MANAGERIAL ECONOMICS

Preface

This is an attempt to the integration of economic theory with business practices for the purpose
of facilitating Decision Making and Forward Planning by the management. As economics
provides as a set of concepts, these concepts furnish us the tools and techniques of analysis. It is
in this context economic analysis is an aid to understand business practices in a given
environment. As decision making is a basic function of manager, economics is a valuable guide
to the manager. In the following we shall be discussing the decision making process of the
management and how managerial economics and its various tools and techniques help a
manager in this process.

Index
S.I. Nos.

Chapter Title

Page

no.
1

Managerial Decision Making

Business Forecasting

Demand Analysis

Cost Analysis

Production Analysis

Objectives of the Firm

Pricing Policy of the Firm

Market Structure

Chapter-I
Managerial Decision Making

Contents:
1.1 Introduction
1.2 Decision Making Process
1.3 Management Decision Problems
1.4 Corporate Decision Making: Ford Introduces the Taurus
1.5 Types of Decision
1.6 Conditions Affecting Decision Making
1.7 The Steps of Decision Making
1.8 Selecting the Best Alternative
1.9 Implementing the Decision
1.10 Evaluating the Decision
1.11 Decision Making Model
1.11.1 The Classical Model
1.11.2 The Administrative Model
1.12 Decision Making Techniques
1.12.1 Marginal Analysis
1.12.2 Financial Analysis
1.13 Group Decision Techniques
1.13.1 Brainstorming
1.13.2 Nominal Group Technique
1.13.3 Delphi Group Technique
1.14 Decision Making Tools
1.14.1 Linear Programming
1.14.2Inventory Control
4

1.1 Introduction
Managerial Economics is the integration of economic theory with business practices for the
purpose of facilitating Decision Making and Forward Planning by the management. As
economics provides as a set of concepts, these concepts furnish us the tools and techniques of
analysis. The use of Economic Analysis is to make business decisions involving the best use
(allocation) of scarce resources. Economic Theory helps managers to collect the relevant
information and process it in order to arrive at the optimal decision given the goals of a firm. A
decision is optimal if it brings the firm closest to its goals. It is in this context economic analysis
is an aid to understand business practices in a given environment. As decision making is a
basic function of manager, economics is a valuable guide to the manager. In the following we
shall be discussing the decision making process of the management and how managerial
economics and its various tools and techniques help a manager in this process.

1.2 Decision Making Process

Decision making is commonly defined a choosing from among alternatives. Decision is a choice
made from alternative courses of action in order to deal with a problem. A problem is the
difference between a desired situation and the actual situation. Therefore, decision making is
the process of choosing among alternative courses of action to solve a problem. The Decision
making process is construed as searching the environment for conditions calling for a decision;
inventing, developing and analyzing the available courses of action; and choosing one of the
particular courses of action.
A second and more detailed method is the following:

Identify the problem.

Diagnose the situation.

Collect and analyze data relevant to the issue.

Ascertain solution that may be used in solving the problem

Analyze these alternative solutions.

Select the approach that appears most likely to solve the problem
Implement it.

1.3 Management Decision Problems

Product Price and Output

Production Technique

Stock Levels

Advertising Media and intensity

Labor hiring and firing

Investment and Financing

A practical example can be found in the following:

1.4 Corporate Decision Making : Ford Introduces the Taurus

In late 1985 Ford Introduced the Taurus -a newly designed, aerodynamically styled, frontwheel drive automobile. The car was a huge success at the time and helped Ford almost to
double its profits by 1987. The design and efficient production of this car involved not only
some impressive engineering advances, but a lot of economics as well. Ford, had to think
carefully about how the public would react to the Taurus design. Would consumers be swayed
by the styling and performance of the car? How strong would demand depend on the price
Ford changed? Understanding consumer preferences and trade-offs and predicting demand
and its responsiveness to price were essential parts of the Taurus program.
Ford had to be concerned with cost of the Car. How high would production costs be, how
would this depend on the number of cars for produced each year? How would union wage
negotiations or the prices of steel and other raw materials effect costs? How much and how fast
would costs decline as managers and workers gained experience with the production process?

To maximize profits, how many cars should Ford plan to produce each year?
Ford also had to design a pricing strategy for the car and consider how its competitors would
react to this strategy. For example, should Ford charge a low price for the basic stripped-down
version of the car but high prices for individual options, such as air conditioning and power
steering? Or would it be more comfortable to make these options "Standard" items and charge a
high price for the whole package? Whatever prices ford choose, how were its competitors likely
to react? Would GM and Chrystler try to under cut Ford by lowering prices? Might Ford be able
to deter GM and Chrysler from lowering prices by threatening to respond with its own price
cuts? The Taurus program required a large investment in new capital equipment and Ford had
to consider the risks involved and the possible outcomes. Some of this risk was due to
uncertainty over the future price of gasoline (Higher gasoline prices would shift demand to
smaller cars). What would happen if world oil prices doubled or tripled, or, if the government
imposed a new tax on gasoline? How should Ford take these uncertainties into account when
making its investment decisions? Ford also had to worry about organizational problems, Ford
is an integrated firm -separate divisions produce engines and parts, then assemble finished
cars. How should the managers of the different divisions be rewarded? What price should the
assembly division be charged for engines it receives from another division? Should all the parts
be obtained from the upstream divisions, or other firms? All these decision come under
managerial decision taking process.

