival
as well as excludable
Common goods
rivalrous but non-excludable
rival
Public enterprise goods
508
Managerial Economics
Public goods are non-rival and non-excludable
CHARACTERISTICS
OF
PUBLIC GOODS
non-excludable and non-rival
rival but excludable
Non-excludable
excluded
harming them.
they are not
non-excludable but rival or is non-
Externalities, Public Goods and Role of Government
509
Non-rival
Rival goods
non-rival goods
PUBLIC GOODS
AND
MARKET FORCES
private
of society.
by malls.
510
Managerial Economics
ROLE
OF
GOVERNMENT
eality
B ites
Unhappy Hours on Highways: Ban on Alcohol
Assigning Property Rights or Ownership Rights
Externalities, Public Goods and Role of Government
511
pure public
Taxation
Another solution is
‘polluter pays principle’, which
polluter pays
principle
social cost, rather than just the private cost.
merit goods such as
Laws and Regulations
512
Managerial Economics
eality
B ites
Dealing with Chemical Emergencies: the Government Way
Source:
.
Other Government Initiatives
Swachcha Bharat
Namami Gange
Externalities, Public Goods and Role of Government
SUMMARY
◆
◆
◆
◆
◆
◆
◆
◆
◆
◆
513
514
Managerial Economics
◆
◆
◆
◆
◆
Apart from formulating various legislations, governments create awareness among people to
KEY CONCEPTS
QUESTIONS
Objective Type
I. State True or False
II. Fill in the Blanks
harm to others.
Externalities, Public Goods and Role of Government
III. Pick the Correct Option
Analytical Corner
each of them.
515
516
Managerial Economics
Check Your Answers
State True or False
Fill in the Blanks
Pick the Correct Option
i. b
ii. c
iii. a
iv. b
v. b
Caselet 1
Death in Air
Sources:
http://www.hindustantimes.com/delhi/all-you-wanted-to-know-about-delhi-air-pollution-clearedup-here/story-V7EkSU7xtNdnlimBYxGg6K.html
Case Questions
517
Externalities, Public Goods and Role of Government
Caselet 2
Millennium Development Goals
Sources:
http://www.who.int/topics/millennium_development_goals/en,
.
.
Case Questions
Bhopal Gas Tragedy: The Lingering Toxic Legacy
518
Managerial Economics
Sources:
story-Dun5WLGTboVhPwmSZKJETK.html,
.
Posers
.
Part
6
Macroeconomic
Aspects of Managerial
Decisions
Building knowledge block by block we have come to the last part of this book, in which we will take
you to the macroeconomic dimension of managerial economics. A firm exists in a large system, that
is, an economy; hence national economy has to be given significant place in managerial decisionmaking process. In the global economy, it has become even more important to know about various
aspects of international dimensions of business. We have shortlisted four major aspects of macro
economics, and have introduced international dimensions at the relevant places. National income,
economic growth, money supply, movements of price and income, and ups and downs in business
activities are the areas that you would come across in the closing part of the book.
CHAPTERS
18.
19.
20.
21.
Macroeconomic Phenomena
National Income
Money Supply, Inflation and Unemployment
Business Cycles
Macroeconomic Phenomena
521
Chapter
18
2. Elaborate the circular flow of economic activity and income.
3. Introduce the concepts of aggregates, stock and flow, intermediary and final goods
and employment.
4. Explain the consumption function, investment function and the marginal efficiency of
capital.
5. Discuss the IS-LM theory of equilibrium.
6. Learn budgeting and fiscal policy and their impact on business.
Chapter Objectives
1. Understand the significance of macroeconomic aspects and their impact on
business.
INTRODUCTION
You have, by now, learnt various aspects of microeconomics, in which you have studied the dimensions
of supply and demand of individuals for goods (like cars, cosmetics and fast food) and services (like
telecom, banking and airlines); cost and production theories, and various pricing strategies followed by
companies. You also know how wages are determined for labour, rent for a property and interest for a
consumer.
We now turn your attention to macroeconomics. We have already
Macroeconomics is that branch of economic
discussed in Chapter 1 that macroeconomics (“macro” meaning analysis that deals with the study of
large) is that branch of economic analysis that deals with the study of aggregates.
aggregates, namely with the performance, structure and behaviour of
the economy as a whole. So we would now discuss aggregate demand and aggregate supply, national
income, general price structure and the movement of economic activity through phases of recession and
522
Managerial Economics
macroeconomic aspects shall be taken up in subsequent chapters.
CIRCULAR FLOW
OF
ECONOMIC ACTIVITIES
AND
INCOME
The crux of macroeconomic theory is based on the
goods and services, income and expenditure takes place. Let us start with the simplest of these models,
in which the primary agents are
government and external sector.
1. Two-Sector Economy
players in the economy, namely consumer (or
intervention in economic activities and the country neither imports goods and services, nor exports
anything.
and services for own consumption, in order to derive some satisfaction from them. A household includes
a set of individuals who live together and take joint decisions about
The simplest form of circular flow of
economic activities and income features
only consumers and firms.
that supply varieties of goods and services. The term “
describe the basic selling unit of consumption and investment goods.
Firms are units which provide consumers with goods and services.
The nature of interdependence is such that consumers need to pay the price for these goods and
for the future. When households save, their consumption of goods and services would decline to the
“
insurance companies and stock markets. You would wonder as to what happens to this saving in the
investment in capital
investment
expenditure, which is termed as “
.
Macroeconomic Phenomena
Saving is the withdrawal
523
injection of money
In other words, planned saving should be equal to planned investment.
factor
consumption
expenditure. There is, in fact,
(given as dotted arrows).
Fig. 18.1
Circular Flow of Money in a Two Sector Economy
output produced (Y ) is equal to the value of output
sold (O). And total income is used either for purpose of consumption, or for investment. Since the value
of output sold is equal to the sum of consumption expenditure and investment expenditure, we can
state that
Y=O=E
…(1)
Y=C+S
Thus,
E=C+I
…(2)
C+S=C+I
…(3)
where Y = income, E = expenditure, O = output, C = consumption expenditure and I = investment
expenditure.
equilibrium, the above equations in fact take form of identity, where the two sides
are always equal for any values of the variables. As a whole, the identity shows that the value of output
produced or sold is equal to the total income received.
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Managerial Economics
2. Four-sector Economy
The
Every economy actually has two more sectors besides consumers and producers, i.e., government and
external sector. The development of basic infrastructure, like roads, electricity, communication and
security is essential for growth of a system. These facilities are created by government; therefore, total
expenditure in an economy will not only consist of C + I but also of government expenditure (G). At the
same time, government receives
whereas government contributes to generation of assets by way of expenditure in form of salaries to
government employees, infrastructure development and public sector enterprise. Some amount of
Total expenditure (E
consumption expenditure, investment
expenditure and government expenditure (denoted by G). Thus, we have:
E=C+I+G
…(4)
Total income (Y ) received is allocated to consumption, savings and taxes (T ). Thus,
Y=C+S+T
…(5)
Since in equilibrium expenditure is equal to the income earned, the above two equations generate the
following:
C+I+G=C+S+T
…(6)
interact with the foreign country through export and import of goods and services, capital investments,
external markets.
An
households buy goods and services from foreign countries in the form of imports (M ). Similarly,
in the form of exports (X
in Figure 18.2.
by aggregate expenditure that includes consumption expenditure, government expenditure and net of
exports, (X – M ), where X represents exports and M
Y = C + I + G + (X – M )
…(7)
Since national income can either be consumed, or saved, or paid as tax to the government, we have:
C + I + G + (X – M ) = C + S + T
…(8)
measurement of national income in an economy which has been discussed later in the chapter. You will
Macroeconomic Phenomena
Fig. 18.2
525
Circular Flow of Economic Activities in a Four Sector Economy
be also gain substantially by this knowledge to understand the concept of national income in Chapter 19
and business cycles in Chapter 21.
eality
B ites
Exporting Against All Odds
In January 2017 Indian exports have exhibited a positive growth of 5.61 percent, valued at `1,50,559.98
crore (US$ 22,115.03 million), as compared to `1,42,568.31 crore (US$ 21,199.02 million) during
January 2016.Cumulative value of exports for the period April–January 2016–17 registered a positive
growth of 4.50 percent over the same period last year. Imports during January 2017 were valued at
`2,17,557.32 crore (US$ 31,955.94 million), which was 12.07 percent higher over the level of imports
valued in January 2016.
Exporters, particularly small and medium players, need “help and hand holding” as they face
global headwinds and the government is looking at all options to support them, the then Commerce
Minister Ms. Nirmala Sitharaman said. In the foreign trade policy review, the Department of Commerce
is focusing on sectors which are labor intensive, such as leather, gems and jewellery, handicrafts and
engineering and are exporting against all odds as their growth has a bearing on employment.
Sources: http://pib.nic.in/newsite/PrintRelease.aspx?relid=158483, accessed on 12/07/2017.
http://economictimes.indiatimes.com/articleshow/60277941.cms?utm_source=contentofinterest&utm_
medium=text&utm_campaign=cppst, accessed on 12/07/2017.
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Managerial Economics
Now we shall introduce you to some of the important macroeconomic variables which will be useful
MACROECONOMIC VARIABLES
savings and investments; here we take you to a detailed understanding of these and other related
concepts. This discussion will help you understand the importance of macro environment from the
Aggregate Demand and Aggregate Supply: First of all, it is important to understand the aggregation
and services by all consumers at a given period of time may be termed
as aggregate demand. Thus, it can be said that aggregate demand
refers to aggregate expenditure made by the society as a whole. You
have seen in equations (1) to (3) that aggregate demand (AD) consists
of two components, aggregate demand for consumer goods (C ) and aggregate demand for capital goods
(I ). We can rewrite the above equations as:
Aggregate demand is the total demand in
terms of goods and assets at a given price
by all the people in an economy.
AD = C + I
Aggregate supply is the total national
output produced and supplied by all the
factors of production in an economy.
…(9)
refers to the supply of all goods and services
in the economy in a given period of time. Aggregate supply consists
of supply of consumer goods and capital goods where capital comes
from savings (S), hence:
AS = C + S
…(10)
And you know that
C+S=C+I=Y
…(11)
This can be further explained with the help of Figure 18.3.
aggregate supply curve (AS ) starts from origin because unless there is some
income there can be no supply but consumption curve (C ) does not start from origin. You will accept
investment curve (I ) does not start from origin. Why is this so? You have learnt that investment comes
from savings and savings come from income; so when there is no income, how can there be investment?
Keynes called this
is assumed to be constant for sake of simplicity. Aggregate demand curve is vertical summation of C
OY is income and OE is
C+S=C+I=Y=O=E
…(12)
Macroeconomic Phenomena
527
Fig. 18.3 Determination of National Income
Stock and Flow: For better understanding of national income determination, it is necessary to understand
. Stock
which has been accumulated at
, like money, assets and wealth. Flow includes the
and investment
Table 18.1
.
Stocks and Flows
Stock
Inventory
Incoming goods
Outgoing goods
Bank balance
Deposits
Withdrawals
Population
Births + immigration
Deaths + emigration
Money Supply
Income
Consumption Expenditure
Intermediate and Final Goods:
stages of production and actual addition to national wealth in a
particular year.
are also known
as producer goods because they are used as inputs in the production of
Intermediate goods (and services) are
items purchased by firms for using them in
production of some other goods of utility.
528
Managerial Economics
recognition in the process. Final goods are those goods that are ultimately consumed, i.e., they are not
used for production of another good.
Final goods are those which are demanded
by the final consumer for using these goods
as they are.
goods. For instance, Tata Sons makes steel and uses it for other goods as trucks and cars, (as also sells
makes steel and sells to others for use in production of other items, like motorcycles, cars, aircraft, etc.
of national income.
Capital Formation: When we refer to an individual, we talk of investment, but when we talk in terms
of a country, we refer to capital formation. The process of savings being converted into investment is
known as
Capital formation is the enlargement of
stock, where
capital stock.
machinery used in the production of goods and services. Gross private
investment is business spending on equipment, residential structures, and inventories; it is net investment
plus depreciation (or capital consumption allowance).
Fixed Capital Formation) and increase in stocks during a period
Table 18.2
Capital formation in India (at Current prices) (` Crore)
2013–14
2014–15
2015–16
33,21,413
35,64,320
38,44,366
2,12,363
1,79,971
2,20,557
Gross Fixed Capital Formation
(as percent of GDP)
33.4
31.6
30.8
Change in Stock (as percent of GDP)
2.1
1.6
1.8
Gross Fixed Capital Formation (` crore)
Change in Stock (` crore)
Macroeconomic Phenomena
529
Rate of capital formation is the measure of growth of an economy, because it determines the volume
of investment in future. The higher the rate of capital formation, higher is the increase in production of
goods and services and hence, higher is the economic growth of the economy.
Employment: This is another very important macro variable that affects the national economy.
in a productive activity is engaged for certain number of hours per week, whether working for self or
someone else. A person who is either not capable or not willing to contribute productively is not termed
dependants. All the people in the age group of 16 to 65 are put under working population and remaining
as dependants. Every country tries to achieve full employment so that maximum economic growth with
maximum social welfare can be achieved.
What is
? Full employment implies absence of involuntary unemployment.
refers to a situation where people are capable to work and willing to work at
the prevailing wage rate but fail to get an opportunity.
is that type of unemployment where a person is out of
want to work at all.
unemployment is an economic condition in which individuals who are willing and capable
of work do not get employed. The level of unemployment differs with economic conditions and other
: This occurs when an individual is out of his current job and looking for
another job. This is purely temporary phenomenon.
This type of unemployment occurs when there is a mismatch of skilled
workers in the labour market. Some of the causes of the structural unemployment are geographical
a new skill) and technological change (introduction of new techniques and technologies that need less
labour force). Structural unemployment is hard to separate empirically from frictional unemployment,
work to easily abolish this type of unemployment.
: Classical unemployment is also known as the real wage unemployment
or disequilibrium unemployment. This type of unemployment occurs when trade unions and labour
organisation bargain for higher wages, which leads to fall in the demand for labour.
530
Managerial Economics
This type of unemployment is a result of trade cycles. During the phase of
recession and
Keynesian unemployment, or as
when there is not enough aggregate demand in the economy to provide jobs for everyone who wants
to work. When demand for most goods and services falls, less production is needed and consequently,
fewer workers are needed, wages are sticky and do not fall to meet the equilibrium level, and mass
unemployment results.
and dispute between partners.
This occurs when certain industries and traders engage workers for a particular
season. Sugar industry, tourism and event management are examples of industries prone to seasonal
unemployment.
This type of unemployment is one where people appear to be employed
but when you remove some of them the total produce remains same, implying thereby that marginal
productivity of labour is zero in such case.
CONSUMPTION FUNCTION
that the aggregate consumption in any economy is the summation of consumption expenditure by all the
individuals.
C ) depends upon disposable income (Y ). You would learn about
disposable income in the next chapter. Logically it can be said that:
C = (Y )
…(13)
Keynes called this function as
marginal propensity to consume (mpc) is?
Marginal propensity to consume (mpc)
changes, i.e., with a certain change in income consumption would also change; mpc tells how much will
be the change in consumption due to a unit change in income. Mathematically,
mpc = dC/dY
…(14)
Let us illustrate this with an example. Suppose you change your job and salary increases by
`10,000 per month. You suddenly have `1,20,000 more in hand than what you had before annually.
Now you may spend whole of this `1,20,000 on consumption but you would normally not do this. You
may decide to spend say `80,000 on luxury items which you otherwise could not buy and save `40,000
`80,000 divided by
`1,20,000).
Assume that the consumption function is as under:
C = bY
…(15)
Macroeconomic Phenomena
531
mpc (b) is assumed to be constant, meaning thereby that every time an increase in
your income (Y
marginal propensity to save (mps) will be 1 – 0.67 = 0.33.
Just as you can calculate mpc, you can also calculate average propensity to consume (apc). Average
propensity to consume refers to the percentage of income that is spent on goods and services rather than
household income (what is earned). Sum of average propensity to consume and average propensity to
save is unity. Mathematically,
apc = C/Y
…(16)
A limitation of the function C = bY is that if income is zero consumption will be zero; although in the
long run that is possible but in short run people will manage to consume in spite of zero income. You
have understood this in Figure 18.3. Consumption level normally is represented as:
C = a + bY
…(17)
where
C = Consumer spending
a = Autonomous consumption, or the level of consumption that would still exist even if income was
zero
b = Marginal propensity to consume
Y = Real disposable income
The consumption function is shown here to be linear, but that is dependent on the variable b (marginal
propensity to consume) staying the same. According to Keynes, consumers tend to spend a smaller
percentage of their disposable income as it rises, creating a curved effect at higher income levels.
mpc declines as income rises. Mathematically, 1 > dC/dY > 0.
Keynesian consumption function can be depicted in Figure 18.4.
Fig. 18.4
The curve LNM shows the marginal propensity to consume. As is clear at low levels of income,
mpc is increasing and high; as income increases mpc declines. The assumption here is that no one will
consume the whole of the increase in income and richer is the person less is the amount of income spent
of income would be saved. You can agree with Keynes here as you see that poor countries remain poor
and rich get richer because as they save more they invest more and growth is directly correlated with
532
Managerial Economics
on investment.
A simple example will help you understand the concepts of marginal and average propensity to
consume and relation between them.
`
`
1000
900
0.9
0.7
2000
1600
0.8
0.5
3000
2100
0.7
0.3
You can see that:
a. Although the rate of change of income is same yet the rate of change of consumption is declining.
b. When mpc is declining apc is also declining.
c. Rate of change of mpc is more than that of apc.
INVESTMENT FUNCTION
Now we shall explain the other component of expenditure, which is investment. You have seen
that savings are converted into investment and in the condition of equilibrium savings are equal to
investment; implying whatever is not spent on consumption, is spent on investment.
the acquisition of capital goods designed to provide us with consumer goods and services in the future.
which can raise the productive potential of an economy. Just like consumption, it is an important
component of aggregate demand.
You should know what the various types of investment are and also what determines it.
(a)
Gross investment is total value of productive assets created during a
amount of depreciation and wear and tear from gross investment, we get net investment. The big
gest single item of investment spending is on new buildings, plant and machinery and vehicles.
Net investment thus creates new productive capacity and employment opportunity. Net invest
ment in any given year = Gross investment minus an estimate for replacement investment. The
available for production.
(b) Private and Public Investment
come under
and departmental undertakings is called public investment. Table 18.3 is drawn from the Economic
can see that private investment has the major share of gross investment in the country. Another
aspect which emerges is that in public sector there is a wide gap between investment and savings.
Government exceeds savings in order to invest in various projects. The gap in private sector is on
the positive side which shows that not whole of private sector savings are invested.
Macroeconomic Phenomena
Table 18.3
533
Savings and Investment Pattern in India as percent of GDP (at Current Prices)
2013–14
2014–15
2015–16
Gross Domestic Savings
33.8
33.0
33.0
Household sector
22.4
20.9
19.1
Private sector
10.0
10.8
12.7
Public sector
1.4
1.3
1.2
33.4
31.6
30.8
Private sector
7.0
7.1
23.3
Public sector
26.4
24.6
7.5
Gross Fixed Capital Formation
(c) Induced and Autonomous Investment: Autonomous investment is the investment which is income
inelastic. According to this, even if the income is zero, there is some amount of investment which
such as higher expected rate of return, increase in demand for capital goods, etc. An increase in
national income brings an increase in induced investment expenditures. At any point of time, Total
investment is the sum of autonomous and induced investment.
investing in risky proposition of capital goods. Keynes explains that people would invest on capital
theory, inducement to invest depends upon two factors: (i)
of interest.
(mec) represents the demand function of capital goods (new investments).
rate of return on amount invested.
a period of time in future in form of annuities. Keynes calls this expected rate of return as prospective
of the asset.
You also know that along with return the cost of capital is also important; Keynes calls it the
price. You should also understand that here we refer to supply price of additional (new) assets and not
of an asset depends upon the prospective yield and supply price of that asset.
(General Theory, p. 135).
of the asset.
We know that demand for investment goods is derived demand, i.e., derived by the demand for the
consumer goods which can be produced by the particular capital good (machine). Therefore we can say
534
Managerial Economics
that demand for investment depends on rate of interest, on one hand and consumption expenditure, on
the other.