1.5 Types of Decision

Managers make many decisions, in order to answer the following questions:

What goods shall firm produce?

How should firm raise the necessary capital and what shall be its legal form.

What technique shall be adopted, and what shall be the scale of operations?

Where production is located?

How shall its product be distributed?

How shall resources be combined?

What shall be the size of output?

How shall it deal with its employees?

Managers make these decisions, and in order to obtain a clear understanding of the decision
making process, a classification system is useful. Three such systems are available; each based
on different types of decisions.

Organizational and personal decisions,

Basic and routine decisions

Programmed and non-programmed decisions.

Organizational decisions are those executives make in their official role as managers. The
adoption of strategies, the setting of objectives and the approval of plans constitute only a few
of these. Such decisions are often delegated to others, requiring the support of many people
throughout the organizational if they are to be properly implemented.
Personal decisions are related to the managers as an individual, not as a member of the
organizations. Such decisions are not delegated to others because their implementation does
not require the support of organizational personnel. Deciding to retire, taking a job offer from a
competitive firm, or slipping out and spending the afternoon on the golf course are all personal
decisions.
A second approach is to classify decisions into basic and routine categories. Basic decisions can
be viewed a much more important than routine ones. They involve long-range commitments,
large expenditures of funds, and such a degree of importance that a serious mistake might well
jeopardize the well being of the company. Selection of a product line, the choice of a new plant
site, or a decision to integrate vertically by purchasing sources of raw materials to complement
the current production facilities are all basic decisions.
Routine decisions are often repetitive in nature, having only a minor impact on the firm. For
this reason, most organizations have formulated a host of procedures to guide the manager in
handing these matters. Since some individuals in the organization spend most of their time
making routine decisions, these guidelines are very useful to them.
Taking a cue from computer technology, decision could be classified as computer technology
programmed and non-programmed. These two types can be viewed on a continuum,
programmed being at one end and non-programmed at the other. Programmed decisions
correspond roughly to the routine decisions, with procedures playing a key role. Non
programmed decisions are similar to the category of basic decisions, being highly novel,

important, and unstructured in nature. The value of viewing decision making in this manner is
that it permits a clearer understanding of the methods that accompany each type.

1.6 Conditions Affecting Decision Making

In an ideal business situation, managers would have al of the information they need to make
decisions with certainty. Most business situations however are characterized by incomplete or
ambiguous information, which affects the level of certainty with which a manager makes a
decision. There are three conditions that affect decision making:

Certainty

Risk

Uncertainty

Certainty is the condition that exists when decision makes are fully informed about a problem
its alternative solutions, and their respective outcomes. Under this condition, individuals can
anticipate, and even exercise some control over, events and their outcomes.
In the context of decision making, risk is the condition .that exists when decision-makers must
rely on incomplete, yet reliable information. Under a state of risk, the decision-maker does not
know with certainty the future outcomes associated with alternative courses of action; the
results are subjects to chance. However, the manager has enough information to determine the
probabilities associated with each alternative. He or she can then choose. The alternative that
has the highest probability of success.
Uncertainty is the condition that exists when little or no factual information is available about a
problem, its alternative solution, and their respective outcomes. In a state of uncertainty, the
decision-maker does not have enough information to determine the probabilities associated
with each alternative. In actually, the decision-maker may have so little information that he or
she may be unable even to define the problem, let alone identify alternative solutions and
possible outcomes.

1.7 The Steps of Decision Making

Identifying the problem

Generating the alternative course of action

Evaluating the alternative

Selecting the best alternative

Implementing the decision; and

Evaluating the decision

The first step in the decision-making process is identifying the problem. Problem identification
is probably the most critical art of the decision making process, for it is what determines the
direction that the decision making process takes, and, ultimately, the decision that is made.
The second step in decision-making process is generating alternative solutions to the problem.
This step involves identifying items or activities that could reduce or eliminate the difference
between the actual situation and the desired situation. For this step to be effective, the decision
makers must allot enough time to generate creative alternatives as well as ensure that all
individuals involved in the process exercise patience and tolerance of others and their ideas.
In the Pursuit of quick fix managers too often shortchange this step by failing to consider
more than one or two alternatives, which reduces the opportunity to identify effective
solutions. After generating a list of alternatives, the arduous task of evaluating each of them
begins. Numerous methods exist for evaluating the alternatives, including determining the
pros and cons of each; performing a cost-benefit analysis for each alternative; and weighting
factors important in the decision, ranking each alternative relative to its ability to meet each
factor, and then multiplying cumulatively to provide a final value for each alternative.

1.8 Selecting the Best Alternative

After the decision-makers have evaluated all the alternatives, it is time for the fourth step in the
decision-making process; choosing the best alternative. Depending on the evaluation method
used, the selection process can be fairly straightforward. The best alternative could be the one
with the most "pros" and the fewest "cons"; the one with the greatest benefits and the lowest
costs; or the one with the highest cumulative value, if using weighting.