The impact of investment on economic activities and employment is further discussed in detail in
Chapter 21, while talking about Keynes’ explanation of business cycles.
FISCAL POLICY
AND
BUDGET
You have also understood that autonomous investment takes place because government makes some
public
revenue and public expenditure. Though
scope of this book, yet we shall take you on a quick trip to the management and administration of public
to affect national income, employment, output and prices through variations in government expenditure
an economy faces recession or fall in demand, government can increase public expenditure,which would
boost aggregate demand for goods and services and lead to a large increase in income via multiplier
effect. Simultaneously, reduction in taxes would increase availability of disposable income, thereby
increasing aggregate consumption and investment expenditure. Reduction in public expenditure and/or
increase in taxation would have just the reverse effect and result in lessened demand and expenditure. We
reducing disposable income, resulting in less aggregate demand, reduced consumption and investment
expenditures.
A brief discussion on public expenditure, public revenue and budgeting is presented in the following
Public Expenditure
infrastructure (like roadways, power and communication), defence goods, education and public
health, civil administration, police, subsidies on various goods, procurement of certain items of mass
consumption, creation and maintenance of
model of an economy, all government current expenditure is included in national output. Government
also invests in public sector enterprises; therefore part of public expenditure can be seen under capital
formation. Another form of public expenditure is payment of salaries of government employees, whether
working in government departments, ministries, or other bodies owned and managed by the government.
Macroeconomic Phenomena
There is another type of public expenditure, known as
535
, which refers to payments made
from one group of people to another group. Transfer payments include unemployment compensation,
to current year’s production or output, and hence, such expenditures made by the government are not
blocking pilferages in various welfare schemes of the government. Like many rights, a universal basic
income is unconditional and universal for any person, just by virtue of being citizen.
eality
B ites
Universal Basic Income
The concept of Universal Basic Income is based on the premise that a just society needs to guarantee
a minimum income to each individual that would provide him/her with the necessary foundation for
support in the form of cash transfers to respect, not dictate, a recipient’s choices). UBI liberates citizens
from paternalistic relationships with the state. Since it considers an individual and not the household as
Source: http://indiabudget.nic.in/es2016-17/echapter.pdf, accessed on 11/05/2017.
Public Revenue
To meet all the above mentioned expenditure, government has to earn revenue either from taxes, or from
dividend and other investments. There are various types of taxes, broadly divided in two heads: direct
tax (which is proportional) and indirect tax (which is differential in nature).
A direct tax is one paid directly to the government by individuals on whom it is imposed (often
incidence and impact is on the
same person. The
company. Direct taxes include personal income tax, gift tax, corporate income tax and wealth tax.
An indirect tax is imposed on one person or entity, but can be shifted on another person. For this
reason, indirect taxes normally result in increased prices. For example, a sales tax is to be paid by a seller
Now how much of the tax burden can be shifted depends upon the price elasticity of demand, which you
centre and those by States.
of Goods and Services Tax, popularly known as GST. Tax rates under GST would vary from 5 to 28
percent, depending on nature of goods. GST is an indirect tax on manufacture, sale and consumption
536
Managerial Economics
nation and removing possibilities of double taxation.
eality
B ites
GST: Taking the Nation by Storm
In 2003, the Kelkar Task Force on Indirect Taxes had suggested a comprehensive Goods and Services
Tax (GST) based on VAT principle. GST is a single tax on supply of goods and services, right from
manufacturer to consumer. Final consumers, thus, bear only GST charged by the last dealer in supply
there would be two components of GST: Central GST (CGST) and State GST (SGST). Both Centre and
States would simultaneously levy GST across the value chain on supply of every good and service.
Goods and Services Tax was introduced in India on 1 July 2017. All major central and State taxes have
been subsumed majorly in GST; furthermore, the Central Sales Tax (CST) is being phased out. This
would not only reduce the cost of locally manufactured goods and services, but would also enhance
emerge in medium term. There are also expectations that this tax reform would boost the economy in
the medium to long term, but job creation would remain a concern as unorganised sector would largely
shift towards organised sector.
Sources: www.gstindia.com/about/http://economictimes.indiatimes.com/markets/stocks/news/how-gst-will-impactaccessed on 12/07/2017.
accessed on 12/07/2017.
Finally, to understand the difference between direct and indirect taxes, you should remember that a
direct tax is one that cannot be shifted by the taxpayer to someone else, that is, incidence and impact of
someone else.
Budget
Budget is the principal instrument of
government budget is a statement of public expenditure
on various items and revenue from taxes and other sources for one year. Aligning public expenditure and
public revenue is called budgeting.
Through your knowledge of rationality, you know that a rational individual would always design
a
A balanced budget
increase in taxes and increase in government expenditure are of an equal amount. This has the impact
of increasing net national income because reduction in consumption resulting from tax is not equal
level.
Macroeconomic Phenomena
537
A surplus budget is when revenue is more than expenditure. A government would follow the policy
about
or reduction in government expenditure, or both simultaneously. This would tend to reduce income and
aggregate demand by multiplier times reduction in government expenditure and consequently, reduction
in private consumption expenditure as a result of increased taxes. Normally, welfare governments do
not adopt surplus budget as that would imply taxing people more and spending less on their welfare.
A
economic growth and welfare.
depression.
When government expenditures exceed receipts, larger amounts are put into the stream of national
net expenditure of government which increases
national income by multiplier times increase in net expenditure. This increase in net expenditure would
provide incentive to investors to invest and thereby come out of recession. You have already learnt about
autonomous investment and induced investment. During recession, producers are shy to invest as there
is no inducement to invest; hence government should bring in autonomous investment. For a detailed
understanding of this relationship, you should refer to Chapter 21 on business cycles.
eventuality of recession and also to give a boost to welfare activities. You have already learnt that public
goods are funded by tax revenue. When
we all are the keenest to know what tax reliefs are given, especially in income tax. What does this mean?
Simple, no one wants to pay tax but everyone wants government to spend! Government also realises that
goods leading to public welfare cannot be left in the hands of private sector and there is a limit to tax.
while keeping taxes unchanged or even reducing taxes, to increase disposable income and thereby
increase private expenditure.
Now an obvious question would arise in your mind that how could any government spend more than
what it earns? This process is called
the most important among them being public borrowing. Government issues various kinds of bonds
as the last resort, it requests the central bank of the economy to print additional currency notes, so as
because it means more currency in the hands of people as compared to availability of goods and services.
as low as possible.
538
Managerial Economics
eality
B ites
Highlights of Budget 2017
The Union Budget 2017 is broadly focused on the farming sector and rural population, youth, healthcare
administration and accountability and transparency. The total expenditure in Budget 2017–18 has been
placed at `
is now on revenue and capital expenditures, which will be 25.4 percent. Main highlight is government’s
percent of GDP, and has committed to achieve 3 percent in 2018–19. The difference between total
lower than projected receipts; it is expected to be 1.9 percent.
Sources: www.pwc.in/assets/pdfs/budget/2017/pwc-union-budget-publication-2017-18.pdf, accessed on
12/07/2017.
www.thehindu.com/business/budget/Highlights-of-Union-Budget-2017-18/article17127298.ece, accessed on
12/07/2017.
show/56907865.cms, accessed on 12/07/2017.
IS-LM ANALYSIS
interest rate (r) and level
of output (Y
would be dealing with two key markets, namely the commodity (or goods) market and the assets (or
money) market. Each of these two markets can be analysed by using a model known as the
According to Keynes, income affects spending; this in turn determines output and income.
markets on income. Spending, income and interest rate are jointly determined by equilibrium in the
Rate of Interest and Planned Investment
Figure 18.5 shows a typical planned investment schedule at each rate of interest. What happens when
higher rate of interest implies lower planned rate of investment spending. Conversely, a lower rate of
it is the cost of borrowing capital. As such, when interest rate falls, it becomes less costly to borrower,
and vice versa. This inverse relationship between interest rate and planned investment is illustrated by
the downward sloping investment schedule in Figure 18.5.
Macroeconomic Phenomena
539
Fig. 18.5
Commodity Market Equilibrium and IS Curve
relationship affects planned aggregate expenditure (E ). You have seen that aggregate expenditure is
the sum of consumption (C ), planned investment (I ) and government expenditure (G
E=C+I+G
…(18)
With change in rate of interest, planned investment (I ) will change; hence planned expenditure (E )
C + I. With increase
in rate of interest, planned investment falls. This lowers aggregate expenditure (E), which in turn results
in a fall in national income (Y ). This relationship between rate of interest and aggregate income or output
(Y
planned expenditure. There is an equilibrium level of aggregate output (Y ) for each value of rate of
interest (r) in the market. For a given value of r
Y. The negative relationship between r and planned investment (I ) can thus, be extended to an inverse
relationship between r and Y as seen in Figure 18.5. Each point on the IS curve represents equilibrium
b shows the shifts in IS curve.
a
b
IS
IS
IS
IS
Fig. 18.6 IS Curve
540
Managerial Economics
Suppose government increases expenditure without any change in the rate of interest. What would
happen to the IS curve? Yes, the curve would shift to the right to IS1. An increase in government
expenditure, given the rate of interest, would increase the equilibrium level of Y, shifting the IS curve to
Y and the IS curve would shift to the left to IS2.
Money Market Equilibrium and LM Curve
Let us now look at the other side of the story, namely the money market. You know that demand for
money is negatively related to rate of interest (r
have seen in the discussion of determination of interest (Chapter 16) that equilibrium rate of interest is
You know that there is an equilibrium value of aggregate output for every value of r
a given value of Y, we can determine the equilibrium value of r in the money market. An increase in
aggregate output would lead to an increase in the demand for money; an increase in the demand for
money would increase the equilibrium rate of interest. This is given in Figure 18.7. This upward sloping
curve showing an equilibrium value of Y for every value of r is known as the LM curve. Each point on
the LM curve represents equilibrium in the money market.
What would happen if the supply of money is increased? At the same level of Y, an increase in the
supply of money would lower the rate of interest. This would shift the LM curve to the right, as shown
1. Conversely, if there is a lesser supply of money,
then the LM curve would shift to the left to LM2.
a
b
LM
LM
LM
Fig. 18.7
LM
LM Curve
Macroeconomic Phenomena
541
eality
B ites
Scope of Indian Money Market
Indian money market has seen exponential growth just after the globalisation initiative in 1992. It has
to the lenders. The varied types of Indian money market instruments are treasury bills, repurchase
of India regulates the money market by either reducing cash reserve ratio or by infusing more money
in the system to ease out liquidity crunch.
, accessed on 14/05/2017.
Combining the Commodity Market and Money Market
From the above discussion, we are able to summarise that the level of aggregate output (income) Y is
determined in the commodity market. Further, Y affects demand for money. Money demanded when
equals to supply of money, would render equilibrium in the money market, which would determine
equilibrium rate of interest (r). Further, it is rate of interest in the money market that affects level of
demand for money depends on income. The second link exists because planned investment depends on
rate of interest.
and LM curves together. The point of intersection of the two curves is the equilibrium point (E) for both
commodity market and money market. Thus, re represents equilibrium rate of interest and Ye represents
equilibrium aggregate income or output for both the markets.
LM
IS
Fig. 18.8 IS-LM Curves
542
Managerial Economics
Let us now see the impact of a change in G on this equilibrium. You have seen that an increase in
G
IS curve to IS1
a.
The equilibrium would shift from E to E1. This would increase the levels of both r and Y to r1 and Y1
respectively. Conversely, a fall in the level of G would shift the IS curve to the left, thus, leading to fall
in the levels of both r and Y.
a
b
LM
LM
LM
LM
IS
IS
IS
Fig. 18.9 Effect of Shift in IS-LM Curves
r and Y. An increase
in supply of money would shift the LM curve to the right to LM1
b. Shift
in LM to the right shifts the equilibrium from E to E1. This lowers the rate of interest from re to r1 and
increases the level of aggregate output from Ye to Y1
lowers the rate of interest and increases Y. The reverse would happen if there is a fall in the supply of
money, i.e., a lower equilibrium value of Y and a higher level of r.
change in government expenditure) on equilibrium rate of interest and aggregate output through the
SUMMARY
◆
◆
goods and services, income and expenditure takes place.
Saving is the withdrawal
injection of
In other words, planned saving should be equal to planned
investment.
◆
that includes consumption expenditure, government expenditure and net of exports, (X M ), where
X represents exports and M represents imports.
Macroeconomic Phenomena
◆
543
Sum of demand for all goods and services by all consumers for a given period of time may be
termed as aggregate demand. Aggregate supply refers to the supply of all goods and services in
the economy for a given period of time.
◆
◆
payments refer to payments made to certain sections of the society as a social welfare measure.
Marginal propensity to consume (mpc) is the ratio of consumption changes to income changes;
Average propensity to consume (apc) refers to the percentage of income that is spent on goods
and services rather than on savings.
◆
◆
planned expenditure. There is an equilibrium level of aggregate output (Y ) for each value of rate
of interest (r) in the market. The LM curve shows an equilibrium value of aggregate output (Y )
for every value of r.
An increase in G
Y. An
increase in supply of money would shift the LM curve to the right. This lowers the rate of interest
and increases the level of aggregate output.
◆
and to affect national income, employment, output and prices.
◆
◆
◆
exceeds revenue.
◆
KEY CONCEPTS
Macroeconomics
Four sector economy
Aggregate supply
Two sector economy
Aggregate demand
Capital formation
QUESTIONS
Objective Type
I. State True or False
i. Seasonal unemployment occurs due to changes in the phases of business cycles.
544
Managerial Economics
iii. Demand for investment goods is direct demand.
v. mpc increases with increase in income.
vi. At equilibrium, C + S = C + I.
xi. When an economy faces recession, public expenditure can be increased.
xii. Welfare governments usually adopt surplus budget.
II. Fill in the Blanks
i.
ii.
iii.
iv.
__________ goods are those which are ultimately consumed.
__________ unemployment happens when a worker fails to get an opportunity to get work.
__________ tax is differential in nature.
__________ investment is income inelastic.
vi. Transfer payment is an exchange of __________ from one group of people to the other.
vii. Cost of capital is also known as __________.
viii. Each point on the LM curve represents equilibrium in __________ market.
__________.
x. The process of conversion of savings into investment is known as __________.
III. Pick the Correct Option
i. All of the following hold good for transfer payments
:
a. They are a social welfare measure.
b. They include retirement pension.
c. They are included in current output of goods and services.
d. They do not contribute to national output.
ii. Classical unemployment refers to:
iii. At the same level of Y, decrease in supply of money would lead to:
a. No change in LM curve
Macroeconomic Phenomena
b. Shift of LM curve to the right
c. Shift of LM curve to the left
iv. Net investment refers to:
a. Total value of productive assets in a year
b. Resources mobilised by the economy
v. When mpc is declining:
a. apc rises at a greater rate
c. apc remains unchanged
vi. Gross capital formation refers to:
b. apc declines
d. apc rises at lesser rate
c. Fixed capital formation less depreciation
d. Aggregate of additions to movable assets
a. Development of infrastructure
b. Development of public sector enterprise
c. Salaries of government employees
viii. Expected rate of return is also referred to as:
a. Y = C + I + G + X – M
b. Y = C + I + G + T
c. Y = C + I + G – X + M
d. Y = C + I + T + X – M
x. Autonomous investment is that investment which is:
b. Made irrespective of demand or savings
c. Equal to savings
d. Equal to demand
a. Wealth tax
b. Decreases net national income
d. Revenue is exactly the same as expenditure
b. Gift tax
545
546
Managerial Economics
Analytical Corner
country? Draw the diagram and explain.
5. Which type of unemployment is controllable and how?
6. The following table provides data on employment under various sectors excluding agriculture and
unorganised sector. Try to interpret the data with logic. Search for similar data on agriculture and
unorganised sector and compare the two.
Employment data in Organised Sector for India (in lakh)
Sectors
1995
2001
2004
Central Government
33.95
32.61
30.27
State Government
73.55
74.25
72.22
Quasi Government
65.20
61.92
58.22
Local bodies
21.97
22.61
21.26
71.18
77.09
72.34
9.40
9.43
10.12
PUBLIC SECTOR
PRIVATE SECTOR
Large Establishments
(Employing 25 or more workers)
Smaller Establishments
(Employing 10–24 workers)
[Source: India 2007, Government of India]
7. Write a note on consumption function while explaining the marginal and average propensity to
consume.
8. Differentiate between the following:
a. Gross and net investment
b. Autonomous and induced investment.
Check Your Answers
State True or False
i. F
xi. T
ii. F
xii. F
iii. F
iv. T
v. F
vi. T
vii. T
viii. T
ix. F
x. F
Macroeconomic Phenomena
547
Fill in the Blanks
i. Final
ii. involuntary
vii. supply price
x. capital formation
iii. indirect
viii. money
xi. surplus
ix. Firms, households
xii. borrowing
Pick the Correct Option
i. c
xi. d
ii. d
xii. b
iii. c
iv. d
v. b
vi. b
vii. d
viii. c
ix. a
x. b
Caselet 1
How Basic is the Universal Basic Income?
poverty);
(through possibility
(by reducing
(by reducing waste in government transfers); and greater
especially of women within households.
The sheer number of schemes and programs run by the government is evident from the reports of
Subsidy and the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS).
Economic Survey of 2014–15 has documented that most of the central sector schemes have been
the trio of Jan-Dhan, Aadhaar and Mobile
From an economic point of view, a serious objection to a universal basic income is, it may reduce
unlikely to crowd incentives to work.
accessed on 6/05/2017.
Case Questions
2. Do you think that universal basic income may reduce the incentive to work?
548
Managerial Economics
Caselet 2
Massive Scheme for City Modernisation
would be seven years. The total Central Government funding will be `50,000 crore. Adding the
contribution of states and municipalities, the amount will go up to `1,25,000 crore over the seven
year period. Through this project, the Central Government will fund 65 cities for developing urban
road network, urban transport and redevelopment of old city areas.
www.jnnurm.nic.in, accessed on 6/05/2011.
accessed on 6/05/2011.
Case Questions
your viewpoint.
India on the Growth Trajectory
and banks. Merchandise exports have registered an annual growth of 17.48 percent in February 2017 at
Macroeconomic Phenomena
549
and sustainable growth.
million by 2020, based on rate of population growth, increased labour force participation, and higher
agency, Invest India
accessed on 6/05/2017.
Posers
initiatives.
Skill Development Programmes
are looking for employment in the country and industry is facing acute shortage of skilled workforce.
is providing funds for skill development activities in States.
Speaking at the Conference of Labour Ministers held on 22 January 2010 at New Delhi, Shri Sharda
three basic objectives, viz., training a large number of boys and girls to ensure their employability in
the industry and provide them opportunities for decent livelihood and at the same time, meet skilled
accessed on 05/05/2011.
Posers
2. Discuss the other problems which may arise due to unemployment.
550
Managerial Economics
Chapter
19
2. Explain the concept of real and nominal national income.
3. Discuss and analyse the different methods to measure national income.
4. Understand the advantages of national income calculation in global perspective.
5. Appreciate the difficulties in estimating national income.
6. Elaborate the concept of balance of payments and its importance.
Chapter Objectives
1. List the various concepts of national income, like GDP, GNP and NNP.
INTRODUCTION
Very often you read about economic growth in one or the other context; for example, India is growing at
a satisfactory rate or India is one of the fastest growing economies. You also hear that some economies
are developed while others are developing. How do we know this? We know this through the data on
context of demand. Now what is the income of a nation? How is it determined? You will learn about all
the aspects related to national income in this chapter.
You have already learnt in Chapter 18 that macroeconomics (“macro” meaning large) is that branch
of economic analysis that deals with the study of aggregates, namely with the performance, structure
and behaviour of an economy as a whole. In other words, we have looked at all economic issues from
some fundamental concepts of macroeconomics, such as, aggregate demand and aggregate supply,
we shall introduce you to various aspects of national income, its determination, and its importance in
an economy.
National Income
CONCEPTS
OF
551
NATIONAL INCOME
First of all, you should understand what is meant by national income. In fact, there are many expressions
Samuelson, which is so simple that one does not need to know economics.
and capital resources.”
Paul A. Samuelson
One of the most important concepts in all economic systems is that of national income, which gives us
a means to measure the economic performance of an economy as a whole. National income accounting
economic activities in an economy. Measures of national
income and output are used to estimate the value of goods and services produced in an economy.
goods and services produced in a
country in a given year. Various goods and services produced in the economy cannot be added together
in their physical form; for this reason they need to be converted into monetary terms.
Thus,
.
Some of the common measures of national income are gross domestic product (GDP), gross value
added (GVA), gross national product (GNP), gross national income (GNI), net domestic product (NDP)
and net national product (NNP). It also helps in understanding the living standard of nationals of an
economy as it provides basis to calculate per capita income and personal income.
Gross Domestic Product
GDP is the sum of money values of all final
within the domestic territories of a country during an accounting year. goods and services produced within the
It includes income from exports and payment made on imports during domestic territories of a country during an
accounting year.
the year. However, it does not include earnings of nationals working
abroad as also of
Indian companies which have their branches or subsidiaries in foreign countries as also subsidiaries and
however, not included in the GDP of the country. This is done to avoid the incidence of double counting,
552
Managerial Economics
company. Logically if incomes of these subsidiary companies are counted in the income of the country
where they are located, it will amount to double counting of their income. We would throw more light
not intermediate
goods. It also excludes items produced in previous years, because those goods were calculated in
previous year’s national income and if they are included this year, it would lead to double counting. You
have learnt in the four-sector model of economy in Chapter 18 that:
Y = C + I + G + (X – M)
…(1)
It can be rewritten as, national income is the summation of consumption expenditure, government
expenditure and net of exports (X – M), where X represents exports and M represents imports:
GDP = C + I + G + (X – M)
…(2)
Now that you understand what in general constitutes GDP, we shall explain some intricate dimensions
of GDP calculation. So far we have made it clear that GDP is the money value of goods and services. You
back from consumers to producers. Hence, goods and services can be converted in monetary terms in
two ways: (i) by using market value of goods and services, and (ii) by using payments for factor inputs.
GDP at Factor Cost and GDP at Market Price
Conceptually, the values of GDP, whether estimated at market price or at factor cost, must be identical
to cost involved in production (i.e., at factor cost). However, in real life, market value of goods and
services is actually not the same as the cost involved in their production; this is because GDP at market
price includes indirect taxes and excludes subsidies given by the government. On the contrary, GDP at
factor cost would include transfer payments which do not contribute to national income. So, in order to
arrive at GDP at factor cost, we must subtract indirect taxes and add subsidies to GDP at market prices.
GDP at Factor Cost = GDP at Market Prices – Indirect Taxes + Subsidies
…(3)
Gross Value Added
of output less value of intermediate consumption. GVA provides money value of the total goods and services
produced in an economy in a year after deducting cost of inputs and raw materials that have gone into pro-
National Income
553
capital to production process.
GVA at basic prices = GVA at factor + (Production taxes – Production subsidies)
GDP at market prices = GVA at basic prices + (Product taxes – Product subsidies)
…(4)
…(5)
You must be wondering as to what could be the difference between production taxes and product
taxes. Production taxes (or production subsidies) are paid or received with relation to production and are
independent of the volume of actual production. On the other hand, product taxes (or subsidies) are paid
or received on per unit of product. Land revenues, stamps and registration fees and tax on profession are
some examples of production taxes and subsidies to railways, input subsidies to farmers, subsidies to
village and small industries, administrative subsidies to corporations or cooperatives, etc., are examples
of production subsidies. Whereas, excise tax, sales tax, service tax and import and export duties are
kinds of product taxes on food, petroleum and fertiliser subsidies, interest subsidies given to farmers,
households, etc., through banks are types of product subsidies.
Gross National Product
So far you have understood national income from the angle of goods and services produced domestically;
but as given in Figure 18.2 that an economy interacts with other countries of the world as well, and
earns income not only within the boundary of the nation, but also from abroad. Similarly, nationals
of other countries also earn income in our country. While calculating GDP we include trade of goods
but not of services, so as to get a clear picture of economic progress.
But actually these incomes from services form a substantial part of GNP is the aggregate final output of
citizens and businesses of an economy in
national income. For this is necessary to know another measure of a year.
national income, namely Gross National Product.
The difference between GNP and GDP arises because of the fact that a part of any country’s total
output is produced by factors which are actually owned by other nation(s). Thus, Net Factor Income from
Abroad (NFIA) is the difference between income received from abroad for rendering factor services and
income paid towards services rendered by foreign nationals in the domestic territory of a country.
GNP = GDP + NFIA
…(6)
GNP = C + I + G + (X – M) + NFIA
…(7)
We can also express GNP as:
For example, we may say that GNP of India would count goods and services produced by all Indians,
.
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Managerial Economics
Table 19.1
National Income Data for India
(` crore at 2011–2012 Prices)
S. No.
Item
(` crore at Current Prices)
2015–16
2016–17
2015–16
2016–17
1,04,90,514
1,11,85,440
1,24,58,642
1,36,69,914
8,90,488
10,04,414
12,23,393
15,13,795
GDP (1+2)
1,13,81,002
1,21,89,854
1,36,82,035
1,51,83,709
NDP
1,01,16,809
1,08,41,917
1,22,36,662
1,35,97,811
1.
GVA at basic prices
2.
Net Taxes on products
including import duties
3.
4.
Source: Economic Survey, 2016–17.
Net Domestic Product and Net National Product
While calculating GDP or GNP, we ignore depreciation of assets or capital consumption; else they would
or
capital consumption allowance. In order to arrive at NDP or NNP, we deduct depreciation from GDP or
wear and tear and replacements during the year of accounting.
Hence,
NDP = GDP – Depreciation
and
NNP = GDP – Depreciation + NFIA
or
NNP = GNP – Depreciation
…(8)
…(9)
…(10)
In other words, NNP is the actual addition to a year’s wealth and is the sum of consumption expenditure,
government expenditure, net foreign expenditure, and investment, less depreciation, plus net income
earned from abroad. It can be expressed as:
NNP = C + I + G + (X – M) – Depreciation + NFIA
…(11)
NNP at Factor Cost (or National Income)
You have already seen that GDP can be measured either in terms of
market price or factor cost. The relationship between GDP, GNP and
NNP has also been elucidated. It would be easy to understand that
Net National Product at factor cost is the net output of an economy evaluated at factor prices or it is the
sum total of income earned by all the people of the nation, within the national boundaries or abroad. It
GNP less depreciation on assets is equal
to NNP.
in the production process. It is also called national income. This measure differs from NNP at market
555
National Income
prices in that indirect taxes are deducted and subsidies are added to NNP at market prices in order to
arrive at NNP at factor cost. In other words,
NNP at Market Price = GNP at market price – Depreciation
…(12)
NNP at Factor Cost = NNP at Market Prices – Indirect Taxes + Subsidies
…(13)
Real and Nominal National Income
As we have explained above, national income is obtained by multiplying the output of goods and
services by their prices. Now you would obviously wonder as to which price to use in this calculation?
There are two practices: we may use either current or constant prices. All the different concepts of
national income, viz., GDP, GNP and NNP can be expressed either in terms of current price or constant
price. Current prices are the prices prevailing in the year in which national income is being calculated;
therefore if national income is estimated at the prevailing prices, it is
National income estimated at the
called national income at current prices or
, prevailing prices is national income at
or Money National Income. Government of India calculates national current prices.
income data on basis of current prices as well as constant prices.
On the other hand, if national income is measured on the basis of
National income measured on the basis of
some fixed price time or by taking a base
year, is real national income.
or by taking a base year, it is known as national income at constant
prices, or
. By looking at Figures 19.1 and 19.2,
you can check that national income data are provided at both 2011–12 prices and current prices. Notice
nominal income with data for GDP.
Table 19.2 explains the difference in real and nominal income with data for GDP.
Table 19.2
Percentage Change in Domestic Product over previous year
At 2011–2012 prices
2015–16
GVA at basic prices
Net Taxes on Products including
import duties
GDP (1 + 2 – 3)
NDP
2016–17
At current prices
2015–16
2016–17
7.9
8.9
6.6
12.8
8.5
27.0
9.7
23.7
8.0
8.1
7.1
7.2
9.9
10.2
11.0
11.1
Source: Economic Survey, 2016–17.
get the true picture, it is important to calculate national income at constant prices. However, government
keeps on changing the reference year for constant prices.
Real GDP measures any change in the
output in an economy, between different time periods,
by valuing all goods produced in the two periods
.1 Real GDP is arrived at by dividing
nominal GDP by the
1
Dornbusch and Fischer (2005).
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Managerial Economics
Real GDP =
Nominal GDP
GDP Deflator
…(14)
GDP deflator is the ratio of nominal GDP in
a year to real GDP of that year.
change in prices between the base year and the current year. In fact, it is a widely based price index used
base year from
time to time for constant prices.
eality
B ites
Nominal and Real National Income in India
current prices.
National Income at Current Prices
GDP at current prices in the year 2016–17 is estimated at `136.82 lakh crore, showing a growth rate of
11.0 percent over the estimates of GDP for the year 2015–16 of `84 lakh crore. Gross National Income
at current prices is estimated at `149.94 lakh crore during 2016–17, as compared to `135.22 lakh crore
during 2015–16, showing a rise of 10.9 percent. Per capita income at current prices during 2016–17 is
estimated to have attained a level of `1,03,219 as compared to the estimates for 2015–16 at `94,130,
showing a rise of 9.7 percent. In 2015–16, rate of growth of the country’s per capita net income stood
at 7.4 percent.
National Income at Constant Prices
Real GDP or GDP at constant (2011–12) prices for the year 2016–17 is estimated at `121.90 lakh crore,
registering a growth rate of 7.1 percent over the year 2015–16 of `113.81 lakh crore.
Real GVA, i.e., GVA at basic constant (2011–12) prices for the year 2016–17 is estimated at `111.85
lakh crore, with a growth rate of 6.6 percent over the GVA for the year 2015–16 of `104.91 lakh crore.
GNI at 2011–12 prices is estimated at `120.35 lakh crore during 2016–17, as against the previous
year’s estimate of `112.46 lakh crore. In terms of growth rates, gross national income is estimated to
have risen by 7.0 percent during 2016–17, in comparison to growth rate of 8.0 percent in 2015–16, the
In real terms (at 2011–12 prices), per capita income in 2016–17 rose 5.7 per cent to `82,269, against
`77,803 a year ago. Per capita income is a crude indicator of the prosperity of a country.
accessed on 12/09/2017.
accessed on 12/09/2017.
National Income
557
Per Capital Income
The average income of the people of a country in a particular year is called per capita income. In simple
words, it is income per head of a country for a year. Per capita income can be arrived at dividing national
income by total population of a country. Hence,
Per Capita Income =
National Income
Total Population
…(15)
Since per capita income is calculated on the basis of national income, it can be referred to as per
capita NNP, per capita GNP, or per capita GDP, depending upon which measure of national income has
concept of per capita income at constant prices and at current prices is
also applicable here because the measure of national income will be
calculated either at current prices or constant prices.
Table 19.3
Per capita income is income per head of a
country for a year.
Per Capita Income, Product and Final Consumption (Rupees)
(At Current Prices)
(At 2011–12 Prices)
2014–15
2015–16
2016–17*
2014–15
2015–16
2016–17*
1. Per Capita Gross Domestic
Product
98,225
1,06,641
1,16,888
83,165
88,706
93,840
2. Per Capita Gross National
Income
97,062
1,05,396
1,15,428
82,181
87,656
92,646
3. Per Capita Net National Income
86,454
94,130
1,03,219
72,862
77,803
82,269
4. Per Capita Gross National
Disposable Income **
1,00,259
1,08,615
1,18,395
1,00,259
1,08,615
1,18,395
5. Per Capita Private Final
Consumption Expenditure
57,086
61,826
68,722
46,586
48,810
52,399
* Provisional Estimates
** Disposable Income is compiled only at current prices.
Source:
accessed on 10/09/2017
The concept of per capita income is very useful as it is the single most commonly used measure of
average income and the standard of living of the people of a nation. At the same time, it is not a very
reliable measure because it is a simple arithmetic mean; hence the extreme values dominate. Due to
capita income.
Personal Disposable Income
Personal income is the total income received by the individuals of a country from all sources before
direct taxes in one year. It is derived from national income by deducting
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Managerial Economics
households before payment of personal taxes. Personal income also includes transfer payments received
by households. Thus,
Security Contributions + Transfer Payments + Interest on Public Debt
…(16)
The entire amount of personal income cannot be spent by household
on consumption and saving because direct taxes have to be paid out
of this income.
means the actual income available to be spent on consumption
by individuals and families. Therefore, disposable income may be calculated by using the following
formula:
Personal Disposable Income is the income
which can be spent on consumption by
individuals and families.
Personal Disposable Income = Personal Income – Personal Taxes
…(17)
You should understand here that personal disposable income includes income earned by individuals
dividend on investment, pension, inheritances, etc., from sources within national boundaries as well as
from abroad.
Let us now sum up all of these concepts with some numerical illustrations. Following data relates to
hypothetical country for a year.
From the following information, calculate GDP at market price, NNP at factor cost and Personal
Income and Per Capita Income.
(` Crore)
Net Domestic Product at market price
25,21,700
Net Indirect Taxes
3,06,087
Net Factor Income from Abroad
– 41,842
Transfer payments
78,821
Depreciation
33,873
Total Population (million)
987
Solution:
GDP at market price = Net Domestic Product at market prices + Depreciation
= 25,21,700 + 33,873
= 25,55,573
NNP at factor cost = NDP at market prices + Net Factor Income from Abroad
– Indirect Taxes
= 25,21,700 + (–41,842) – 3,06,087
= 21,73,771
National Income
559
Personal Income = NNP at factor cost + Transfer payments
= 21,73,771 + 78,821
= 22,52,592
Per Capita Income (NNP at Factor Cost) = NNP at factor cost/Total population
= 21,73,771/987
= `2203
MEASUREMENT
OF
NATIONAL INCOME
National income is nothing but the measurement of aggregate production in an economy during a
of expenditure on goods and services. Based on these three ways, there are three methods of measuring
national income, discussed next.
i. Product (or Output) Method
As per the product method of estimating national income, also called
National Income by Industry of Origin, market value of all goods
The product method adds up the market
values of all final goods and services
produced in the country by all the firms
across all industries.
are added up together. When in the earlier section, we had referred
to national income at market price, we were actually talking about
national income calculated by product method. This method involves the following steps:
large scale manufacturing, small scale manufacturing, electricity, gas, etc.
ii. The physical units of output are then interpreted in money terms, i.e., by taking market price of
all the products.
iii. The total values thus obtained are then added up.
iv. Indirect taxes are subtracted and the subsidies are added. This gives the Gross Domestic Product
or Gross National Product, as the case may be, depending upon what data are being used (refer to
the earlier sections).
v. Net value is calculated by subtracting depreciation from the total value thus obtained, in order to
arrive at NNP.
A word of caution to be repeated here is that goods produced in the particular year and only in their
phone to a retailer for `3000 and the retailer sells it to the consumer at `5000, how much has the mobile
contributed to GDP? Is it `8000? No. If we do that, it would be double counting. Instead we would either
`5000) or the value added at each stage (`3000 by the manufacturer and `2000 by
the retailer). The sum of all such values added by all industries in the economy is known as Gross Value
Added (GVA) at basic prices.
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Managerial Economics
National income by product method can be calculated in two ways:
(a) Final Product Method
productive activities are collected and assessed at market prices. You should note here that only
are not taken into account. This avoids chances of double counting. So in the previous example
of cell phone that we have taken, we shall only consider `5000, which is the market price for the
(b) Value Added Method Another method of measuring national income is the value added
by each industry of the economy. This method measures the contribution of each producing
enterprise of the economy. The difference between the values of material outputs and inputs at
each stage of production is the value added. If all such differences are added up for all industries
in the economy, we arrive at the Gross Domestic Product. Like in the above example national
`
`
`5,000.
method and value added method should be same, though this is not possible in real life.
Limitations of Product Method
This method has the following limitations:
i. Problem of Double Counting
possibilities of double counting cannot be fully eliminated. An economy has such complex
ii. Not Applicable to Tertiary Sector This method is useful only when output can be measured in
physical terms. Due to this reason it cannot be applied to the service sector due to the absence of
input output relationship, which is basis of this method.
iii. Exclusion of Non-marketed Products National income is always measured in money, but
for example, painting as a
by an individual. It has an opportunity cost in terms of time and
resource involvement, but it does not go to national income data.
Indian economy can be studied under three broad sectors: agriculture and allied services, industry
and services.
sector includes agriculture (agriculture proper and livestock), forestry and
(both registered and unregistered), electricity, gas, water supply and construction, while
sector
estate and professional services, and public administration, defence and other services. Table 19.4
presents the GVA at current prices for the three sectors in 2016–17. You know that GVA includes total
output less intermediary consumption.
National Income
Table 19.4
561
GVA at Current Prices
Sector
GVA (in ` lakh crore)
Agriculture and Allied Services
17.32
23.82
Industry
29.02
39.90
Services
53.66
73.79
Total
137.51
accessed on 10/08/2017.
Source:
ii. Income Method or National Income by Distributive Shares
factor payments to households in return
of their services as factors of production; these include wage for labour, rent on land, interest on capital,
also added here. You should note here that
. However, income received in the form of transfer payments is not included.
This is the Gross Domestic Product at factor cost; now, we add the money sent by the citizens of the
nation from abroad and deduct the payments made to
Gross National Income (GNI). World Bank has adopted Gross National Income (GNI) in the System of
National Accounts 1993 (93SNA), replacing the term Gross National Product (GNP) which was used in
earlier versions of the SNA and World Bank documents.
Income method involves the following steps:
i. The economy is divided on the basis of income groups, such as wage/salary earners, rent earners,
ii. Income of each of these groups is calculated.
iv. From iii, income earned by foreigners and transfer payments made in the year are subtracted.
In other words,
Abroad – payments made to foreigners) – Transfer payments
…(18)
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Managerial Economics
Limitations of Income Method
Though the income method covers all sections of the economy, it is also not a complete system of
national income calculation, because of the following limitations:
i. Exclusion of Non-monetary Income
ignores the non-monetised section of economic activities, such as a farmer and family working
economic in nature and contribute to national income, but due to their non-monetary nature, they
go unrecorded. Hence, the calculated value of national income is less by this amount.
ii. Exclusion of Non-marketed Services There may be cases when people undertake a particular
activity which is not economic in the strict sense, but have opportunity cost and real-cost
implications. Typical examples may be mother’s services or housewife’s services. These services
iii. Expenditure Method
You have seen that whatever is earned is spent either on consumption or on investment. Therefore, it
is possible to calculate national income by expenditure method. Also the two methods discussed above
have their own limitations and do not ensure complete enumeration of national income data. According
to expenditure method, total expenditure incurred by the society in a particular year is added together
to get that year’s national income; such expenditure includes personal consumption expenditure, net
domestic investment, government expenditure on goods and services, and net foreign investment. This
a. Consumption Expenditure
individuals receive income, they can spend it on domestic goods or foreign goods (durables and
non-durables) and services; they pay taxes out of it and save the rest. Personal consumption
expenditures refer to payments by households for goods and services.
b. Investment Expenditure
(construction of new housing units and renovation of existing structures) and inventory investment
(unsold portion of output).
c. Government Expenditure Government expenditures refer to government payments for goods
d. Net Exports Spending on imports is subtracted from total expenditure on exports, because such
spending escapes the system and does not add to domestic production. Exports to foreign nations
are added to total expenditures.
National Income
Table 19.5
563
Gross Value Added at Factor Cost by Industry of Origin
Year
added at
communica
tion
real
estate and
Personal
2014–15
(at 2011–12 prices)
18,99,961
27,41,451
18,00,919
20,75,549
12,01,143
97,19,023
2014–15
(at current prices)
23,83,135
31,51,061
20,95,121
23,63,250
14,89,226
11,48,1794
2015–16
(at 2011–12 prices)
19,41,948
29,76,344
19,89,161
22,98,798
12,84,263
10,49,0514
2015–16
(at current prices
24,71,800
33,92,873
22,94,364
26,31,120
16,68,486
12,45,8642
2016–17*
(at 2011–12 prices)
20,26,660
31,55,185
21,43,956
24,29,638
14,30,002
11,18,5440
2016–17*
(at current prices)
26,74,006
36,41,178
25,19,999
28,89,048
19,45,683
13,66,9914
*Provisional Estimates
Source:
accessed on 10/09/2017.