1.9 Implementing the Decision

This is the step in the decision making process that transforms the selected alternative from an
abstract situation into reality. Implementing the decision involves planning and executing the

10

actions that must take place so that the selected alternative can actually solve the problem.

1.10 Evaluating the Decision

In evaluating the decision, the sixth and final step in the decision-making process, managers
gather information to determine the effectiveness of their decision. Has original problem
identified in the first step been resolved? If not, is the company closer to the situation it desired
than it was at the beginning of the decision-making process?

1.11 Decision Making Model

There are basically two major models of decision-making -the classical model and the
administrative
model.

1.11.1 The Classical Model

The classical model of decision making is a prescriptive approach that outlines how managers
should make decisions. Also called the rational model, the classical model is based on
economic assumptions and asserts that managers are logical, rational individuals who make
decision that are in the best interest of the organization. The classical model is characterized by
the following assumptions:

The manager has completed information about the decision situation and operations
under a condition of certainty.

The problem is clearly defined, and the decision-maker has knowledge of all possible
alternatives and their outcomes.

Through the use of quantitative techniques, rationality, and logic, the decision-maker
evaluates the alternatives and selects the optimum alternative -the one that will
maximize the decision situation by offering the best solution to the problem.

1.11.2 The Administrative Model

The Administrative model of decision making is a descriptive approach that outlines how

11

managers actually do make decisions. Also called the organizational, neoclassical, or behavioral
model, the administrative model is based on the work of economist Herbert A. Simon
recognized that people do not always make decisions with logic and rationality, and he
introduced two concepts that have become hallmarks of the administrative model- bounded
rationality and satisfying.
Bounded rationality means that people have limits, or boundaries, to their rationality. These
limits exist because people are bound by their own values and skills, incomplete information,
and their own inability-due to time, resource, and rational decisions. Because managers often
lack the time of ability to process complete information about complex decisions, they usually
wind up having to make decisions with only partial knowledge about alternative solutions and
their outcomes. this leads managers often forgo the six steps of decision making in favor of a
quicker, yet satisfying, process- satisficing. The Administrative model of decision making also
have some basic assumptions:

The manager has incomplete information about the decision situation and operates
under a condition of risk or uncertainty.

The problem is not clearly defined, and the decision-maker has limited knowledge of
possible alternatives and their outcomes.

The decision-maker satisfies by choosing the first satisfactory alternative- one that will
resolve the problem situation by offering a good solution to the problem.

1.12 Decision Making Techniques

It is useful to examine some of the specific technique that has proved valuable in the decision
making process, two of which are marginal analysis and financial analysis.

1.12.1 Marginal Analysis

The "marginal product" of a productive factor is the extra product or output added by one extra
unit of that factor, while other factors are being held constant. Labors marginal product is the
extra output you get when you add one unit of Labor holding all other inputs constant.
Similarly, land's marginal -product is the change in total product resulting from one additional
unit of land with all other inputs held constant. The manager can use the concept to answer

12

questions such as how much more output will result if one more worker is hired? The answer
often called marginal physical product, provides a basis for determining whether or not one
new man will bring about profitable additional output.

1.12.2 Financial Analysis

The firms are supposed to safeguard their interest and avert the possibilities of risk or try to
minimize it. For this a firm needs to analyze the assets as well as liabilities, efficiency of capital
investment, choice of project and various vital ratios. The cost benefit analysis ensures the firms
to take prudent financial decision.

1.13 Group Decision Techniques

There are several group decision techniques:

1.13.1 Brainstorming
Brainstorming is a technique in which group members spontaneously suggest keys to solve a
problem. Its primary purpose is to generate a multitude of creative alternatives, regardless of
the likelihood of their being implemented.

1.13.2 Nominal Group Technique

The Nominal Group Technique involves, the use of highly structured meeting agenda and
restricts discussion or interpersonal communication during the decision making process. While
the group members are all physically present, they are required to operate independently.

1.13.3 Delphi Group Technique

The Delphi group Technique employs a written survey to gather expert opinions from a
number of people without holding a group meeting. Unlike in brainstorming and nominal
groups, Delphi group participants never meet fact to face; in fact, they may be located in
different cities and never see each other.

1.14 Decision Making Tools

The major decision- making tools are as under:

1.14.1 Linear Programming:

One of the most widely used techniques is that of linear programming. It has been described as
a technique for specifying how to use limited resources or capacities of a business to obtain a

13

particular objective, such as least cost, highest margin, or least time, when those resources have
alternative uses. It is a technique that systematizes for certain conditions the process of
selecting the most des able course of action from a number of available courses of action,
thereby giving management information for making a more effective decision about the
resources under its control.
All linear programming problems must have two basic characteristics. First, two or more
activities must be competing for limited resources. Second, all relationships in the problem
must be linear.
Linear programming can be used in the solution of many kinds of allocation decision problems,
but its application is certainly limited. For example, to be employed effectively the decision
problem must be formulated in quantitative terms. Nevertheless, the approach has many
advantages and its application in the area of business decision making is increasing.