Limitations of Expenditure Method
Expenditure method too is not devoid of limitations, which are as follows:
(i) Neglects Barter System
barter,
in which a commodity (or service) is exchanged for another commodity (or service). The extent of
this non-monetised segment is fairly large in less developed and developing economies, though it
also has entered into most modern setups in the form non-monetary components of compensation
packages offered by large multinational corporations.
(ii) Ignores Own Consumption In developing countries like India another aspect of expenditure
farmer may use a part of yield as seeds, another part for own consumption and sell the remaining
in the open market. Such situations create possibilities of multiple counting.
As in this method, money spent on goods and services is taken as the
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Managerial Economics
USES
OF
NATIONAL INCOME DATA
National income data are of utmost importance for the economy of any country primarily because
national income is the most dependable indicator of a country’s economic health. Such data reveal
aggregate production/total expenditure/total income of the economy for a year and provide database for
i. National income data are necessary for economic planning of a country. Such data help in
and are a useful tool to the government in taking decisions about necessary changes.
ii. As we have mentioned earlier, a sustained increase in national income of a country over time is an
indicator of economic growth. The difference between GDP and GNP indicates the contribution
of net income earned abroad. This is very important especially in the era of globalisation and free
movement of resources, including human resource and capital.
iii. These data also help in comparing the situations of economic growth in two different
countries. The World Bank categorises countries on the basis of GDP as
, middle
and
countries. Traditionally,
low income countries are termed as developing countries.
iv. These data also help in determining regional disparities,
v. National income is considered as a measure of economic welfare. As national income rises,
aggregate production of goods and services rises. Since welfare is associated with a better
standard of living, a higher aggregate production implies more and more goods and services being
available to people. This implies there is a positive relation between increase in national income
and welfare.
eality
B ites
2016 report by Asian Development Bank suggests that share of GDP generated by the region rose to
40.5 percent in 2015, increasing nearly 11 percentage points between 2000 and 2015. On the other
hand, Europe’s share of global GDP fell 4.9 percentage points during the same period, while North
region’s total GDP in 2015 is accounted for by People’s Republic of China and India. China contributed
42.0 percent of regional GDP and India 17.2 percent. India’s economic growth accelerated to 7.6
percent in 2015 from 7.2 percent in the previous year, led by services on the supply side and private
consumption on the demand side. Among the most populous developing members, only China’s per
capita GDP in 2015 was higher than the regional average, while those of Bangladesh, India, Indonesia
line of $3.10 (2011 PPP) a day.
accessed on
10/09/2017.
accessed on 10/09/2017.
National Income
DIFFICULTIES
IN
MEASUREMENT
OF
565
NATIONAL INCOME
As you have seen in the preceding section, national income data have many uses, because of which
measurement of national income is a crucial activity of any economy. However, such measurement is
development of a country. For example, in an economically advanced country, the income method is
is a prevalence of the barter system, many transactions are non-monetised and a large number of people
are engaged in informal sector. Because of this reason, income method may not be very appropriate in
i. Non-monetised Transactions There are numerous incidents of exchange of goods and services,
like services rendered out of love, courtesy or kindness, which have no monetary payments as such.
These services have an economic value but no money value. For example, a businessman takes the help
of his wife in managing his business but does not pay her any salary. Thus, the wife’s contribution to
national income goes unrecorded. Let us extend the same example, assuming that this couple runs the
of inclusion and computation of such goods and services in national income remains unresolved.
There are many goods and services produced in an economy which do not enter the market for
exchange, or which are exchanged under barter, and there is no means of estimating the volume and
value of these goods.
ii. Unorganised Sector The unorganised sector of any economy, including petty traders, unskilled
labour, domestic servants, and household production units contributes substantially to the national
do not pay income tax.
iii. Multiple Sources of Earnings A person may have multiple sources of income, of which only one
may be the main activity while the others may be executed on a part time basis. For example, in India
most of the small farmers cultivate only one crop a year, and in lean season, they work in the unorganised
iv. Categorisation of Goods and Services
Validity of national income accounting depends upon
the problem in this is that there are many cases in which this categorisation is not very clear. Let us
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Managerial Economics
case is trained persons. In such cases, there would either be incidence of double counting, or less-thanactual counting. Similarly, categorisation of goods and services is found to vary between countries. For
intermediary.
v. Inadequate Data
national income of underdeveloped countries. Often, authentic data may not be available from many
of national income.
BALANCE
OF
PAYMENTS
Balance of Payments (BoP) is a systematic record of all economic transactions between the residents
of a country and rest of the world. A country’s international transactions can be between governments,
companies or individuals. You should understand that transactions between residents and non-residents
sided transactions. Balance of payments is the statistical record of a country’s international transactions
over a period of time presented in double-entry book keeping. This means that BoP has two aspects:
every payment results in a debit entry and every receipt results in a credit entry. This logic applies to all
types of transactions, whether goods or services. Balance of payments includes exports, imports, bank
accounts, bonds, stocks, real estate, investments, receipts and payments for services, interest, dividends,
grants and aids.
The basic structure of balance of payments consists of:
i. Current account: export and import of goods, services, income (both investment income and
compensation of employees) and current transfers, representing
ii. Capital account: assets and liabilities covering direct investment, portfolio investment, loans,
banking capital and other capital
iii. Statistical discrepancy
iv.
eality
B ites
India’s Balance of Payments Procedure
Transactions in balance of payments in India are recorded in accordance with the guidelines given in
of the world.
accessed on 10/09/2017.
accessed on 10/09/2017.
National Income
567
CURRENT ACCOUNT
Current account is an important long run and comprehensive measure of a country’s transaction with the
rest of the world, and comprises trade in goods and services, income from assets abroad and payment
on foreign-owned assets in the country. Under current account of balance of payments, transactions are
merchandise (exports and imports) and
types now.
i. Merchandise includes trade in all visible items, also termed as export and import of commodities.
Whatever is sold to foreign countries is termed as export, while whatever is purchased from
model. Exports appear as credit items, whereas imports feature as debit items in balance of
payments. Trade in goods results in
, i.e., net balance of exports minus
imports on merchandise (goods). This is also referred to as
and can be either
ii. Invisible transactions
a.
: Freight, passenger fares, royalties, fees, tourism, travel, transportation, insurance,
Government not Included Elsewhere (GNIE) and miscellaneous (such as communication,
construction, financial, software, news agency, royalties, management and business
services).
b. Income
c.
made by governments or individuals such as grants, gifts, remittances, relief funds,
income earned by guest workers, etc., which do not have any
These transfers do
not involve any claim for repayment, for this reason they are also called
or
.
eality
B ites
J Curve Hypothesis
Sebastian Edwards (1989) had studied balance of payments of many developing nations to see the
impact of currency depreciation on trade balance. He found that in more than 40 percent cases after
devaluation, trade balance had worsened in the beginning and improved with time. When plotting on a
accessed on 10/09/2017.
accessed on 10/09/2017.
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Managerial Economics
CAPITAL ACCOUNT
maturity (short- or long-term), such
transaction (by the central bank).
The main components of capital account include foreign investment, loans and banking capital,
explained as follows:
i.
represents non-debt liabilities and comprises foreign direct investment
(FDI) and portfolio investment consisting of foreign institutional investors (FIIs) and American
Depository Receipts/Global Depository Receipts.
ii. Loans include external assistance, external commercial borrowings and trade credit.
iii.
including non-resident Indian (NRI) deposits in debt liabilities.
OFFICIAL RESERVES ACCOUNT
Gold, foreign exchange and Special Drawing Rights comprise the
year, it is called surplus balance of payments, else
External Account must Balance
As the name balance of payments suggests, the statement of external accounts must always balance, i.e,
this mean? Is it not contradictory? No, it is not. First, you should understand that the following identity
should always be maintained:
Payments to Abroad = Receipts from Abroad
In order to achieve this,
has to be compensated with
.
In case there is surplus, the private sector can buy assets abroad or pay off past debt or the central
bank can buy foreign exchange earned by private sector and increase reserves. You know that increase
National Income
569
We present here the summary of balance of payments for India as given in Economic Survey 2016–17.
reduced over the years.
Table 19.6
Summary of Balance of Payments (US $ billion)
2014–15
2015–16
2016–17
H1
Trade balance
–147.6
–144.9
–130.1
–49.5
73.1
76.5
69.7
32.0
Invisibles (net)
115.2
118.1
107.9
45.7
Current Account Balance
–32.4
–26.9
–22.2
–3.7
47.9
88.3
40.1
19.2
–15.5
–61.4
–17.9
–15.5
Net services
Total Capital/ Finance A/C (Net)
Reserve Movement
(– increase) and (+ decrease)
MEASURES
TO
REDUCE TRADE DEFICIT
not possible for an emerging country like India to keep its trade balance in surplus. Governments make
measures, which are used to deal with immediate crises, and long-term measures aimed at maintain
healthy balance of payments.
Short-Term Measures
Short-term measures relate to crisis management, that is when the situation seems to be going out of
control, government takes various steps. Actions are taken to
. You know that trade
imports should be decreased. However, in short run it is not possible to increase export revenue because
it depends upon several external factors. For this reason government imposes curbs on imports of all
those goods which do not add to economic growth. Another measure is to seek
from
term basis to meet international liabilities. When nothing works, government may be forced to use
gold as the last resort. India had used gold to meet international liabilities in 1990-91. This is the worst
situation and no country wants to adopt it.
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Managerial Economics
Long-Term Measures
Sustainable results are possible by taking long-term measures such as reforming the economy. After the
1991 crisis, India undertook several reform measures, commonly known as New Economic Policy, which
reset the growth path by opening the economy to foreign players. The trio, liberalisation, privatisation
a U-turn in India’s economic policy from a regime of regulations, protectionism and subsidies. We
are presently in the third decade of economic reforms, and results are visible in the form of reduced
IMPORTANCE
OF
BALANCE
OF
PAYMENTS
and government policy. BoP shows demand and
supply of a currency. Imports are an indicator of demand for foreign currency, while exports show
supply of foreign currency. An important point to note here is that in an open economy the exchange rate
Secondly, BoP is an important indicator of
of a country. You would
agree that it is the international demand for goods and services produced in a country that determines
its export revenue. Higher the demand, greater is the bargaining power of that country and stronger is
its currency. Similarly, lower the demand for its goods, lower is the export revenue and weaker is the
home currency.
Thirdly,
monitor balance of payments situation very closely so as to watch for factors that
could lead to currency instability or government actions to correct an imbalance. It is well-known how
Government of India was compelled to take a U-turn in its economic policy, which changed the whole
scenario in the country as well as rules of the game. Companies which were accustomed to low or no
competition were suddenly facing multinational giants. Therefore, balance of payments and especially
trade balance information is useful not merely for government, but also for companies.
SUMMARY
◆
economy during an accounting period.
◆
territories of a country during an accounting year. It can be measured at current or constant prices.
National Income
571
◆
◆
◆
◆
year. NNP is GNP less depreciation.
The average income of the people of a country in a particular year is called per capita income or
income per head of that country for that year.
National income can be measured by product method, income method and expenditure method.
National income accounting data are of utmost importance for the economy of any country;
such data reveal the aggregate production of the economy and also help to determine the total
expenditure and total income of that country.
◆
◆
◆
about informal sector, etc.
National income is considered as a measure of economic welfare. As national income rises, the
aggregate production of goods and services rises. Therefore, there is a positive relation between
increase in national income and welfare.
Balance of payments is a systematic record of all economic transactions between the residents of
a country and rest of the world.
◆
◆
KEY CONCEPTS
Gross Domestic Product
Personal income
KEY EQUATIONS
AD = C + I
AS = C + S
AD = AS = C + S = C + I
Y=E=O
Y=O=C+I
Y=E=C+S
C+I=Y=C+S
Total Expenditure (E) = C + I + G
National Income = C + I + G + (X – M)
Gross National Product
National Income Accounting
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Managerial Economics
GDP at Market Price = C + I + G + (X – M )
GDP at Factor Cost = GDP at Market Prices – Indirect Taxes + Subsidies
GNP at Market Price = GDP + NFIA
GNP = C + I + G + (X – M ) + NFIA
NNP = C + I + G + (X – M ) – Depreciation + NFIA
NNP = GDP – Depreciation + NFIA
NNP at Market Price = GNP – Depreciation
NNP at Factor Cost = NNP at Market Prices – Indirect Taxes + Subsidies
NNP at Factor Cost = National Income = FID + NFIA
Security Contributions + Transfer Payments + Interest on Public Debt
Personal Disposable Income = Personal Income – Personal Taxes
National Income
Per Capita Income =
Total Population
Real GDP =
Nominal GDP
GDP Deflator
QUESTIONS
Objective Type
I. State True or False
i. You buy a 2004-made Maruti 800 at a very good bargain in 2007. It would be counted in the GDP
of 2007.
ii. Transfer payments are included in Personal Income.
iii. National income calculated at constant price is the real national income.
iv. GDP will be less than GNP if net income from abroad is negative.
C + S = C + I.
vii. An unemployed person’s earnings from the Government is included in national income.
viii. You buy a second hand apartment in 2011 that was built in 2007. It is not taken into account in
the calculation of national income in 2011.
x. The average income of the people of a country in a particular year is called per capita income.
xi. Exports are an indicator of demand for foreign currency.
National Income
573
II. Fill in the Blanks
income method.
income.
production of other goods.
ix. If national income is estimated at the prevailing prices, it is called national income at current
xi. Balance of payments is an important indicator of international _______of a country.
III. Pick the Correct Option
i. In a four-sector economy, national income is measured as:
a. Y = C + I + G + X – M
b. Y = C + I + G + T
c. Y = C + I + G – X + M
d. Y = C + I + T + X – M
ii. If GDP is `34,000 crore and net income from abroad is `
a. 34,000 – (–4200)
b. 34,000 ¥ (–4200)
c. 34,000 + (–4200)
d. 34,000/(–4200)
a. Chair
b. Book
c. Alumina
d. Airplane
iv. Autonomous investment is that investment which is:
a. Induced by demand
b. Made irrespective of demand or savings
v. Which of the following is not considered in calculation of national income?
a. Salary of employees of State Electricity Board
b. Interest on bank deposits
c. Dividend earned on share of Reliance Energy Limited
d. Pension received by government employees
c. Additions to capital stock
d. None of the above
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Managerial Economics
time is:
a. Gross Capital Formation
c. Net investment
viii. The nominal GDP is `36,000 and real GDP is `
a. 36000/34000
c. 36000–34000
ix. Transfer payments are included in:
a. GDP
c. Per capita income
x. Net factor income from abroad is:
a. GDP – NDP
c. GNP – GDP
c. Current account surplus
xii. Loans include all the following EXCEPT:
a. External commercial borrowings
c. External assistance
b. Gross private investment
d. None of the above
b. 34000/36000
d. 36000 ¥ 34000
b. GNP
d. Personal income
b. GNP – NNP
d. None of the above
d. Balance of trade
b. Trade credit
d. NRI deposits in debt liabilities
Analytical Corner
1. “National income does not necessarily refer to income produced within the borders of a country”.
In the context of this statement, explain the difference between GNP and GDP.
2. “Real measure of national income is NNP, and not GDP.” Do you agree with this statement? Give
arguments in support of your point of view.
3. What is meant by the three identities of national output, national income and national expenditure?
taken as an indicator of standard of living of people of the country.” Discuss.
5. No method of national income accounting is perfect. Critically evaluate different methods of
national income accounting in the context of this statement.
measure national income.” Discuss.
8. The following information has been obtained from the national income accounts of India.
Find out: (i) Net National Product at market price and (ii) Disposable Income, for each year
under reporting.
National Income
Item
2001–02
Net National Product (at factor cost)
Indirect taxes less subsidies
Interest on Public debt
Personal income
Direct Taxes paid by households
575
2004–05
1856217
2003282
2268576
2531223
183859
194162
216828
277517
28270
45343
57369
73598
125521
140782
166797
173602
2000703
2128742
2392604
2617279
49716
61807
81046
84131
9. The following table provides data on employment under various sectors excluding agriculture and
unorganised sector. Try to interpret the data with logic. Search for similar data on agriculture and
unorganised sector and compare the two.
Employment data in Organised Sector for India (` in lakh).
Sectors
2001
2004
PUBLIC SECTOR
Central Government
33.95
32.61
30.27
State Government
73.55
74.25
72.22
Quasi Government
65.20
61.92
58.22
Local bodies
21.97
22.61
21.26
71.18
77.09
72.34
9.40
9.43
10.12
PRIVATE SECTOR
Large Establishments
(Employing 25 or more workers)
Smaller Establishments
(Employing 10–24 workers)
Source: India 2007, Government of India.
10. From the following data, calculate GDP at factor cost.
GNP at market prices
Net Income from Abroad
2005–06
2006–07
1,890,884
2,090,658
2, 722,241
–11098
–15665
–16631
11. What do you understand by the following information? Explain on basis of relationship between
these measures of national income:
i. GNP is `28, 33,558 crore and NNP is `25, 01,067 crore.
ii. GDP at factor cost is `28, 55,933 crore and GDP at market price is `31, 26,596 crore.
12. Elaborate the components of balance of payments. What is the difference between balance of
payments and balance of trade?
576
Managerial Economics
Check Your Answers
State True or False
i. F
xi. F
ii. T
xii. F
iii. T
iv. F
v. T
vi. F
vii. F
viii. T
xi. F
x. T
Fill in the Blanks
v. different
vi. aggregates
vii. producer
viii. capital formation
iv. b
vi. b
viii. a
Pick the Correct Option
i. a
xi. b
ii. c
xii. d
iii. c
v. d
vii. a
xi. d
x. c
Caselet 1
Industry or Services?
Growth rate of industrial sector in India is estimated to be somewhat moderate, lowering to 5.2
growth of 0.4 percent has been observed in the Index of Industrial Production (IIP) because of
strong growth in electricity generation offset by moderation in mining and manufacturing. The
eight core infrastructure supportive industries,
products, steel, cement and electricity that have a total weight of nearly 38 percent in the IIP, have
registered a cumulative growth of 4.9 percent during April–November, 2016–17 as compared to 2.5
percent during April-November, 2015–16. On the other hand, services sector contributed around 66.1
percent of its Gross Value Added (GVA) growth in 2015–16. Overtime, the share of services sector
in GDP has been increasing, while agriculture is consistently losing ground. In the last decade, share
of services had even surpassed the combined share of agriculture and industry, making it the most
important contributor to the country’s GDP.
Many new initiatives taken by the Government in the form of Make-in-India, Invest India, Start Up
the much needed boost to the manufacturing sector.
Case Questions
1. Discuss the case in light of the relative role of different sectors in a country’s national income.
2. Do you think government’s recent initiatives can improve the performance of manufacturing
sector?
National Income
577
Caselet 2
Raising the Exemption Limit
The Union Budget for 2011–12 has offered income tax sops to salaried and retired people, raised the
outlay for infrastructure, education and development of North-East and J&K, set a disinvestment
target of `40,000 crore, and given a big push to agriculture as a part of policy initiatives.
The Finance Minister has announced in his budget speech that the personal income tax exemption
limit is raised to `180,000 from `
age is reduced to 60 years from 65 years and exemption limit is raised to `2.50 lakh from `2.4 lakh.
having an income tax exemption of `5 lakh. (The exemption limit implies that income up to this level
is exempted from income tax payment). The Finance Minister further announced that the direct tax
proposals will cause a revenue loss worth 115 billion rupees.
accessed on 6/05/2011.
Case Questions
1. Identify the type of income which will be affected by direct tax, and discuss the impact of rising
of exemption limit on individuals.
2. What measures are available to the government to cover the revenue loss occurring due to
direct tax proposals?
India’s External Sector
A look at India’s position in the external sector will show that over a period of time Indian economy has
somewhat made progress in easing balance of payment situation. As an aftermath of global slowdown,
India’s export of goods and services were also adversely affected. Corresponding to subdued growth in
of 2016–17 year estimates show that a large number of export sectors have moved to positive growth
territory as compared to 2015–16. Moreover, value of imports declined from US$ 448 billion in 2014–15
to US$ 381 billion in 2015–16, mainly on account of decline in crude oil prices, reduced imports of
gold and capital goods. The downward spiral in international crude oil prices resulted in a decline in oil
import bill by around 18 percent, which, together with a sharp decline in gold imports, led to a reduction
in India’s overall imports (on BoP basis). As a net result of less import burden and improved exports,
Furthermore, it declined by 23.5 percent to US$ 76.5 billion in 2016–17 (April–December) compared
to US$ 100.1 billion in the corresponding period of previous year.
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Managerial Economics
In invisible trade, although service receipts increased by 4 percent, Net Services Receipts declined by
10 percent in H1 of 2016–17 as growth in services payments was higher (16 percent). Subdued income
conditions, particularly in the Gulf region due to downward spiral in oil prices continued to weigh down
on remittances by Indians employed overseas as private transfers moderated to US$ 28.2 billion in H1
of 2016–17 from US$ 32.7 billion in H1 of 2015–16.
from US$ 88.2 billion (4.8 percent of GDP) in 2012–13 to US$ 22.2 billion (1.1 percent of GDP) in
2015–16.
Despite higher net repayments on overseas borrowings and fall in banking capital due to building up
foreign exchange reserves. Other indicators have also showed gradual improvement.
Posers
1. “A country’s international trade is a mirror of global growth and trade”. Discuss the statement in
the backdrop of this case.
2. Can we say that India’s position in terms external sector is comfortable? What measures can be
taken to improve it further?
National Income of India
“
continue
largest economy behind the US and China in terms of real prices and purchasing power.
Ironically, it was only some 15 to 20 years back, when India used to look at China and South Korea
with great envy, as they were growing at above 9% per year, whereas India was growing at a sluggish
4 to 5%. To add to the woes of the national economy, population was growing at over 2% a year and
there have been periods of growth as high as 9.5% (1975–76) and 11% (1988–89) but at the same time,
there have been periods of less than 1% growth and even negative growth rate! To summarise, Indian
economy is a saga of checkered growth.
National Income
579
indicator of real growth. Statements 1 and 2 stated ahead present a picture of national income of India
over a period of three years at constant prices and current prices respectively. These statements show
various aspects of national income. As can be seen, the country seems to be growing at a staggering
13.8% and 18.5% in the years 2005–06 and 2006–07, but when we compare the same at constant prices,
real growth rate is constant for the two years under consideration.
STATEMENT 1: Estimates of National Income
(At 1999–2000 prices)
Item
2004–05
2005–06 (QE)
1.1 Gross national product (GNP) at
factor cost
23,67,711
25,80,761
(9.0)
28,29,349
(9.6)
1.2 Net national product (NNP) at
factor cost
21,03,350
22,95,243
(9.1)
25,22,576
(9.9)
2.1 Gross domestic product (GDP) at
factor cost
23,89,660
26,04,532
(9.0)
28,48,157
(9.4)
2.2 Gross domestic product (GDP) at
market prices
26,02,235
28,42,478
(9.2)
31,08,360
(9.4)
2.3 Net domestic product (NDP) at
factor cost
21,25,299
23,19,014
(9.1)
25,41,384
(9.6)
2.4 Private Final Consumption
Expenditure (PFCE)
15,69,130
16,75,025
17,78,697
2.5 Government Final Consumption
Expenditure
2,78,757
3,06,087
3,33,713
2.6 Gross Fixed Capital Formation (GFCF)
6,57,317
7,57,806
8,68,618
2.7 Change in Stocks (CIS)
46,633
78,821
86,840
2.8 Valuables
33,873
33,992
46,921
4,69,902
4,97,683
5,40,721
2.10 Less Imports
4,11,535
4,53,922
5,05,871
2.11 Discrepancies
–41,842
–53,014
–41,279
A. ESTIMATES AT AGGREGATE LEVEL
1. NATIONAL PRODUCT (` Crore)
2. DOMESTIC PRODUCT (` Crore)
2.9 Exports
B. ESTIMATES AT PER CAPITA LEVEL
Population (million)
Per capita NNP at factor cost (`)
QE: Quick Estimate; RE: Revised Estimate
1,090
19,297
1,107
20,734
(7.4)
1,122
22,483
(8.4)
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Managerial Economics
(Contd.)
STATEMENT 2: Estimates of National Income
(At current prices)
Item
A. ESTIMATES AT AGGREGATE LEVEL
1. NATIONAL PRODUCT (` Crore)
1.1 Gross national product (GNP) at
factor cost
1.2 Net national product (NNP) at
factor cost
2. DOMESTIC PRODUCT (` Crore)
2.1 Gross domestic product (GDP) at
factor cost
2.2 Gross domestic product (GDP) at
market prices
2.3 Net domestic product (NDP) at
factor cost
2.4 Gross National Disposable Income
2.5 Private Final Consumption
Expenditure (PFCE)
2.6 Government Final Consumption
Expenditure
2.7 Gross Fixed Capital Formation
(GFCF)
2.8 Change in Stocks (CIS)
2.9 Valuables
2.10 Exports
2.11 Less Imports
2.12 Discrepancies
B. ESTIMATES AT PER CAPITA LEVEL
Population (million)
Per capita NNP at factor cost (`)
2004–05
28,33,558
2005–06 (QE)
32,25,963
(13.8)
28,46,762
(13.8)
37,22,669
(15.4)
32,96,639
(15.8)
31,96,192
18,65,645
32,50,932
(13.8)
35,67,177
(14.1)
28,71,731
(13.8)
36,49,038
20,64,638
37,43,472
(15.2)
41,25,725
(15.7)
33,17,442
(15.5)
42,27,311
23,27,331
3.42,542
4,04,511
4,67,702
8,22,786
10,00,760
12,16,552
63,789
41,054
5,69,051
6,25,945
47,674
1,04,036
42,457
7,25,124
8,30,678
56,329
1,20,620
61,138
9,47,868
10,64,606
49,120
1,090
1,107
1,122
25,01,067
28,55,933
31,26,596
25,23,442
22,946
25,716
(12.1)
29,382
(14.3)
QE: Quick Estimate; RE: Revised Estimate
For calculating national income, the Indian economy is divided into 14 broad sectors, which are then
air transport, water and organised transport, communications, banking and insurance, real estate, public
administration and defence are included in category B. In category C, gas and water supply, unorganised
roads and water transport, storage, trade, hotels and restaurants, ownership of dwelling and other
services are included.
National Income
581
The production method is applied to category A. The value added by category A is found by subtracting
the value of raw materials and other inputs from the aggregate of commodity wise output. For category
B, the income method is applied and, for this, all the types of factor incomes which are reported in
the annual accounts of various organisations are aggregated. For category C, sample surveys are done
or extrapolated and periodical computations of average productivity are carried forward or backward by
using certain indicators.
Posers
2. Prove the statement that no method of national income is perfect on basis of this case.
a. NNP = GNP – Depreciation
b. GNP = GDP + Net income from abroad
c. Per capita income = NNP (at Factor Cost) / Total Population
Chapter
20
2. Understand the value of money and demand and supply of money.
3. Explore the realms of inflation and its different frontiers.
4. Explain concepts like wage price spiral, hyperinflation and inflationary gap.
5. Understand various measures of inflation and their role in decision-making.
6. Analyse the reasons behind inflation, its impact on the economy and measures to
curb it.
Chapter Objectives
1. Know the evolution of money and its functions.
INTRODUCTION
In the previous units, you have learnt about various aspects of price and that it determines the slope
of demand and supply curves and is determined by the twin forces of demand and supply; further it is
happens when there is an increase in price? In the discussion on national income determination you have
read that when price increases, the money value of national income increases without any increase in
persistent, it is referred to as
you are told
notes? Or that what has money supply to do with prices? Here is an attempt to demystify all your doubts
Money Supply, Inflation and Unemployment
583
Evolution of Money or Monetisation
inconvenient and uncertain?
is called
coincidence
realised that it is convenient to use
as a
of money in brief, followed by functions of money, demand and supply of money, value of money and
1. Metallic Money:
Metallic money consists of
demand for money
of money in
2. Paper Money:
paper money was
584
Managerial Economics
In present times, paper money is the
based on the
central
or
the
in which reserve worth `
to `
`
non-convertible in any precious metal and is a
`
that is declared by the state to be a
it is also referred to as
3. Credit Money:
It includes
, as it can be conveniently converted into cash and
4. Electronic Money:
Money Supply, Inflation and Unemployment
Demonetisation
note would cease to be
that is demonetisation that
585
586
Managerial Economics
Characteristics of Money
to everyone in the society
Money does not have to necessarily have a
Money can be
Money is
form of money is
Functions of Money
Functions of money:
Medium of exchange
Measure of value
Store of value
1. A Unit of Account:
national income is the
that it may not be very easy for you to convince the other person that one watch is actually worth
say that money is
disembodied money; money with no function other than that of
2. Medium of Exchange:
unit of account and as a
Money Supply, Inflation and Unemployment
was evolved due to the limitations of barter system in which
3. Store of Value:
587
is the ba-
Money is also a store of value; it can be saved for future with convenience
times,
but the
4. A Standard of Deferred Payments:
Money acts as a standard of
-
-
DEMAND
AND
SUPPLY
OF
MONEY
Money is in demand because all the
commodities which have utility are
available in exchange for money.
Demand for Money
Transactions Motive
of income to meet their day-to-day needs, and as producers they need money in the form of capital to
588
Managerial Economics
Precautionary Motive
Speculative Motive
A currency issued by the government is
called a fiduciary issue (based on trust and
confidence).
circulation, whereas
the total money supply at any point of time will consist of money in
Supply of Money
separate
Concepts of Money Supply
narrow money and broad
term
M1:
narrow money
M2: M1 +
M3 M2 +
broad money
.
Money Supply, Inflation and Unemployment
589
M4 M +
M0:
reserve money
Money Multiplier: Money multiplier is the ratio of broad money M to reserve money M0
Money Multiplier =
M
M0
Monetization of economy is measured by the ratio of M1 to
Monetary Deepening is the ratio of M
Quantity Theory of Money
Monetarists led by
MV = PT
or
P=
MV
T
where P
T
and services, M is supply of currency and V is velocity with
`1000
According to quantity theory, any given
percentage increase (or decrease) in the
quantity of money will lead to the same
percentage decrease (or increase) in the
general price level.
`1000 multiplies
as follow
MV + M ¢V ¢
T
V¢ is the
T and V remain constant in the short run, so P
P=
where M¢ is
M lead to fall in V
Value of Money
590
Managerial Economics
In previous sections, you have noticed that people want to earn, save and invest money because they
`
`
that `
`
`
eality
B ites
Monetary Developments during 2016–17
(Contd.)
Money Supply, Inflation and Unemployment
591
net foreign assets and net domestic assets in its balance sheet. In fact, RBI has shifted its monetary
Source: http://indiabudget.nic.in/es2016-17/echap03_vol2.pdf (Economic Survey 2016-17, Chapter 3), accessed
Monetary Policy
(i) Bank Rate Policy:
credit
is called
rate manipulations are more effective in the developed countries where most of the transactions
592
Managerial Economics
Repo Rate
Marginal Standing Facility (MSF)
Marginal Cost Lending Rate (MCLR)
(ii) Open Market Operations:
This includes direct sale and purchase of securities by the central
(iii) Reserve Ratios:
statutory
Money Supply, Inflation and Unemployment
593
`
`
(iv) Selective Credit Control:
`
These are
(v)
economy as it increases money supply in the hands of people without a commensurate increase in
594
Managerial Economics
INFLATION
Inflation is a persistent increase in the
general price level or a persistent decline in
the real income of people.
It is when the price rise is
and
However, normally whenever the term
is referred, it implies
Other sources of additional money supply are
eality
B ites
rate depreciation. So, if there are structural changes in the oil market and in domestic agriculture, the
Source: Economic Survey 2016-17, Volume 2, p. 102.
Money Supply, Inflation and Unemployment
595
Headline inflation is a measure of total
inflation within an economy and is
affected by areas of the market which may
experience sudden inflationary spikes.
Headline Inflation
Inflationary Spikes
Hyperinflation
The
of money erodes drastically and the economy is trapped between
or
Stagflation
This is a typical situation when
Suppressed Inflation
Disinflation
Under hyperinflation, prices increase at
such a speed that value of money erodes
drastically and the economy is trapped
between rising prices and wages.
596
Managerial Economics
Deflation
result in fall in investment, fall in demand for factors of production, and fall in money income of factors
Inflationary Gap
Inflationary gap represents rise in price
due to a gap between effective demand
and supply.
fully responsive to increase in
This term was coined by
is an
Money Supply, Inflation and Unemployment
597
Wage Price Spiral
real income
of people reduces; therefore to maintain their purchase level, they
demand more money
Wages chase prices and prices chase wages,
and thus create a wage price spiral.
Prices
Wages
Wages
Prices
Fig. 20.1
means a commodity which could be earlier purchased for `100 can now be purchased for `
CAUSES
OF
INFLATION
598
Managerial Economics
Excess Money Supply
Demand Pull Inflation
Increase in Money Supply
Increase in Disposable Income
Increase in Aggregate Spending
Money Supply, Inflation and Unemployment
599
Increase in Population of the Country
eality
B ites
sustained increase in wages have a number of macroeconomic implications. First, increase in wages,
unaccompanied by productivity increases, could lead to a wage-price spiral, thereby, offsetting the
positive impact of initial increase in real wages on welfare. Also, if increase in wages in one sector
negatively impacted if such wages increase are not matched with productivity increase.
rural wages. It was found that in all major labour supplying States (Odisha, Chhattisgarh, Maharashtra,
rural labor market. Hence, cost of farm labour increased. In response, farmers lobbied for, and received,
hefty rises in the minimum support prices the government pays for rice, wheat and sugar. Higher prices,
in turn, nurtured demand for even higher wages. For a while an “institutionalised wage-price spiral” was
left unchecked, says Sajjid Chinoy of J.P.Morgan.
Sources: www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=2846,
rainfall-and-price,
Cost Push Inflation
600
Managerial Economics
Low Increase in Supply of Goods
Obsolete Technology
Scarcity of Resources
Many countries have remained behind in the race of development simply because they did not have
Natural Calamities
Industrial Disputes and External Aggressions
Built-in Inflation
Built-in inflation is a type of inflation that
has resulted from past events and persists
in the present.
Money Supply, Inflation and Unemployment
INFLATION
AND
601
DECISION-MAKING
Impact on Consumers
has already been discussed in the earlier sections while we were
price of one commodity or a number of commodities upsets the whole
have applied for home loan worth `
`
602
Managerial Economics
Impact on Producers (or Suppliers)
Impact on Government
Money Supply, Inflation and Unemployment
603
Indexation
this has lead to adoption of
Indexation is the automatic linkage
between monetary obligations and
price levels.
MEASURING INFLATION
maintain
`40 and this year it is `
then we will have to consider each and every commodity and service;
`
A price index is a numerical measure
designed to help to compare how the prices
of some class of goods and/or services,
taken as a whole, differ between time
periods or geographical locations.
price index
red
604
Managerial Economics
¥ 100
Producer Price Index (PPI)
Producer Price Index measures average
changes in prices received by domestic
producers for their output.
Wholesale Price Index (WPI)
Table 20.1
Wholesale Price Index (India)
2016–17
Base year
prices
2011–12
prices
Source:
2016–17.
Consumer Price Index (CPI)
Consumer Price Index measures the price of
a selection of goods purchased by a “typical
consumer.”
purchased by a
prices
2011–12
prices
prices
2011–12
prices
Money Supply, Inflation and Unemployment
Table 20.2
605
Consumer Price Index of India (CPI-NS, Base 2012 = 100)
Rural
Urban
Combined
Cost of Living Indices (COLI)
Cost of living indices are used to adjust
fixed incomes and contractual incomes to
maintain the real value of such incomes.
Service Price Index (SPI)
eality
B ites
(Contd.)
606
Managerial Economics
mandi
not cover services.
methodological changes have been made:
implemented.
practices, and are currently used for compilation of All India CPI.
are given in the following table:
Weights
Number of Items
2011–12
Number of Quotations
2011–12
2011–12
All Commodities
Primary Articles
Fuel and Power
Manufactured Products
Inflation Rate
-
¥ 100
607
Money Supply, Inflation and Unemployment
AND
EMPLOYMENT: PHILLIPS CURVE
unemployment and
The main implication of Philips curve is that
the government has to choose between
feasible combinations of unemployment
and inflation.
that
hW/W
in prices on the Y
percent; whereas when unemployment is 2 percent,
shows various combinations of unemployment
Annual Price Rise %
hP/P
8
10
6
8
Ph
4
CONTROL
OF
INFLATION
p’s
C
ur
2
4
ve
O
2
the most appropriate combination as per the needs
6
ili
Fig. 20.2
6
4
Unemployment %
8
2
1
Annual Wage Rise %
INFLATION
608
Managerial Economics
Monetary Measures
Under monetary measures, the central
bank of the country uses various methods
of credit control to keep a check on
inflation.
the responsibility of money supply, uses various methods of credit
(i) Increasing Discount Rate
eality
B ites
environment.
Source: www.tradingeconomics.com/india/interest-rate,
Money Supply, Inflation and Unemployment
(ii) Higher Reserve Ratios
(iii) Open Market Operations
(iv) Selective Credit Control
Fiscal Measures
Reducing Public Expenditure
bonds and
609
610
Managerial Economics
Increasing Public Revenue
Under fiscal measures, the government
may reduce public expenditure or increase
public revenue to keep a check on inflation.
disposable income in
Increasing Supply of Goods and Services
imports and
SUMMARY
Money is a
, as well as a
Money Supply, Inflation and Unemployment
KEY CONCEPTS
QUESTIONS
Objective Type
I. State True or False
611
612
Managerial Economics
II. Fill in the Blanks
III. Pick the Correct Option
Money Supply, Inflation and Unemployment
1
2
4
Analytical Corner
used in the Indian economy?
613
614
Managerial Economics
Check Your Answers
State True or False
Fill in the Blanks
Pick the Correct Option
Caselet 1
Headline Inflation
Money Supply, Inflation and Unemployment
Case Questions
measures?
Caselet 2
Wage-Price Spiral
Case Questions
615
616
Managerial Economics
the
The Long and Short of Demonetisation
up to `
`
Money Supply, Inflation and Unemployment
617
Posers
has the authority to denounce it?
transparency, which are essential for economic development?
“Dragon”
the size of population of India even a small increase of `100 in the per capita income would mean
`
`
618
Managerial Economics
Posers
pressure?
Chapter
21
2. Develop a critical understanding of the various theories on business cycles.
3. Understand multiplier and accelerator.
4. Comprehend the measures of controlling business cycles.
Chapter Objectives
1. Examine the intricacies of business cycles, causes of such cycles, and their effects.
INTRODUCTION
Almost a decade back, Sensex had crossed 10,000 marks in February 2006 and 20,000 marks in October
2007. An amazing saga of expansion and high spirited enterprise! Indian economy grew at staggering 13
percent (market price) and satisfactory 8 to 9 percent (constant prices) for these two years. There was a
boom in real estate, in manufacturing and in services. Rupee appreciated as against the mighty US dollar.
Then there was news about US recession, and concern about Indian economy. Economists, analysts and
media started debating whether India would be affected by the US slowdown, and to what extent. And
such fears were not baseless. In January next year, the Sensex crashed! And it dropped more than 1,000
points, not without a reason. It was only few years back when we heard about dotcom bubble being
burst and millions of professionals being offered pink slips in the US and thousands of jobless Indians
coming back home. And then the phrase was coined ‘when the US sneezes India catches cold’! Again we
heard same bell ringing. Why is it so? Is there an explanation to this phenomenon or is it just like that?
Yes! This is an economic phenomenon and there are various explanations. This tendency of economic
activities to expand and contract in periodical interventions is known as trade cycles or business cycles.
620
Managerial Economics
eality
B ites
The Cyclical Pulses
Business cycle is the periodic up and down movements in economic
activities. It has been observed that economic activities measured
in terms of production, employment and income move in a cyclical
manner over a period of time. This cyclical movement is characterised by alternative waves of expansion
and contraction, and is associated with alternate periods of prosperity and depression.
Business cycle is the periodic up and down
movements in economic activities.
FEATURES
OF
BUSINESS CYCLES
Business cycles have three basic characteristics: periodicity, synchronism and self-reinforcing. Let us
understand each in details now.
Periodicity
These wavelike movements in income and employment occur at intervals of 6 to 12 years. To understand
it further you should know that when an economy continues to grow for certain period of time, it is
bound to slow down. However, the gap between two cycles is not regular or predictable with certainty.