1.14.2Inventory Control
A problem faced by managers is that of maintaining adequate inventories. On the one hand, no
one wants to have too many units available because there are costs associated with carrying
these customerss future business.
There are two types of costs that merit the manager's consideration. One way for the manager
to solve the inventory problem is to make certain assumptions regarding future demand and
then attempt a solution. Three of the most common assumptions made in determining optimal
inventory size are: demand is known with certainty; the lead time necessary for recording
goods is also known with certainty; and the inventory will be depleted at a constant rate. Now,
the manager has to decide if he or she wishes to use what can be labeled a trial-and -error
approach, or if he wants to employ an OR (Operations Research) tool known as the economic
order quantity formula which can be given by:

OQ = {2DA} vr

14

Where:
D = expected annual demand
A = Administrative costs per order
V

= Value per item

r = Estimate for taxes, insurance and other expenses

The EOQ formula is used by many firms in solving inventory control problems. However, it is
only one of many mathematical techniques that lave been developed to help the manager make
decisions.
Another important tool in taking one of the most economical decisions is "Decision Trees"

15

Many managers weight alternatives base don their immediate or short-run results, but a
decision- tree format permits a more dynamic approach because it makes some elements
explicit that are generally implicit in other analyses. A decision tree is a graphic method that
the manager. can employ in identifying the alternative courses of action available to him in
solving a problem; assigning payoff corresponding to each act-event combination.
For example, consider the case of a firm that has expansion funds and must decide what to do
with them. After careful analysis, three alternatives identified:

Use the money to buy a new company

expand the facilities of the current firm

put the money in a saving account

And wait for better opportunities. In deciding which alternative is best, the company has
gathered all the available information and constructed the decision tree.
In the figure there are four important components. One is the decision point, represented by a
square, which indicates where the decision maker must choose a course of action. second is a
chance point, represented by a circle, which indicates where a chance event is expected, such as
solid economic growth, stagnation, or high inflation. A third is the branch, represented by a
line flowing from the chance points, which indicates an event and its likelihood such as 0.5 per
solid growth, 0.3 for stagnation or 0.2 for high inflation. Finally, at the far right is a payoff
associated with the each branch. It is called a conditional payoff since its occurrence depends
on certain conditions. For example, in figure the conditional ROI (Return on Investment)
associated with buying a new firm and having solid economic growth is 15 per cent, but this
return is conditional on the two preceding factors (buying the firm and having solid growth).

In building a decision tree, the company will start by identifying the three alternatives, the
probabilities and events associated with each alternative, and the amount of return that can be
expected from each. Having then constructed the tree, the firm will roll back it from right to
left, analyzing as it goes.
This analysis is conducted, first by taking the conditional ROls at the far right of the tree and
multiplying them by the probability of their occurrence. For example, if the company buys a
new firm and there is solid growth in the economy, as seen in figure, it will obtain a 15 per cent

16

ROL However, the probability of such an occurrence is 0.5 Likewise, the probabilities
associated with stagnant growth, where the return will be 9 percent, and high inflation, where
the return will be 3 percent, are .3 and .2 respectively. In order to determine the expected return
associated with buying a new firm, each of the conditional ROls is multiplied by its respective
probability and the products are then totaled. For alternative one, buying the firm, the
calculation is as follows:

Conditional ROI

Probability

Expected Return

15.0

0.5

7.5

9.0

0.3

2.7

3.0

.02

0.6
10.8

For alternative two, expanding current facilities, the calculation is:

Conditional ROI

Probability

Expected Return

10.0

0.5

5.0

12.0

0.3

3.6

4.0

0.2

0.8
9.4

For alternative three, expanding current facilities, the calculation is:

Conditional ROI

Probability

Expected Return

6.5

0.5

3.25

6.0

0.3

1.80

6.0

0.2

1.20
6.25

17

These expected returns are often placed over the chance points on the decision tree. They can
be determined only after the tree has been drawn and the analysis of the branches has been
conducted. The first alternative is the best, because it offers the greatest expected return. In
evaluating alternatives, decision these help the manager identify both what can happen and the
likelihood of its occurrence .In building the tree we moved from left to right but in analyzing
we moved from right to left. In the final analysis the decision tree does not provide any
definitive answers. However, it does allow the manager to allow benefits against costs by
assigning probabilities to specific events and then ascertaining the respective payoff.

18

End Chapter quizzes :

Q.1. The Technique that employs a written survey to gather expert opinions from a number of
people without holding a group meeting is known as (a) Brainstorming
(b) The Delphi group Technique
(c) The Nominal Group Technique
(d) None of the above
Q.2. Approval of Plans is the best example of (a) Organizational decisions,
(b) Basic decisions
(c) Programme decisions.
(d) Both (a) & (c)
Q.3. Which sort of decision does not require the organizational support(a) Basic decision
(b) Routine decision
(C) Personal decision
(d) Organizational decision

Q.4 In the context of formulation of an investment decision on a project, the availability of

land, plant, machinery, raw materials and technical know how etc. means(a) Technical Feasibility
(b) Financial feasibility
(c) Commercial feasibility
(d) None of the above

19

Q.5. The method of inventory valuation & thereupon decision making in which, the cost of
production is calculated on the assumption that the material which was last to enter the
inventory of the company was used first is
(a) LIFO
(b) FIFO
(c) F I LO
(d) None of the above
Q.6. Which out of following is significant threat in front of a manager in his decision making
related to technological up gradation?
(a) Conflict of Interest
(b) Time & Resource constraints
(c) Both A & B
(d) None of the above
Q.7. Knowing the problem, its possible alternative solutions and their respective outcomes in
the decision making process of a manager refers to the condition of
(a) Risky information,
(b) Certainty
(c) Uncertainty of probable action,
(d) Risk & Uncertainty

Q.8. Prescriptive approach that outlines how managers should make decisions is
(a) Administrative Model of decision making
(b) Rational Model of decision making
(c) Alternative Model of decision making
(d) Both (b) & (c)
Q.9. The use of highly structured meeting agenda and restricted discussion or interpersonal
communication during the decision making process is known as

20

(a) Nominal Group Technique,

(b) Brainstorming,
(c) Delphi Group Technique,
(d) Both (b) & (c)
Q.10. In identifying the alternative courses of action available to a manager while solving a
problem, a decision tree is
(a) More dynamic in nature,
(b) Graphical method,
(c) Assigns payoff corresponding to each act-event combination,
(d) All of the above.

21

Chapter-II
Business Forecasting
Contents:
1.1 Introduction
1.2 Purpose and need of forecasting
1.2.1 Specific purposes of demand forecasting
1.3 Steps Involved in Forecasting
1.4 Period of forecasting
1.5 Levels of Forecasting
1.6 Methods of Forecasting
1.6.1Qualitative Forecast
1.6.1.1 Survey techniques
1.6.1.2 Opinion pools
1.6.2 Statistical Forecast
1.6.2.1 Trend projection method
1.6.2.2 Barometric methods
1.6.2.3 Regression method
1.6.2.4. Simultaneous equation method (Econometric Models)
1.6.2.5. Input Output Forecasting
1.7 Reasons for fluctuations in time series data
1.7.1 Cyclical fluctuations
1.7.2 Seasonal variation
1.7.3 Irregular and random variation
1.8 Smoothing Techniques
1.8.1 Moving average smoothing technique
1.8.2 Exponential smoothing technique
22

1.9 Risks in Demand Forecasting

1.1 Introduction
Estimation of demand for a product in a forecast year/ period is termed as Demand forecast.
Demand forecast is a must for a firm operating its business as today's market is competitive,
dynamic and volatile.

1.2 Purpose and need of forecasting

Forecasting is done both for long term as well as short term. The purpose of the two however
differs. In a short run forecast seasonal patters are of prime importance. Such a forecast helps in
preparing suitable sales policy and proper scheduling of output in order to avoid over-stocking
or costly delay in meeting the orders. It helps in arriving at suitable price for the product and
necessary modifications in advertising and sales techniques. Long run forecasts are helpful in
proper capital planning. It helps in saving the wastages in material, m -hours, machine time
and capacity. Long run forecasting is used for new unit planning, expansion of the existing
units, planning long run financial requirements and manpower requirements. Different set of
variables is used in than in short term forecasts.

1.2.1 Specific purposes of demand forecasting

Better planning and allocation of resources

Appropriate production scheduling

Inventory control

Determining appropriate pricing policies

Setting s les targets and establishing controls and incentives.

Planning a new unit or expanding existing one

23

Planning long term financial requirements

Planning Human Resource Development strategies.

1.3 Steps Involved in Forecasting

Identification of objective

Determining the nature of goods under consideration.

Selecting a proper method of forecasting.

Interpretation of results.

1.4 Period of forecasting

Short run forecasting: In short run forecasting, we look for factors which bring
fluctuation in demand pattern in the market for example weather conditions like
monsoon affecting the demand.

Medium run forecasting: In medium run forecasting is done basically for timing of an
activity like advertising expenditure.

Long run forecasting: It is done to ascertain the validity of trend. It is done for decision
like diversification.

1.5 Levels of Forecasting

Macroeconomic forecasting is concerned with business conditions of the whole

economy. It is measured with the help of indices like wholesale price index, consumer
price index.

Industry demand forecasting gives indication to firm regarding direction in which the
whole industry will be moving. It is used to decide the way the firm should plan for
future in relation to the industry.

Firm demand forecasting is done for planning companies overall operations like sales
forecasting etc.

24

 Product line forecasting helps the firm to decide which of the product or products should
have priority in the allocation of firm's limited resources.

General purpose or specific purpose forecast helps the firm in taking general factors
into consideration while forecasting for demand.

Forecast of established product or a new product

Types of commodity for which forecast is to be done. Goods can be broadly classified
into capital goods, consumer durable and Non-durable consumer goods. For each of
these categories of goods there is a distinctive pattern of demand.

1.6 Methods of Forecasting

25

26

1.6.1Qualitative Forecast
1.6.1.1 Survey techniques

Survey of business executives, plant and equipment, expenditure plans.

Basically compilation of expenditure plans of related industries.

Survey of plans for inventory changes and sales expectations.

Survey of consumer expenditure plans.

1.6.1.2 Opinion pools

Consumer survey: In this method the consumers are contacted personally to

disclose their future purchase plans. This could be of two types-Complete
enumeration and sample survey.