Does this mean that any change in economic activity can be termed as trade cycles? No! Seasonal
variations or random variations are not termed as trade cycles; rather movements which last for longer
duration are regarded as trade cycles. You have learnt about this difference in Chapter 6.
Synchronism
Another very interesting feature of business cycles is that their impact is all embracing, i.e., large
sections of an economy experience the same phase. It happens because of interdependence of various
all the sections in an economy are interlinked in some way or the other; further, due to globalisation,
different economies are bound with each other through economic interdependence. Let us understand
this feature with the help of an example. Suppose, due to any reason, aggregate demand for electronic
Business Cycles
621
goods declines. This would result in closure of some units, on one hand creating unemployment and
on the other hand reducing demand for capital, raw material, intermediary products, marketing agents,
advertisers, and so on. This way contraction of economic activities in one sector would lead to recession
in many other areas, and also create a chain of less economic activities. You can reverse this example to
understand how creation of one new unit would result in multiple increase in activities.
Self-Reinforcing
This is one of the most critical features of business cycles. Due to interdependence of various sectors and
economies, cyclical movements faced by one sector spreads to other sectors in the economy; those faced
by one economy spread to other economies as well. In this way, upward swing of the cycle is reinforced
for further upward movement and vice versa.
eality
B ites
The Brexit Touch
Source:
PHASES
OF
BUSINESS CYCLES
A typical business cycle can be studied in four phases: expansion, peak, contraction (recession), trough
(depression) and two turning points, upward and downward. For understanding these phases, we may
refer to Figure 21.1. If we draw a country’s economic activities over a few decades in a graph, we can
form of a smooth curve, some seasonal or
It is evident from Figure 21.1 that economic activities, measured in terms of GNP, increase for some
years and then start falling, and the process of up and down movements continues. The portion AB is
known as “trough” or slump or depression; BC is the expansion phase; CD is the peak or boom, and
DE is the phase of contraction or recession and EF is another period of slump. Normally, the time gap
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Managerial Economics
Peak
C D
G
Expansion
G¢
GNP(%)
Expansion
Contraction E
F
G
Contraction A B
Trough
Time Unit (Years)
Fig. 21.1
between two bouts of trough (say, from B to E) or peaks (say, from D to G) can vary between 6 to 12
years. In other words, for 3 to 5 years, the economy experiences growth, and then for another 3 to 5
years, it faces contraction or recession. GG¢ is the steady growth line, which is normalised over the
period to show that the general trend is that of growth.
Now that we have provided brief meanings of these four phases of business cycles, let us explain
them one by one in detail.
Expansion
As the term itself denotes, this is a phase when all macroeconomic variables like output, employment,
income and consumption increase. At the same time, prices move up, money supply increases, and the
self reinforcing feature of business cycle pushes the economy upward.
Peak
This is the highest point of growth; hence it is referred to as peak or boom in a business cycle. This is
the stage beyond which no further expansion is possible, and it is that phase which sees the downward
turning point.
a turning point comes in the economy.
Business Cycles
623
Contraction
The term contraction means slowing down process of all economic
what happens in this phase. There are workers who are willing to
work, but cannot, because no one is willing to hire them; there are
consumers who would like to spend, but cannot, because their income
activities. Let us comprehend
There are two turning points in the cycle:
one at peak when the economy starts
sliding down, and the other at trough,
when the economy picks up momentum for
another phase of growth.
and produce and hire more workers, but cannot, because there is not
enough demand for their product. When investment reduces, industrial
production slows down, increasing unemployment and reducing income and consumption. This marks
the onset of recession.
Trough
Also termed as slump or depression, this is the lowest ebb of economic cycle. And it is also followed by
the next turning point in the cycle, when new growth process starts afresh.
Evidently there are two turning points in the cycle, one at peak when the economy starts
sliding down, and the other at trough, when the economy picks up momentum for another phase
of growth.
THINK OUT
CONCEPTS
OF
OF
BOX
MULTIPLIER
AND
ACCELERATOR
The simple multiplier is one of the main building blocks of Keynesian macroeconomic theory. The
multiplier is often referred to as autonomous expenditure multiplier or investment multiplier. It actually
depicts the relationship between changes in national income due to change in autonomous investment.
We have talked in length about the concept of
income is composed of consumption and investment. In other words,
Y =C+I=E
(1)
Keynes assumed that consumption is a linear function of national income and the relationship is
represented by the following form:
(2)
C = C + cY
where C (>0) is autonomous consumption. Recall that even when national income is zero, there is some
positive consumption expenditure. Remember Figure 18.3.
Before we dwell deeper into the concept of multiplier, it is important to understand two more
concepts, namely Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS),
introduced by Keynes.
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Managerial Economics
Marginal Propensity to Consume
It is the measure of an effect of change in total income on the keenness of people to spend on consumer
goods. Marginal propensity to consume change in consumption expenditure due to change in income.
In other words:
MPC =
Marginal Propensity to Consume (MPC) is
the measure of effect of change in total
income on the keenness of people to spend
on consumer goods.
dC
dY
(3)
The value of MPC lies between zero and unity. It is assumed that as Y
increases, C also increases, but increase in C is less than increase in Y.
At equilibrium, aggregate expenditure (E) equals aggregate output or
national income (Y). Therefore,
Y =C+SfiS=Y–CfiS=I
(4)
Marginal Propensity to Save
It is a measure of the effect of change in total income on the keenness of people to save. Now, since
consumption function is given as C = C + cY, the saving function is derived as:
(5)
S = Y – C = Y – ( C + cY)
Hence, MPS can be stated as:
MPS =
Marginal propensity to save is a measure of
the effect of change in total income on the
keenness of people to save.
dS
dY
(6)
It should be noted that the sum of marginal propensity to consume
and marginal propensity to save is equal to one. Since MPC lies
between zero and one, MPS = (1 – c) also lies between zero and one.
Let us prove this now.
Calculus Corner
fi
fi
Y =C+S
dY = dC + dS
1=
d C dS
+
fi MPC + MPS = 1
dY dY
Multiplier
Now that we have introduced concepts of MPC and MPS, you can understand what a multiplier is, and
how to determine the value of multiplier. A multiplier measures the effect of certain amount of capital
investment on total employment or total income or total consumption. We can alternatively say that
1
a change in income due to change in investment is given by the multiplier. Since dY =
dI ,
1 - mpc
multiplier can be stated as:
k=
1
1
dY
=
=
1 - mpc
mps
dI
(7)
Business Cycles
625
In other words, multiplier is the reciprocal of marginal propensity to save, because of which, more is
the marginal propensity to save less is the value of multiplier. For example, if the marginal propensity
to consume is 1/2, then marginal propensity to save is also equal to
Multiplier is the reciprocal of marginal
1/2. The multiplier is therefore 2. Consequently, in this case, increase propensity to save.
in output is double the increase in investment. On the other hand, if
MPC is 2/3, which means MPS is 1/3, multiplier will be 3; but when MPC is 1/3 and MPS is 2/3,
multiplier will be only 1.5.
Why is it that when investment increases, output increases by the multiplier? This is because as more
investment is injected into the economy, more and more goods and services are produced, and income
of people increases. Consequently consumption expenditure also increases, depending on marginal
propensity to consume. As people spend more on consumption, the suppliers of these consumption
goods have a rise in their income, and they in turn spend on consumption, based on their marginal
propensity. As a result, there is a continuous process of consumption expenditure taking place, leading
to more and more income generation. Thus, income increases much more than what is actually injected
into the system as investment. It is clear that increase in income depends on the value of MPC; more the
value of marginal propensity to consume, greater is the value of multiplier.
Since MPC lies between zero and unity, value of the multiplier is always greater than one. Value of
cases are:
a. It is equal to 1 when MPC = 0, i.e., when marginal propensity
to consume is nil. Consumption here is independent of income.
In this case, consumption and investment are both autonomous
and there is no multiplier effect.
Value of the multiplier is always greater
than one.
to unity implies that if there is an increase in autonomous expenditure, the entire increase in
income is manifested through consumption expenditure and there are no savings. Thus, a very
impossible, because marginal propensity to consume in reality is always less than one.
Let us illustrate with this numerical example.
The consumption and investment function of an economy are given as C = 100 + 0.8Y and
I = 200. Find Y. If investment increases by 100, what would happen to equilibrium national
output?
Solution: For the economy to be in equilibrium:
Y = E fi Y = C + cY + I fi Y = 100 + 0.8Y + 200 (1 – 0.8)Y = 300 fi Y = 1500
If investment increases by 100, Y = 100 + 0.8Y + 200 + 100
(1 – 0.8)Y = 400 fi Y = 2000
(Contd.)
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Managerial Economics
Thus, if investment increases by 100, output increases 5 times the increase in investment due
to the multiplier effect.
The concept of multiplier can be understood with the help of a diagram. You know that C = C + cY
where C is the level of autonomous consumption irrespective of income. c is the MPC and Y is income.
national output is equal to the sum of consumption and
investment shown by E = C + cY + I . The 45° line represents equality between aggregate demand
and supply.
– –
E = C + I¢
E*
–
E = C + cY+ I¢
–
C = C + cY
E
–
dI
IPQ
Consumption and Investment
Y=E
–
I=I
O
IPQ
dY a
1
dI
1E c
National Income
Fig. 21.2
At any point of time, economy is in equilibrium at point E where income is equal to expenditure.
Now suppose investment increases by dI , then the C + I curve shifts upwards by dI . Since marginal
propensity to consume is constant at c, shift of C + I line due to increase in autonomous investment is
parallel. The new equilibrium is at a point E*, where change in income is dY, which is much more than
change in investment dI . If, for example, the value of c is ½, then the multiplier is 2 and consequently
increase in income would be double the increase in investment. We may conclusively say that multiplier
depends on the slope of consumption function.
THINK OUT
OF
BOX
Accelerator
The acceleration principle was formulated by J. M. Clark. Whenever demand for one commodity (like
capital goods) is derived by the demand for another commodity (like consumer goods), it is possible that
a change in demand for a commodity brings a change in demand for another commodity but not
proportionately. Changes in the demand for consumer goods bring about wider changes in the production
Business Cycles
627
of appropriate capital goods. This is known as acceleration principle. Increase in aggregate demand,
whatever be the reason, induces investors to invest more in order to produce the increased output. This
amount of investment depends on the rate of increase in production
As per acceleration principle, changes
and not the volume of production. According to this principle, the in demand for consumer goods bring
level of investment is accelerated through an increase in national about wider changes in the production of
output in the economy. It shows that there is a functional relationship appropriate capital goods.
between consumption and investment, i.e., an increase in consumption
bringing about a greater increase in demand for machines to make those consumer goods.
The acceleration principle is based on the following assumptions:
a. Full utilisation of the total stock of capital takes place keeping no idle capacity.
capital output ratio. The model does not consider change in
capital output ratio due to change in technology.
c. The capital stock is assumed to be expanded without any constraint or delay, i.e., supply of capital
stock is assumed to be perfectly elastic.
d. The increase in total output or income does not change in the structural composition of aggregate
output.
Acceleration principle deals with the relationship between capital
optimum relationship between capital stock and the level of aggregate
demand (Y). As long as aggregate demand remains at Y, there is no
change in capital stock except that depreciated capital is replaced
Accelerator measures the relationship
between changes in investment due to
change in national output or national
income.
of capital stock must be increased to meet the increase in production. If the optimum capital stock is
more than the actual stock, more investment needs to be pumped into the system. This principle shows
the relationship between changes in investment due to change in national output or national income.
Let us study the acceleration principle mathematically.
Let v
t.
Therefore,
Kt = vYt
(8)
where v is a positive constant and Kt is the optimum capital stock required to produce an output Yt at
period t. This relationship for the time period (t – 1) is given by:
Kt–1 = vYt–1
(9)
Now if Yt > Yt–1, i.e., the output in period t is more than output in period (t – 1), then the total capital
stock Kt–1 is fully utilised by the economy and this falls short of the optimum capital stock Kt. This
induces the need for new investment (It
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Managerial Economics
Kt – Kt–1
DKt
It
It
The accelerator coefficient v is the
incremental capital output ratio.
= vYt – vYt–1
= v(Yt – Yt–1)
= v(Yt – Yt–1)
= vDYt
(10)
(11)
(12)
(13)
This implies that required change in stock of capital or investment
depends on the accelerator v and the change in the national output.
Therefore we have,
DKt
(14)
v=
DYt
In other words, the
v is the incremental capital output ratio.
Interaction of Multiplier and Accelerator
The idea of the interaction between multiplier and accelerator was brought together by the postKeynesian economists like Paul Samuelson and others. In the Keynesian multiplier, we have already
seen that if there is a change in autonomous investment, national output increases by multiplier effect. But
according to the acceleration principle, apart from autonomous investment, a change in national output
thereby aggregate demand also brings about a change in induced investment. Because as production is
increasing, investors are induced to invest more, and this induced investment goes through the multiplier
effect. So, increase in induced investment also has a multiplier effect; consequently there is an enormous
increase in production, and thereby a huge increase in national output or income. Change in production
requires more investment, which again multiplies via the multiplier effect. Interaction of multiplier and
accelerator takes place in this process of income generation. But the joint intensity of multiplier and
accelerator effect cannot go on very long, because of which booms do not continue for a longer period of
time. When production becomes steady, investors just spend to replace the depreciated capital, whereby
investment again reduces to zero at a very high level of production. This has been further explained later
in the chapter while talking of
multiplier acceleration interaction explained above.
Increase in
autonomous
investment
Increase in income
through
multiplier
1
dY a
dI
1E c
Increase in induced
investment through
accelerator
It = vhYt
Magnified
increase in
aggregate
output and
income
Fig. 21.3
CAUSES
OF
BUSINESS CYCLES
We have so long talked about characteristics of business cycles and their phases. Very rightly you must
be wondering that why does this happen? Why is it so that after a spell of expansion, contraction must
come? Why we cannot maintain the upward movement continuously? Not only you, even economists have
Business Cycles
629
explanations included climatic changes such as sunspots that may cause different moods; psychological
aspects of entrepreneurs and consumers, such as moods of optimism and pessimism; economic factors,
such as over investment, under consumption and over savings; and monetary phenomenon like changes
in money supply, rate of interest, etc.
The most recent explanation includes shocks in the conditions under which producers supply goods,
trade cycles.
Keynes’ Theory
had to posit on
he coined a new term ‘
to explain expected rate of return on investment.
Let us get into the details of Keynesian theory now.
changes in rate of investment, that depends upon two factors: rate of
According to Keynes, marginal efficiency
of capital depends upon changes in
prospective yield and supply price of capital
goods.
of capital depends upon changes in prospective yield and supply price of capital goods. Keynes further
assumed that supply price (cost) of capital goods is only a supplementary factor, and does not change
rate of return is change in prospective yield. Now you would like to know what may bring changes in
prospective yield. According to Keynes, it is entrepreneurial
Rate of
expectations that determine prospective yields. So what
Investment
determines entrepreneurial expectations? Here Keynes
introduces the psychological aspect of business, and says
that when entrepreneurs feel optimistic, they have high
Marginal efficiency
Rate of
expectations from business and when they feel pessimistic,
of capital
Interest
they have low expectations of returns.
Are you lost in this maze of dependence and
Prospective
Supply price of
interdependence? Fine! We shall link the threads for
yield
capital goods
you. When entrepreneurs are optimistic and have high
expectations from business (i.e., they expect higher rate
would be high, and this induces them to make more
Entrepreneurial
expectations
Fig. 21.4
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Managerial Economics
Now that you have understood what determines investment, we take you to Keynes’ explanation
of capital; hence entrepreneurs make huge investments. At this point, the multiplier starts its action,
bringing an increase in income, which is much higher than increase in investment. Why? Simply due to
multiplier effect! And when investment decreases, the reverse action of multiplier lowers income more
than the fall in investment.
Keynes’ biggest contribution to theory of business cycles is the use of multiplier effect in explaining
trade cycles. You can understand Keynesian theory like this. When economy is in slump, there is
shortage of capital goods; autonomous investment, say in the form
At the upward turning point, the economy
of government expenditure, helps the economy to recover. A unit
recovers from depression and is set on the
increase in investment brings about a multiplier times increase in
path to expansion.
income and employment. This is the upward turning point, recovering
the economy from depression and putting it on the path to expansion. Increase in income increases
and brings in more investment. In this manner the cycle goes on. But this process cannot continue
inventory of capital goods brings pessimistic feelings in entrepreneurs, who fear
investment. Then comes the downward turning point. Now the reverse action of multiplier starts, which
reduces income more than the fall in investment, resulting in recession and contraction of economic
activities.
Take a simple example. Suppose at any point of time, `100 million are invested in construction of
a dam; this gives employment to 10,000 people, including labour, suppliers, etc. These 10,000 people
increase the aggregate demand for consumer goods, which boosts supply of consumer goods and
creates further employment of say, 30,000 people in different sectors, whose combined income is, say,
`250 million. So you can follow that an increase of investment by `100 million brings in an increase in
income by 250 million (2.5 times). This is the multiplier effect, which, according to Keynes, is the most
important reason of business cycle.
So long you saw expansion; now reverse the process. Suppose the plan to invest `100 million is
withdrawn, resulting in unemployment of 10,000 people. This will reduce the aggregate demand for
consumer goods, forcing the producers of these goods to close (or reduce) operations, rendering 30,000
people unemployed. This is the reverse action of multiplier, bringing contraction in the economy.
Keynes is credited with presenting a systematic analysis of role of investment in causing business
cycles; however his theory does not provide a complete answer to the problem, as it ignores the role of
accelerator. So we would now discuss about the role of accelerators in business cycles.
Business Cycles
631
eality
B ites
Global Economy on the Path to Recovery
accessed on
Hicks’s Theory
Many scholars, including neo-classical economists, propounded that trade cycles occur due to interaction
of multiplier and accelerator. They believed that neither multiplier nor accelerator alone can explain the
complexity of business cycles.
due to interaction of multiplier and accelerator. He also distinguished between autonomous investment
and derived investment and pointed out the various types of cycles. Later, Hicks, Hansen and Kaldor
further developed this theory. We shall discuss views of Hicks here, as they are the most comprehensive
of all of these theories.
Hicks demonstrated through mathematical models how the interaction of multiplier and accelerator
combined the approaches of Keynes, Samuelson, Harrod and Domar. In Hicksian model, three concepts
play important role: (i) warranted rate of growth; (ii) induced and autonomous investment; (iii) multiplier
and accelerator.
(i) Warranted Rate of Growth Warranted rate of growth is one
that will sustain itself in congruity with the equilibrium of saving and
investment. According to Hicks, the interaction between multiplier
Warranted rate of growth is one that
will sustain itself in congruity with the
equilibrium of saving and investment.
of growth. In this way, Hicks’s model of trade cycles represents an important step towards integrating
Harrod and
Domar’s model of growth, Hicks assumes that equilibrium rate of growth of an economy is that where
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Managerial Economics
actual rate of growth is equal to natural rate of growth. This rate is determined by the rate of autonomous
investment and savings. Hicks also proposed that there is a full employment ceiling beyond which the
economy may not grow.
(ii) Autonomous and Induced Investment According to Hicks, public investment, investment which
occurs in direct response to inventions, and much of the long range investment which is only expected
to pay over a long period—all of these can be regarded as autonomous investment. On the other hand,
induced investment depends upon changes in the level of output or income; thus it is a function of an
economy’s growth rate. Hicks conceived investment to increase at a regular rate, so that it remains in
progressive equilibrium, if it is not disturbed by extraneous forces.
(iii) Multiplier and Accelerator Unlike Keynes, Hicks has formulised multiplier and accelerator
with a time lag. Hicks has started with the assumption that consumption of current year is a function of
income of last year, implying that with an increase in income, consumption would increase, but with a
lag of one year; whereas investment is function of output of the same year. Hicks admits that monetary
He further argues that except in rare cases, the effective ceiling is the level of full employment and
the
theory of trade cycles is an explanation in the real sense of a mechanical technological sort, in which
monetary factors are left out or admitted as modifying elements, and where human judgement, business
based on formula, not on human judgment.