Sales force opinion method: In this method people who are closest to the

27

market are asked for their opinion on future demand. Then opinion of
different people is compiled to get overall demand forecast. This method has
advantage that it is based on first hand knowledge of sales people and also it
is cheap and easy. However the opinion of the concerned people could be
biased or twisted for their own benefit. Therefore a final ratification has to be
done by the head office.

Experts opinion method: In this method opinion of experts' in the related

field is solicited and the final forecast based on their opinion. A special case
in this method is the Delphi Technique. In this different sets of experts are
given the relevant problem without each knowing about the other and their
opinions or conclusions are compared. If the opinion is matching then the
opinion is accepted other wise the experts are asked to sit together and arrive
at a narrow range. Thus the experts giving a very high or a very low value
are concerned and the group argues until it comes up with a narrow range of
value. This process is continued till a sufficient range is reached. Then the
mean of the upper and lower values is computed to reach a point estimate.

1.6.2 Statistical Forecast

1.6.2.1 Trend projection method
Under the trend method the time series data on the variable under forecast are used to
fit a trend line or curve either graphically or by means of a statistical technique known
as the Least Squares method. Trend projection method can be used when there is some
sort of correlation between the two variables. It could be linear, logarithmic or power
correlation. The linear regression model will take the form of

Y = a + bX

28

 Fitting a trend line by observation: This method involves the plotting of the
data on the graph and estimating where the trend line lies. The line can be
extrapolated and the forecast read from the graph.

Trend through least squares method: This method uses statistical formulae to
find the trend line which best fits the available data. The trend line is the
estimating equation, which can be used for forecasting demand by extrapolating
the line for future and reading the corresponding values of variables on the
graph.

Time series analysis: This is an extension of linear regression which attempts to

build seasonal and cyclical variations into the estimating equation. This method
assumes that past data can be used to predict future sales. This is one of the
most frequently used forecasting methods. It refers to he values of variable
arrange chronologically by days, weeks, months, quarters or years. The first step
in time series analysis is usually to plot past values of the variable that we seek
to forecast on vertical axis and the time on the horizontal axis in order to visually
inspect the movement of the time series over time. It assumption is that the time
series will continue to move as in the past. For this reason time series analysis is
often referred as "native forecasting.

1.6.2.2 Barometric methods

Barometric methods are used to forecast or anticipate short term changes in economic
activity by using leading economic indicators. These indicators are time series that tend
to precede changes in the level of economic activity. There are only three types of
indicators:

Leading economic indicator: These indicators tend normally to anticipate

turning points in a business cycle. There are certain problems associated with
this method. The major problem is not choosing the technique but choosing the

29

relevant indicator for the product in question. Secondly even if the relevant
indicator is found out the changes in factors may render the indicator redundant
over time. Thirdly the time lag between the indicator and forecast could be so
small that it could become useless.

Coincident indicators: These are indicators which move in step or coincide with
movements in general economic activity or business cycle.

Lagging indicator: These are indicators which lag the movements in economic
activity or business cycle.

1.6.2.3 Regression method

It is one of the statistical tools to fore cast demand. In this estimating equations are
established and tests can be carried out to observe any statistically significant. It involves
following steps

Identification of variables which influence the demand for the good whose
function is under estimation.

Collection of historical data on all relevant variables.

Choosing an appropriate form of the function.

Estimation of the function

Regression method is popular because it is prescriptive as well as descriptive.
Also it is not as subjective or objective as other methods. However if the
variables chosen are wrong then the forecast will also be wrong. A typical
demand equation could be :

Log d = -12.4 + 1.78 log y -1.22 log 0 + 2.20 log v + 0.8 log g + 1.62 log e

Y = National income
O = groundnut oil price
V = Vanaspati price
G = ghee price

30

E = egg, fish and meat price

The above equation is a demand forecast equation for groundnut oil

1.6.2.4.Simultaneous equation method (Econometric Models)

Econometric forecasting incorporates or utilizes the best features of other forecasting
techniques such as trend and seasonal variation, smoothing techniques and leading
indicators. Econometric forecasting models range from single equation models of the
demand that the firm faces for tits product to large multiple equation models describing
hundreds of sectors and industries of the economy.
Single equation models: The simplest form of econometric forecasting is with the
single equation model. The first step here is to identify the determinants of the variable
to be forecasted.
Q = a0 + a1P + a2Y +a3N + a4P5 + a5Pc + a6a + e
Q = demand
P = Price
Y = disposable income
N = size of population
Ps = price of a substitute
Pc = price of complement
A = level of advertising by the firm

Multiple equation model: Sometimes economic relationships may be so complex that a

multiple equation model may be required. This is particularly used in forecasting micro
variables or the demand and sales of major sectors or industries. Multiple equation
model for GNP

Ct = a1+b1GNPt+u1t
It =a2+b2IIt-1+U2t

31

GNPt= Ct+ It+Gt

C = consumption expenditures
GNP = Gross national product in year t
I = investment
II = Profit
G = Government expenditures
U = stochastic disturbance (random error term)
T = current year
t-1 = previous year
Variables to the left of the equal sign are called endogenous variable. These are
the variables that the model seeks to explain or predict from the solution of the
model. Exogenous variables are those determinants outside the model or right
of the equal sign of the equation.