(iv) Upswing, Downswing, and Two Turning Points Increase in autonomous investment results in
increase in income due to the effect of multiplier, leading further to more investment, more income, and
so on. Based on the interaction of multiplier and accelerator a cumulative process of income generation
and investment expansion is encountered in an economy, creating an upswing in the economy. This
is called ‘leverage effect’ by economists, and the combined multiplier and accelerator leverage is
known as super multiplier. This process of expansion continues till economic activities touch the full
employment ceiling. Here you should know that in a dynamic economy there will be a rising ceiling.
That is how you see in Figure 21.5 that all the paths are slanted upwards. But once this ceiling is touched,
the cycle starts its downward swing. When the path has encountered the ceiling, after a little while it
must bounce off from it, and begin to move in a downward direction. This change of trend is known as
upper turning point. This upper turning point is affected by many elements like population, technology,
capital stock, etc. In some cases, where the interaction between multiplier and acceleration is not that
strong, the turning point may come before the full employment ceiling is reached.
After the upper turning point is reached, surplus capacity appears, and investment starts declining. With
each decline in investment, due to the backward operation of multiplier, income falls and consumption
a boost to the economy to move upward.
Business Cycles
633
We can say that the lower tuning point is when disinvestment is At lower tuning point, disinvestment is less
less than the increment in investment; thus there is increase in net than increment in investment; thus there is
investment, turning the cycle upward. Here you should note that while an increase in net investment, turning the
upswing was an outcome of the interaction between multiplier and cycle upward.
accelerator, downswing is largely a result of multiplier alone, since the
accelerator remains inactive for the most part of downswing.
Hicks has explained his model with the help of a diagram, as depicted in Figure 21.5. Time is
AA¢; this
is determined by autonomous investment. LL¢ is the
which shows income level determined
by autonomous investment and multiplier. EE¢ is the equilibrium path of income and output. FF¢ is
the full employment ceiling, where all the productive resources are fully utilised in gainful activity. It
According to him, autonomous investment grows at a constant rate, and all other levels are determined
by autonomous investment. Taking this in account they are shown parallel to each other, although each is
moving upward from left to right, showing dynamic economy. The vertical distance between two levels
shows the impact of relationship between various variables like investment, multiplier and accelerator
on output and employment.
F¢
S
T
E¢
GNP (%)
F
L¢
E
R
U
V
A¢
L
A
O
Time (years)
Fig. 21.5
LL¢
[AA¢
EE¢
FF¢
Let us now elaborate on how Hicks explains the process. Assume
that at any given point of time an economy is at point R, which is on
equilibrium path EE¢. Income increases multiplier times investment,
Induced investment is increase in further
investment due to income.
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Managerial Economics
and is shown at LL¢. What after that? Multiplier explains only one time increase in income but does not
complete the cycle; however accelerator does! You also know that when income has increased, as an
outcome of investment, aggregate demand for consumer goods also increases. Because of this demand
for capital goods to produce these consumer goods would also increase. Thus, increase in income brings
increase in further investment, i.e., induced investment. It is known as induced investment, because it
is induced by the demand for goods it can produce. How much would be the increase in investment?
It would be accelerator times! To recapitulate, increase in investment brings multiplier times increase
in income, which in turn brings accelerator times increase in investment. It may be concluded that
equilibrium path EE¢ is determined by the interaction of multiplier and accelerator.
So coming back to point R, the economy is gradually crawling along EE¢, but at point R some changes
occur in the environment which bring a sudden jump in investment. You must be wondering as to what
possible change this can be. It can be a technological invention, a new product, or a new government
policy promoting investment in particular area. The outburst of investment increases income at a rate
higher than that shown by the slope of EE¢. Consequently the economy shifts above the level of EE¢
path. Due to interaction of multiplier and accelerator and induced investment, the process of growth is
S, which is on FF¢, which is nothing but the full employment
ceiling.
So you can understand here that RS represents expansion phase. Hicks says that the downward
turning point does not come immediately at point S, the economy again crawls for some time at FF¢. You
can observe that the rate of growth of output between RS and ST is very different. This slackening of
growth rate will adversely affect entrepreneurial expectations and result in fall in induced investment,
with which, the reverse action of multiplier starts and the economy slides below the FF¢ line, bringing
further contraction of economic activities. Once growth rate starts falling, it will not stop at EE¢, but
would slide further down to LL¢
model, the economy will not slide below LL¢, because at this level, simple multiplier is active on
autonomous investment without any simultaneous action by the accelerator.
So TU is the contraction phase. The economy will again start
In Hicks’s model, the main cause of
crawling at LL¢ for some time, say, from point U to V. This will increase
fluctuation is in the effect of change in
the levels of income and investment, and the process of recovery will
output (or income) on investment.
start because between U and V autonomous investment is greater than
declining investment prior to U. Moreover, positive acceleration effect becomes operative again, as a
result of which the cycle will be repeated.
Business Cycles
635
We can conclusively say that
of change in output (or income) on investment.
Interaction of multiplier and accelerator can also be understood with the help of Table 21.1. It is
assumed that autonomous investment in the economy is `100 million, MPC is 2/3 and accelerator is 2.
Autonomous investment made in Period 1 will increase consumption in Period 2.
Table 21.1
Interaction of Multiplier and Accelerator
Autonomous
Business Cycle
Consumption
¸
˝
˛
¸
Ô
˝
Ô
˛
Contraction
You can mark that an increase in investment by `100 million in Period 1 will increase consumption
by 67 (100 ¥ 2/3) in Period 2 and induced investment by 134 (67 ¥ 2) and income will increase by `301
million, which is 3 times the autonomous investment. In Period 3, induced consumption will be 200 (2/3
of 301); thus increase in consumption from Period 1 to Period 2 is 133 (200-67). So, induced investment
will be 266 (=133 ¥ 2) and income will be 566, and so on. Period 5 shows the full employment ceiling,
beyond which output cannot increase further. In Period 6, the economy crawls at the same income
and then downswing sets in. It is evident that expansion was faster due to interaction of multiplier
and accelerator, whereas contraction is brought by multiplier, since accelerator does not have a
reverse action.
In a nutshell, Hicks propounded that trade cycles occur due to interaction of multiplier and accelerator
over a period of time when the values of marginal propensity to consume and of accelerator are given
over the period.
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Managerial Economics
Assumptions of Hicksian Model
The basic assumptions adopted by Hicks are following:
1. The economy is progressive, in which autonomous investment is increasing at a regular rate.
the equilibrium path results in displacement from equilibrium, though it may be lagged.
3. Production cannot exceed the full employment ceiling.
4. Working of the accelerator in an economy in downswing is different from its working while the
economy is in upswing.
cycle.
6. Disinvestment cannot exceed depreciation because transformation of accelerator in the
downswing provides indirect constraints.
However, these assumptions became the main cause of criticism of Hicksian theory as they were
simplistic and limited the practicality of analysis. Prominent among those who criticised Hicks’s theory
include Kaldor and Duesenberry.
Real Business Cycle Theory
So far you have read that whole responsibility has been laid on changes in aggregate demand for
bringing about cycles in an economy. A different view on trade cycles is that these are caused not by
shocks in the conditions under which producers supply their
products. Real business cycle theory
John Muth (1961), and is
associated most with Robert Lucas. Many other scholars like Nobel laureate Kydland and Prescott are
in close link with the theory. The underlying idea of this theory is to study business cycles with the
assumption that they were driven entirely by technology shocks, rather than by monetary shocks or
changes in expectations.
This view highlights the importance of supply side of business
According to real business cycle theory, the
ups and downs are caused by technology
or other similar shocks to the supply side of
the economy.
associates business cycles with rational expectations, and lays down
the idea that markets generally function very smoothly; for this reason
rational decisions made by many individuals. According to this theory, the ups and downs are caused by
technology or other similar shocks to the supply side of the economy. It postulates that with an invention
of a productivity increasing device, entrepreneurs will increase investment, expand output and employ
more people. These will lead to a boom. There may be other times when new advances are lacking, or
productivity is low, and at that point employers will rationally choose not to produce as much and there
will be a recession. Downturn is simply the optimal reaction of individuals to the lack of productive
opportunities. When rate of technology slows down, marginal productivity of workers will fall and then
real wages will fall; people will react to that change in real wage in a rational manner by shifting their
work and leisure decisions over time.
Business Cycles
637
, the economy will be busier in high
productivity times than in low productivity times. When there is a technological shock raising real wage,
people will work more, causing output to surge, and when there is a technological shock lowering real
wage, people will withdraw from work, causing output to fall. This pattern is what we observe as booms
and recessions.
Further, a very interesting recommendation from the proponents of this theory is that although booms
are nicer than recessions, there is no need to react to either, as they represent the best use of opportunities
available.
In reality the real business cycle theory has not attracted much empirical support. Many economists
that are at the heart of this explanation. Most do not agree with the proposition that unemployment
during recession is voluntary. On the other hand, economists who have formed these arguments show
that the patterns their mathematical models generate are remarkably similar to patterns that the real
world generates.
EFFECTS
OF
BUSINESS CYCLES
So long we have talked about various explanations that have been given by scholars from time to time to
explain the up and down movements of economic activities. Surprisingly, research on such movements
is far from getting over! One thing is certain now in the minds of economists that whatever may be the
reason, business cycles are bound to take place and that there is need to control them. But why so? There
should only be need to control only the contraction phase so that slump does not come, right? No! The
problem is that you cannot have either of the two; you must have both of them. That is why it is called
cycle, you see! After a spell of expansion, contraction is bound to occur. Let us take a glance at the
effects of business cycles. We shall divide the effects on basis of two phases, expansion and recession
(contraction).
Effects during Expansion
As you have noticed that expansion is the phase of high growth coupled with large investments, increase
in employment, income and expenditure, but that is not all about it. Expansion also comes along with
competition.
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Managerial Economics
investment increases demand for capital, which forces more money supply in the system, demand for
factor inputs increases, due to which their prices rise, thus increasing cost of production. Wages and
Severe Competition
the only bad thing about this situation is that they resort to large amount of non-productive expenditure
differentiation is not generic or utility based, but is more due to consumers’ preferences and biases,
producers (or sellers) are forced to spend huge funds on such expenditures which do not add real value
to the product. For this reason GNP may increase, but only in money terms, and not in real terms.
Effects during Recession
Recession being unwarranted and since it creates negative implications for an economy, there are
no doubts that it should be controlled. During this phase, the basic problems that occur are that of
unemployment, excessive inventory, below capacity operations and
Excess Inventory
You know that one of the most important reasons for recession is fall in aggregate demand, due to which
items. This further dampens the spirit to investment. They not only have excess inventory of unsold
This creates unemployment for suppliers of these goods.
Another problem is that inventory maintenance has a cost, which is in addition to cost of production.
Retrenchment
axe falls on workers and recession phase is marked by large scale retrenchment. You would recall that
with the news of a possible downswing of the US economy, many software majors in India have put
recruitments on hold and have also cut down workforce in the name of rationalisation.
CONTROLLING BUSINESS CYCLES
many and often at different times different factors become active. Therefore, there is need for controlling
such cycles. In fact, governments constantly keep a watch on macro variables so as to contain either over
heating or over dampening of economic activities. And yet the most interesting part of the whole story
is that come what may, these cycles will continue to occur as a natural phenomenon. They cannot be
avoided; what can be done in this matter is to control the cycles to the extent possible so as to minimise
Business Cycles
639
their evil effects. Measures to control business cycles can be categorised into: (i) preventive measures
and (ii) curative measures. Further, although governments have the responsibility to ensure market
stability yet you would agree that corporates cannot be abdicated from their role in taking such measures
which help reducing the effect of cycles. Mainly for this reason preventive and curative measures
preventive measures are proactive, while curative measures are reactive.
At Firm Level
Firms are the main victims of cycles; at the same time they are one of
For firms expansion is the desired phase,
and recession the unwarranted phase.
and during recession they suffer; following this logic, expansion is the desired phase for them and
recession the unwarranted phase. But the problem is that no one can choose just one. As such the
analogy with human body: those who take preventive measures remain healthy and develop immunity
are minimised. Don’t they say ‘prevention is better than cure’?
Precautionary Measures
These include safeguarding against swaying away with the wave of expansion, so that sufferings during
recession may be minimised.
Investments Firms should deter from investing huge amount of funds in
pattern should be a balanced mix of debt and equity.
Inventory
strategy helps in such cases.
Products
Firms should diversify in different markets and different products, because in this way
Pricing Flexibility should be the right strategy, so that during recession prices may be adjusted
to increase demand without eating away margins.
Curative Measures
It is clear by now that business cycles cannot be avoided. If in spite of all precautions they must occur,
understand the cause of the current phase of the cycle. Another thing that you should comprehend is
that as preventive measures are taken during expansion phase, so corrective measures are taken during
recession phase.
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Managerial Economics
You would recall that in Chapter 15, while talking about cyclical pricing we had referred to an
interview with Ms Nooyi, CEO of PepsiCo, that stability in pricing is the strategy to face recession.
At Government Level
Here, we would like to tell you that most of the measures at government level to control business
Since inflation is an important corollary of
expansion, measures to control inflation
also help in controlling business cycles.
categorised into monetary and
help in controlling business cycles. Basic difference between the two
whereas in case of business cycles focus is on stability in the economy.
Monetary Measures
You know that
has occurred due to excess money supply; similar assumption is taken as the root cause of business
cycles while applying monetary measures.
Central bank of a country uses various methods of credit control. Such methods include: (i) rediscount
rate; (ii) reserve ratios; (iii) open market operations; and (iv) selective credit control. You have already
two differing contexts of expansion and recession.
During expansion the central bank
increases the rediscount rate to curb money
supply, whereas in recession it reduces the
rate to increase money supply.
Rediscount Rate During expansion, central bank increases
rediscount rate to curb money supply, whereas in recession it reduces
the rate to increase money supply. Increase in money supply encourages
people to spend more and thus increases aggregate demand.
Reserve Ratios
Reserve ratios function in the same manner as rediscount rate. During expansion
the ratios are increased so that banks are left with less cash to be extended as credit, while during
recession the ratios are decreased so that banks can extend easy credit. You know that there are two
major reserve ratios, i.e., Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR). These ratios
determine a bank’s liquidity and capability to extend credit.
Open Market Operations During expansion, central bank sells securities, taking away
disposable income from people’s hands. At the other extreme, during recession it buys securities to give
more in the hands of people for consumption.
Selective Credit Control
All the above methods are aimed at controlling money supply in
general without any segmentation, on the basis of use or amount. And it may not be always desirable
Business Cycles
641
to control credit at all levels, and for this reason central banks have devised another method, known as
selective credit control. Actually this method is a very useful preventive tool, through which credit may
be extended to certain areas and contracted from certain other areas, thereby providing a safety cushion
against strong bouts of expansion and contraction in the economy.
eality
B ites
Burst of the Bubble: Learning the Jap Way
Fiscal Measures
measures have to be undertaken.
Public Expenditure You have learnt that an important tool in the hands of government is
expenditure. And in the analysis of business cycles you have read that scholars especially have strongly
recommended that one important form of autonomous investment could be public expenditure. So you can
understand that public expenditure is an important measure to recover
During recession, governments normally
an economy from recession. When government spends money on
use public expenditure as a tool, while
various activities like health, transport, communication, etc., income during expansion they use public revenue
of individuals increases; this in turn increases aggregate demand. items as controlling device.
Public Revenue As increase in expenditure boosts aggregate demand, increase in public
revenue takes away portion of people’s money income and brings down aggregate demand. So, during
recession, it is desirable that governments reduce taxes. During recession, governments normally use
public expenditure as a tool, while during expansion they use public revenue items as controlling device.
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Managerial Economics
They are complementary, and it is for the government to ensure that an appropriate combination of these
measures is adopted after thorough examination of the causes of business cycles.
SUMMARY
Business cycle is the periodic up and down movement in economic activities, measured in terms
of production, employment and income moving in a cyclical manner over a period of time.
It is characterised by alternative waves of expansion and contraction, and is associated with
alternate periods of prosperity and depression.
A business cycle has three basic characteristics: periodicity, synchronism and self-reinforcing.
A typical business cycle can be studied in four phases: (i) expansion, (ii) peak, (iii) contraction
(recession), and (iv) trough (depression); and two turning points, (i) upward and (ii) downward.
Expansion is a phase when all macro economic variables like output, employment, income and
consumption increase. Peak or boom is the stage beyond which no further expansion is possible,
and it sees the downward turning point.
Contraction implies slowing down of all economic activities; it marks the onset of recession.
Slump or depression is the lowest ebb of economic cycle, followed by the next turning point in
the cycle, when new growth process starts afresh.
Hicks combined the approaches of Keynes, Samuelson, Harrod and Domar, and demonstrated
through mathematical models how the interaction of multiplier and accelerator could bring
According to Hicks, the interaction between multiplier and accelerator fabricates economic
The real business cycle theory associates business cycles with rational expectations, and proposes
that the ups and downs are caused by technology or other similar shocks to the supply side of
the economy.
Recession is unwarranted and creates negative implications for the economy; during this phase,
the basic problems that occur are that of unemployment, excessive inventory, below capacity
Business Cycles
643
Business cycles create problem for the economy. Hence, governments constantly keep a watch
on macro variables so as to contain either over heating or over dampening of economic activities.
Measures to control business cycles can be categorised as preventive and curative measures.
Not only governments but also the corporate sector plays a vital role in taking such measures
which help reducing the ill effect of cycles. At government level, these can be categorised into
Just as preventive measures are taken during expansion phase, similarly corrective measures are
taken during recession phase.
KEY CONCEPTS
Business cycle
Turning point
Multiplier
Slump
Autonomous and Induced Investment
Recession
Expansion
Accelerator
Boom
Marginal Propensity to Consume
QUESTIONS
Objective Type
I. State True or False
i.
ii.
iii.
iv.
Peak marks the onset of recession.
Accelerator does not have a reverse action.
When rate of technology slows down, marginal productivity of workers rises.
There is a consensus that fall in aggregate demand causes recession.
vi. Trough announces the momentum for a new growth process.
vii. If MPC is equal to 1, the investment multiplier is also equal to one.
ix. Investment starts falling beyond the upper turning point if a business cycle.
x. The phase of contraction is also known as ‘slump’.
I. Fill in the Blanks
i. Recession phase is marked by large scale ________of workers.
ii. Increase in investment brings ______times increase in income.
iii. Keynes had assumed that supply price of capital goods is a _______factor.
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Managerial Economics
iv. Gap between two cycles can not be ________with certainty.
v. The combined multiplier and accelerator ______is known as ‘super multiplier’.
vi. The investment multiplier is the ________ of marginal propensity to save.
viii. During recession, the government generally uses ________ as a tool to recover from recession.
ix. The buying and selling of government securities by the central bank is known as ________.
x. Disinvestment is less than increment in investment at ________ turning point.
II. Pick the Correct Option
a. Autonomous investment
b. Rate of investment
c. Warranted rate of growth
d. Disinvestment
ii. All of the following are true about the effects of expansionary phase of business cycles, EXCEPT:
a. Intensive competition
b. Increase in wages and prices of goods
c. Increase in GNP in money terms
d. Fall in aggregate demand
a. Prospective yield
b. Supply price of capital goods
c. Both (a) and (b)
d. Either (a) and (b)
iv. Lower turning point may come when:
a. Autonomous investment increases
b. Positive action of multiplier begins
c. Only (a)
d. Both (a) and (b)
v. The important monetary measures in the hands of the central bank include all of the following
EXCEPT:
a. Rediscount rate
b. Reserve ratios
c. Open market operations
d. Public revenue
a. Changes in prospective yield
b. Supply price of capital goods
c. Marginal propensity to consume
d. None of the above
vii. The investment multiplier in a simple Keynesian model depends on the slope of:
a. Trade balance
b. Investment function
c. Consumption function
d. None of the above
viii. Expansion in a business cycle is generally accompanied by:
c. Negative growth
d. None of the above
a. Wage rate
b. Rate of consumption
c. Rate of investment
d. None of the above
x. During recession phase, the basic problems are that of:
a. Unemployment
b. Excessive inventory
c. Below capacity operations
d. All of the above
Business Cycles
645
Analytical Corner
1. Why is it better to keep a check on business cycles? Is it feasible, keeping in view their obvious
and inevitable occurrence?
of economic expansion?
5. Compare and contrast the effects of expansion and recession on selected variables like output and
employment.
cycles?
8. How does the real business cycle theory establish linkages between business cycles and rational
expectations?
9. Compare preventive measures and corrective measures against trade cycles.
10. How does a phase of expansion lead to recession?
11. Critically analyse the theories of trade cycles by Keynes and Hicks. Which one of the two appeals
to you in terms of real-life relevance?
economy? Explain in detail.
13. Is it right to say that business cycle is a monetary phenomenon? Answer with special reference to
the Hicksian model of trade cycles.
recession and its impacts on Indian economy.
15. “Although India and China have different economic political systems yet they are equally affected
by the US recession”. Discuss.
Check Your Answers
State True or False
i. T
ii. T
iii. F
iv. F
v. T
vi. T
vii. F
viii. T
ix. T
x. F
Fill in the Blanks
i. retrenchment
v. leverage
ix. open market operations
ii. multiplier
vi. reciprocal
x. lower
iii. supplementary iv. predicted
vii. incremental
viii. public expenditure
iv. d
vi. a
Pick the Correct Option
i. b
ii. d
iii. c
v. d
vii. c
viii. b
ix. c
x. d
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Managerial Economics
Caselet 1
Is IT Ringing Recession Bells?
India is witnessing some extraordinary layoffs across the Information Technology (IT) sector. Major
IT companies, including MNCs as well big Indian names, have been sending shock waves through
their announcement of laying-off large number of employees since 2016. Cognizant, for example,
is likely to cut at least 6,000 employees, equal to 2.3 percent of its total workforce. It is noteworthy
that 72 percent of Cognizant’s total workforce is based in India. Indian IT majors like Infosys
and Wipro have released more than 8,000 employees in the past one year due to automation of
lower-level roles. IT companies are, thus, in the midst of the industry’s largest retrenchment drive,
and the number is likely to be twice the employees laid off by companies last year. Main cause cited is
under-performance and lack of preparedness to adopt fast changing technology.
Besides IT, the e-commerce sector is also facing the challenges of rapidly changing technology
trends. The year 2016 saw many e-commerce companies reducing their workforce. In August 2016,
the consumer internet search platform AskMehad to close down its operations, laying off its staff.
Snapdeal has announced its plans to lay-off about 600 employees from its logistics unit (Vulcan) and
payments (Freecharge) divisions due to cash crisis.
Sources:
www.entrepreneur.com/article/290902, accessed on 15/06/2017.
www.livemint.com/Industry, accessed on 15/06/2017.
accessed on 15/06/2017.
Case Questions
1. Do you think Indian IT sector is heading towards recession, or is this a temporary
phenomenon?
2. On a business cycle curve, where would you like to place Indian IT sector as per above
information? Why?
Caselet 2
The Turning Point
The Government of India reports that the “economy has emerged with remarkable rapidity from the
. The turnaround has been fast and strong
due to agriculture and continued momentum in manufacturing, although there was a deceleration
in services and industry. However, the medium to long-run prospect of the economy, including the
industrial sector, continues to be positive. On the demand side, a rise in savings and investment and
pickup in private consumption have resulted in strong growth of the Gross Domestic Product (GDP)
Business Cycles
647
at constant market prices at 9.7 percent in 2010–11. A sequenced and gradual withdrawal of the
up in credit growth, vibrant equity market and stable foreign exchange market. Though downside
risks of global events, particularly movement in prices of commodities like crude oil (exacerbated by
political turmoil in the Middle East), remain, the Indian economy is poised to further improve and
consolidate in terms of key macroeconomic indicators.
Source: Economic Survey, 2010–11, Chapter 1.
Case Questions
1. Identify the factors helping India to recover from the recession.
Volatility in World Economy
The Federal Reserve Board (Fed), the Central Bank of USA, has increased interest rates by 0.25 percent
and has indicated to increase the rates at least three times in 2017. Looking at the relative risk image
of USA and emerging economies like India, it is envisaged that even a small increase in interest rates
would encourage foreign investors to pull money out of emerging markets like India and invest in bonds
issued by the US Government. Prime Minister of India, Mr. Narendra Modi, has shown his concern
that many Indian business houses prefer to invest outside India, while he is consistently promoting and
encouraging companies to invest in India in manufacturing units through several schemes. Among many
advantages, it is also expected that increased investment might lead to employment generation on long
term basis, which would further boost the economy and create a virtuous circle of growth. However, at
this point, it is noteworthy that Foreign Institutional Investors have already pulled out about $ 2 billion
from India.
Another announcement by the US Government, which has repercussions for India, is the temporary
suspension of the fast-track processing of H-1B visas. H-1B visa grants permission to skilled workers
to work in the US on temporary basis. This is likely to affect India and especially the IT sector. Industry
analysts posit that Indian IT companies have no other option but to increase hiring in overseas markets
along with other measures to tackle with the new visa norms.
The same is evident from the recent announcement by Indian IT majors. “We are (now) looking
at hiring from more colleges in the US. With the (new) visa rules, we will have to look at building a
company Tata Consultancy Services also said it would hire increased number of young engineers from
India is much less than that of hiring an engineer in USA. On an average, a fresh engineering graduate
in the US gets $40,000, (or `26 lakh approximately) while salaries for fresh engineers in India have
remained stagnant between `
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Managerial Economics
as well. As per an estimate, the outsourcing business stands at $ 150 billion; but now they will have
to restructure their recruitment strategy. It is needless to say that this is going to impact the overall
employment scenario in India, especially of technical human resource. It is estimated that annually more
than one million engineers graduate in India.
Sources:
accessed on 15/06/2017.
www.thehansindia.com/posts/index/Editors-Desk/2016-12-26/Beware-Recession-coming/ 270337,
accessed on 15/06/2017.
Posers
1. Discuss the case in light of causes of business cycles and measures to control them.
2. “Synchronism is a feature of business cycles.” Explain this statement by analysing the far
reaching effects of the situation described in the case.
3. Use multiplier-accelerator relationship to explain employment generation due to increased
investment.
IT Industry Growth Cycle: Manifesting or Synchronism
With a CAGR of more than 50 percent between 1992 and 2001, estimated at mere `6.5 billion in 1990,
Information Technology (IT) industry in India has expanded almost twice as quickly as its counterpart in
the US. With a modest beginning in 1984–85, software export moved up to `3.8 billion approximately
in 1991–92. Since then, IT export has grown at an ever-increasing rate; it grew by 115 percent in 1993
and 61 percent in 1994. Over the last decade of twentieth century, the IT industry has consistently shown
one of the highest growth rates compared to most others; the industry’s average annual rate of growth
between 1992 and 1997 has been 46 percent, with exports growing much faster than domestic sales.
During 1999–2000, more than one million PCs were sold in India, and the ITeS (IT enabled Services)
segment earned revenue of `
The merriment in the Indian IT industry, however, started dying down since the advent of the new
at the end of second quarter of 2000 to a quarterly rate that was close to zero. The factors contributing to
this included a rise in interest rates and oil prices, which reached around US$ 35 a barrel in September
and the World Bank reduced their growth estimates within a short span of time. While the World Bank
put on an estimated growth rate of 2.2 percent in 2001, IMF cut down its growth estimate sharply from
4.2 percent to 3.4 percent. The US IT industry had a major setback with a sharp fall in demand for IT
and related products and services. More than 3 lakh jobs were slashed and as a result of severe liquidity
Business Cycles
649
crunch, several companies were compelled to shut down their operations. The shake out in the US
economy as a whole, inclusive of the IT slowdown, had a repercussion on the growth rate of global
GDP, which was estimated to go down from 4 percent in 2000 to 3.3 percent and further to 2.2 percent
by the end of 2001.
countries like Turkey and several East Asian nations were hammered in the foreign exchange market.
India was no exception, as she too felt the tremors of the US slowdown. The steep fall in demand for
Indian IT products and services in North America, which accounted for as much as 80 percent of the
Indian software exports, sent shockwaves all across the IT industry. A bigger blow came with the dot
market with a decent job and command a lucrative remuneration. Companies like Compaq, Motorola,
Ericsson and Intel resorted to desperate means to revise their quarterly results by laying off their
employees and closing off their off-shore centres. Lay offs in the high tech sectors had put thousands
of foreign workers mainly from India, China and Western Europe in a state of jeopardy in the US. The
real pain was that the domestic industry itself was not in a position to absorb the returned professionals.
The situation got worsened with the September 11 attack on World Trade Centre and the Pentagon.
The US economy dwindled and cut back the already low volumes of projects that were heading towards
the East, including India. Apart from rendering talented software engineers jobless, the September
11 carnage hit hard the Indian IT training industry. In a major stride to cut down their costs, US
companies curtailed many of their projects heading towards India. This had a ricocheting effect,
impacting the fortunes of not only IT companies both in India and the US, but also of the legions of
people they employed. The US tech majors such as Nortel, Cisco, Intel, Hewlett-Packard (HP) and many
others slashed their jobs, especially of the contractual software workers. It was estimated that in
January–February, 2001 alone, some 30,000 jobs were axed. Major companies like Sun, Lucent and
Cisco either stopped hiring completely, or drastically slowed down on fresh recruitment.
Indian companies were forced to compete for new projects aggressively, which initiated a wave of
undercutting prices. Billing rates came down by 30 to 50 percent for the various layers of middlemen in
line growth, or grab projects that would earn lower rates and margins.
In 2001–02, the industry had a sharp fall in growth rate of its share of GDP to 5.90 percent, from 44.91
percent in the previous year. The total IT market also showed a fall in growth rate from 56.42 percent
in 2000–01 to a mere 16.24 percent in the next year, growing further at the rate of 16.25 percent in the
next year (refer to Table I). Software export was also affected, registering a low growth of 28.74 percent
and failed to maintain its growth rate of 65.30 percent in the previous year. It got further lowered to
26.30 percent in 2002–03. CAGR of total output of software and services came down to `25.61 crore
in 2001–02 and further to `25.11 crore in 2002–03. The domestic market showed a steep decline in
growth to 3 percent in 2001–02 from an amazing 50.39 percent in 2000–01. It could, however, recover
by growing at 4.11 percent in the next year. The growth rate of software exports fell sharply to 20 percent
in 2001–02 from 65 percent in the previous year.
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Managerial Economics
Table I
Indian IT Industry
Year
A*
%*
B*
%*
C*
%*
D*
%*
%*
`
`
`
`
Sources:
1. Computers Today, 1-15 November 2000.
Info Tech Industry, Doctoral Thesis (unpublished), Motilal Nehru National Institute of Technology
Allahabad.
4. NASSCOM (2003), The IT Software and Services Industry in India: Strategic Review, New Delhi.
5. www.bankofengland.co.uk/speeches/speech115.htm.
Posers
1. Do you think that the US recession and resultant recession in Indian IT industry describe business
cycles? Which theories can you validate on basis of this case?
phases on basis of data provided.
3. The case proves that business cycles are synchronic and self-reinforcing. Discuss.
4. Why was the Indian IT industry hit more severely with the US recession?
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A
Abba Lerner 332
Ability to pay 9
Acceleration principle 626
Accounting
costs 200, 202
year 551
Actual rate of growth 632
Autonomous
consumption 531, 626
demand 96
expenditure multiplier 623
investment 526, 533, 623
Average
cost 205
propensity to consume 531
revenue 216
variable cost 205
Advertising (or promotional) elasticity 132
Agency theory 53
Aggregate
consumption 530
demand curve 526
production 559
B
Balanced budget 536
Balance of
payments 566
Bank
supply 521, 526
Annuities 533
rate 591
rate policy 591
Assets 532
Index
Barometric
Carbon tax 511
Base
rate system 592
year 556, 603
Benchmark
interest rate 592
prime lending rate 592
Centralised cartel 396
CES production function 265
Ceteris paribus 5, 103
Charles W. Cobb 261
Cheap money policy 591
Cheating 399
Classical unemployment 529
Boom 621
Cobb–Douglas production function 261
Break-even
analysis 221
chart 221
Collusion 363, 395
Budget 536, 601
Budgeting 536
Commercial banks 591
Commodity market equilibrium 539
Common
costs 215
C
Company 39
Comparative statics 119
Completeness 66
Constant
elasticity of substitution 265
657
658
Index
price 555
Current
returns to scale 261
costs 202
price 555
Cyclical
Consumer 522
credit 102
Cyert and March 52
goods 96, 526, 626
D
Dear money policy 591
Decision
curve 526
Contraction 620, 621
Decreasing returns to scale 261
Deferred
Contribution margin 223
Controllable costs 203
Corporate social responsibility 202, 506
Cost 200
of living indices 605
push 600
Degree of
homogeneity 262
responsiveness 132
Degrees of elasticity 133
Delphi technique 166
Demand 95
curve 105
deposits 592
forecasting 162
Credit
control 591, 593
entry 566
Cross
elasticity 132
function 102
schedule 105
Demerit goods 502
Curative measures 639
Demonstration effect 111
Index
Derived
Economic
activities 551
investment 631
Desire 96
Determinants of
monopoly 330
supply 112
Differentiated
products 361
Economies of
Economy 551
Direct
cost 200, 203
tax 535
Edward H. Chamberlin 361
Effective
ceiling 632
demand 596
Discounting principle 15
Diseconomies of scale 213, 226
Disequilibrium unemployment 529
Disinvestment 633, 636
Distant substitutes 326
Distributive shares 561
Elasticity of 132
output 261
substitution 253, 262
Employment 529, 622
Domar 631
Entrepreneurial expectations 629
Double counting 551
Downswing 633
Downward turning point 630
Entry and exit 363
Envelop curve 211
Duesenberry 636
path 633
rate of growth 631
Dynamic economy 633
E
Exclusive marketing rights 330
659
660
Index
path 260
Expenditure method 562
Experts’ opinion method 166
Floor line 633
External
cost 500, 501
costs of consumption 502
diseconomies 500
diseconomies of consumption 502
diseconomies of production 501
economies 225, 500
Follower 391
Forecasting 162
Foreign
nationals 551, 561
economies of production 503
Four-sector model of economy 552
Franchise monopoly 330
F
Frictional unemployment 529
Full
Factor
cost 552
payments 523, 561
services 553
employment 529
employment ceiling 632, 633
Future costs 203
G
Family branding 226
Final
output 552
product method 560
Financial
economies 225
GDP
at factor cost 552
at market price 552
Giffen goods 109
GNP 621
Going
market 522
Firm 522
Goods and services 551
Fixed
assets 639
Government
budget 536
Index
monopoly 330
revenue 609, 610
securities 609
Income 99, 623
elasticity 132
Gross
domestic product 551
investment 532
national income 561
national product 553
value added 559
Growth line 622
H
Harrod 631
Harrod and Domar’s model of growth 631
tax 610
Increasing returns to scale 261
Incremental
Indeterminate curve 393
Indexation 603
Indifference 66
Indirect
cost 203
tax 535, 552
Individual
consumption 530
Herbert Simon 52
Highly elastic demand 133
Historic costs 203
Homogeneous product 303
Homogeneous production function 262
Horizontal
gap 596
spikes 595
rate 603
summation 205
Households 522
H.V. Stackelberg 391
I
Imperfect
competition 361
knowledge 363
Implicit costs 201
Intermediary
consumption 560
661
662
Index
Internal
economies 225, 503
unemployment 530
Kink 393
L
Investment 522, 532, 623
curve 526
multiplier 623
Involuntary unemployment 529
IS curve 539
Labour
Lag 632
Law of
demand 95, 99, 103
marginal rate of technical substitution 251
Leader follower model 391
J
Leakages 522
J.M. Clark 626
Legal
monopoly 330
John Hicks 253
John Muth 636
Lerner index 332
Joint
Linear demand function 103
Liquidity
stock company 39
K
Kaldor 631, 636
Keynesian
consumption function 531
average cost 210
marginal cost 212
total cost 213
Index
Long-term forecasting 162
Mass unemployment 530
Luxuries 133
M
Macroeconomics 6, 521, 550
Managerial economies 225
Marginal
cost lending rate 592
productivity 636
propensity to consume 530, 623
propensity to save 531, 623
Merit goods 503, 511
Microeconomics 6
Model of managerial utility function 50
Monetary
policy 591
shocks 636
revenue 216
standing facility 592
costs 200
Margin of safety 223
Market 301
national income 555
equilibrium 116
failure 505
morphology 301, 326
price 552
value 551
Monopolist 326
Monopolistic competition 361
power 331, 365
sharing cartel 396
Monopsonist 350
stability 639
Monopsony power 350
Moral
Mark up ratio 331
suasion 593
663
664
Index
New
and accelerator leverage 632
effect 625
Nominal
costs 200
GDP 555
national income 555
Non-
N
marketed products 560
monetised transactions 565
National
income accounting 551
income by industry of origin 559
output 626
Natural
monopoly 331
rate of growth 632
Negative
consumption externalities 501
external costs of production 501
externalities 501
production externalities 501
Net
rival goods 509
Normal
n
O
exports 562
factor income from abroad 553
investment 532
national income 536
Oliver Williamson 50
welfare loss 505
technical progress 266
Optimal level of advertising 369
Optimum
Index
665
Personal
consumption expenditures 562
Out of pocket costs 202
rights 510
P
Phases of business cycles 621
Physical measure 215
Pigou 350, 505
Planned
saving 523
Planning
cost function 210
curve 210
Paul H. Douglas 261
Paul Sweezy 392
Payment 566
Point elasticity of demand 136
Polluter pays principle 511
Population 101
Positive
Peak 621
production externalities 501, 503, 509
Positive spillover effect 503
Precautionary
Per capita
Preference 66
Preventive measures 639
Perfect
competition 303, 326
degrees of price elasticity 133
determinants of price elasticity of demand 139
elasticity 132
Perfectly
measuring elasticity 135
ratio (or percentage) method 135
Price
Periodicity 620
index 556, 603
666
Index
Progressive equilibrium 632
stickiness 392
taker 305, 333, 396
Prime lending rate 592
Prospective yield 533, 629
Prosperity 620
Public
agent problem 53
Private
costs 202, 501, 509
investment 532, 632
investment 532
marginal cost 502
returns 503
Producer
Purchasing power parity 603
Pure
Producers’
public goods 511
Product
PV ratio 223
homogeneity 315, 361
Production 239
Q
R
Product
method 559
function 391
Random
events 169
variations 620
Rate of
capital formation 529
exploitation 350
Index
Rival 391
investment 629
return 533
Rational
decisions 636
expectations 636
Rationality 5, 305, 536
Reaction curve 391
Real
business cycle theory 636
costs 201
GDP 555
national income 555
wage unemployment 529
Receipt 566
Robert Giffen 109
Robert J. Gordon’s 600
Robert Lucas 636
Ronald Coase 506
Rothschild index 332
S
Sales
force composite 165
value at split off 215
Rectangular hyperbola 206
Regional monopoly 331
Replacement
costs 202
Scallop curve 211
Scarcity 13
Seasonal
trend 169
variations 620
Secular trend 169
Repo rate 592
Reserve
Self reinforcing 621
Semi variable costs 205
Responsiveness 131
Retention ratio 50
Returns to scale 260, 262
Reverse repo rate 592
Separable costs 215
Service
price index 605
sector 560
Shocks 636
equilibrium 309
Short run
marginal cost 212
forecasting 162
667
668
Index
Shut down point 311
Supply 95, 112
Simultaneous
function 113
Slope 626
Slump 621
price 533
Social
marginal cost 502
returns 503
Sole proprietorship 35
Synchronism 620
Specialisation 225
Speculative
T
Tacit collusion 395
Tastes and preference 100
Spillover effects 500
Split off point 215
Stackelberg
burden 535
Taxpayer 535
Technical
Stagnation 595
Statistical discrepancy 566
Statutory
reserve requirement 592
progress 265
Technological parameter 261
shocks 636
Tertiary sector 560
Structural barrier 329
Structural unemployment 529
Thorstein Veblen 109
Time lag 632
Subsidies 552
Total
Sunk cost 203
Super multiplier 632
cost 205
Index
Upward turning point 630
revenue 216
utility 69
Trade 553
V
Value added method 560
Value of
Variable
Transfer
Veblen goods 109
Trend 622
Voluntary unemployment 529
Trough 621
Turning points 621
W
Two-sector economy 522
indexation 605
price spiral 595
U
Umbrella branding 226
Warranted rate of growth 631
Weighted
Uncontrollable costs 203
Withdrawals 522
Unitary elastic demand 133
Unorganised sector 565
Z
Zero
Upper turning point 632
Upswing 632, 633
Z-shaped demand curve 109
669