1.6.2.5.Input Output Forecasting

Input output analysis was introduced by Prof. Leontief. With this technique the firm can
also forecast using Input output tables. It shows the use of the output of each industry
as input by other industries and for final consumption. Input and output analysis allow
us to trace through all these inter industry input and outputs flow though out the
economy and to determine the total increase of all the inputs required to meet the
increased demand. In this technique we have two input output matrixes.

Direct Requirement Matrix

Total Requirement Matrix

1.6.2.5.1 Uses and shortcomings of input output forecasting

Input output analysis and forecasting has many uses and applications. It is used by the
firm to forecast the raw material, labor and capital requirement needed to meet the
forecasted change in the demand for their product. The shortcomings are that the direct

32

and total coefficients are assumed to be fixed and thus do not allow input substitution.
Input output tables are usually available with a time lag of many years and while the
input output coefficients do not change very rapidly they can become very biased.

1.7 Reasons for fluctuations in time series data

Changes occur in secular trend i.e. long run increase or decrease in data series.

1.7.1 Cyclical fluctuations

There are the major expansions and contractions in most economic time series data that
seem to re-occur every several years.. A typical cycle could last 15-20 years.

1.7.2 Seasonal variation

This refers to regularly recurring fluctuations in economic activity during each year e.g.
a typical factor could be weather and social customs.

1.7.3 Irregular and random variation

This is the variations in the data series resulting from unique events like wars, natural
disasters or strikes. The total variation in the time series is the result of all the above
four factors operating together. They are usually examined separately by qualitative
techniques.

1.8 Smoothing Techniques

This technique predicts feature value of time series on the basis of some average of its
past value only. This technique is useful when the time series exhibits little trend or
seasonal variation but a great deal of random variation. There are two smoothing
techniques.

1.8.1 Moving average smoothing technique

The simplest smoothing technique is the moving average. Here the forecasted value of a

33

time series in a given period is equal to the average value of the time series in a number
of previous periods. This method is more useful the more erratic or random is the timeseries data.

1.8.2 Exponential smoothing technique

This technique is used more frequently than simple averages in forecasting. This
method is a refined version of moving average method. The disadvantage of moving
average method is that it gives equal weightage to the data related to different periods
(i.e. months) in the past. According to exponential smoothing method more recent the
data the more relevant it is for forecasting and therefore it would be more appropriate
to give more weightage to recent observations. The value given to weightage is normally
chosen to form a geometric progression.
With exponential smoothing, the forecast for period t +1 (i.e. Ft + 1) is a weighted
average of the actual and forecasted values of the time series in period. The value of the
time series at period t (i.e. At) is assigned the weight of 1-w6. The greater the value of w,
the greater is the weight given to the value of the time series in period as opposed to
previous periods. Thus, the value of the forecast of the time series in period t +1l is Ft +
1 = WA1 + (1-w) Ft.
In general, different values of W are tried, and the one that leads to the forecast with
smallest root-mean-square error (RMSE) is actually used in forecasting.

1.9 Risks in Demand Forecasting

Demand forecasting faces two major risks

Overestimation of demand

Underestimation of demand

One risk arises from entirely unforeseen events such as war, political upheavals and
natural disasters. The second risk arises from inadequate analysis of the market.

34

All these forecasting errors could possibly have been avoided through:

Carefully defining the market for the product to include all potential users of the
market and considering the possibility of product substitution.

Dividing total industry demand into its components and analyzing each
component separately.

Forecasting the main driver or user of the product in each segment of the
market and projecting how they are likely to change in the future.

35

End Chapter quizzes :

1. Out of the given plannings, short run forecasting is required for
(a) Expansion of the existing units
(b) New unit planning
(c) Sales forecasting
(d) capital planning
2 This forecasting technique helps the firm to decide which of the product or
products should have priority in the allocation of firm's limited resources.
(a) Product line forecasting
(b) Industry demand forecasting
(c) Firms demand forecasting
(d) Sales Forecasting

3. In Sales force opinion method, opinion of sales people is collected to forecast the
future demand, because

(a) They cannot deny from providing the information.

(b) They are paid by the company.
(c) They are the only experts of consumer behaviour.
(d) Sales People are closely associated with the market.

36

4. Reasons for fluctuations in time series data may occur due to

(a) Seasonal variation
(b) Cyclical fluctuations
(c) Irregular and random variation
(d) All of the above
5. Which one is not a type of Barometric Indicator?
(a) Leading economic indicator
(b) Coincident indicators
(c) Lagging indicator
(d) Climate indicator
6. The disadvantage of this technique is that it gives equal weightage to the data
related to different periods (i.e. months) in the past.

(a) Moving average smoothing technique

(b) Exponential smoothing technique
(c) Input Output Forecasting
(d) None of the above
7. Which of the following step may help in avoiding or minimizing the errors
in business forecasting?
(a) Carefully defining the market for the product to include all potential users of
the market and considering the possibility of product substitution.
(b) Dividing total industry demand into its components and analyzing each
component separately.

37

(c) Forecasting the main driver or user of the product in each segment of the
market and projecting how they are likely to change in the future.

(d) All of the above

8. This forecasting technique incorporates or utilizes the best features of other
forecasting techniques such as trend and seasonal variation, smoothing techniques
and leading indicators.

(a) Regression Technique

(b) Econometric forecasting
( c) Barometric methods
(d) None of the above

9. Variation in Data occurring due to regularly recurring fluctuations in

economic activity during each year is

(a) Cyclical fluctuations

(b) Seasonal Variations
(c) Random Variation
(d) Irregular Variation
10. In this technique two types of matrices i.e. Direct Requirement Matrix and Total
Requirement Matrix are used to forecast the demand.

(a) Regression Technique

(b) Exponential smoothing technique
(c) Input Output Forecasting
(d) Econometric forecasting

38

Chapter-III
Demand Analysis

Contents:
1.1 Meaning of Demand
1.2 Types of Demand
1.2.1 Individual and Market Demand
1.2.2 Autonomous and derived demand
1.2.3 Demand for durable and nondurable goods
1.2.4 Demand for firms product and industry
product
1.2.5 Demand for consumers and producers goods
1.3 Determinants of Demand
1.4 Demand Function
1.5 Law of Demand
1.6 Demand Schedule
1.7 Demand Curve
1.8 Shift of Demand Curve v/s Movement along the demand curve
1.9 Effect of a Price Change

39

1.10 Elasticities of Demand

1.10.1 The Price Elasticity of Demand
1.10.1.1 The relationship between marginal revenue
and price elasticity
1.10.1.2 Determinants of Price Elasticity of Demand
1.10.1.3 Price elasticity and Decision Making
1.11 Classification of Goods
1.12 Exceptions to the Law of Demand Upward Sloping
Demand Curve
1.13 Theory of Consumer Behaviour
1.13.1The Cardinal Utility Theory
1.13.1.1 Equilibrium of Consumer
1.13.2The Ordinal Utility Theory
1.13.2.1Equilibrium of Consumer
1.13.2.2 Properties of Indifference Curve
1.14 The consumer surplus

40

1.1 Meaning of Demand

Conceptually, demand can be defined as the desire for a good backed by the
ability and willingness to pay for it. The desire without adequate purchasing
power and willingness to pay do not become effective demand and only an
effective demand matters in economic analysis and business decisions.

1.2 Types of Demand

The demand for various commodities is generally classified on the basis of the
consumers of the product, suppliers of the product, nature of goods, duration of
the consumption of the commodity, interdependence of demand, period of
demand and nature of use of the commodity(intermediate or final).

Individual and Market Demand

Autonomous and derived demand

Demand for durable and nondurable goods

Demand for firms product and industry product

Demand for consumers and producers goods

1.2.1 Individual and Market Demand

41

The quantity of a commodity which an individual is willing to buy at a

particular price during a specific time period given his money income, his taste
and prices of other commodities is called individuals demand for a commodity.
On the other hand market demand of a commodity is the summation of
individual demand by all the consumers. Market demand is a multivariate
relationship and determined by many factors simultaneously. Some of the most
important determinants of the market demand for a particular commodity are
its own price, consumers income, prices of other commodities, consumers taste,
income distribution, total population, consumers wealth, credit availability,
Government policy, past level of income and past level of demand.

1.2.2 Autonomous and derived demand

The demand for a commodity that arises on its own out of a natural desire to
consume or possesses a commodity independent of the demand of other
commodities, which may be substitute or complementary or on the raw material
side or on the product side, the demand for the product is termed as
independent. Commodities like tea and vegetables do come on absolute terms.
On the other hand if the demand for a product is tied to the demand for some
parent product, the demand is termed as derived demand.

1.2.3 Demand for durable and nondurable goods

Durable goods are those whose total utility is not exhausted in a single or short
run use. Such goods can be used repeatedly over a period of time. Durable
goods may be consumer goods as well as producer goods. The demand for
durable goods changes over a relatively longer period. Perishable (non-durable)

42

goods are defined as those which can be used only once. Their demand is of two
types. Replacement of old products and expansion of existing stock. The
demand for nondurable goods depends largely on their prices, consumer
income and is subject to frequent change.

1.2.4 Demand for firms product and industry product

Firms demand denotes the demand for the products by a particular company or
firm whereas industry demand is the aggregation of demand for the product of
all the firms of an industry as a whole. A Clear understanding of the relation
between company and industry demand necessitates the understanding of
different market structures. These structures can be differentiated the basis of
product differentiation and number of sellers.

1.2.5 Demand for consumers and producers goods

Consumer goods are those, which are, meant for the final consumption by the
consumers or the end users. Producer's goods on the other hand are used for the
production of consumer goods or they are intermediate goods, which are further
processed upon to convert them into a form to be used by the end user. Another
distinction is that the demand for producers goods is derived demand and it
indirectly depends on the demand for the consumer goods which the producer
goods is used to produce. It may also be possible that this demand may be
accelerated or accentuated in the same proportion as the change in the demand
for the final consumer goods. A small change in the demand for consumer
goods may either completely wipes out the demand for the producer goods or

43

may accelerate it.

1.3 Determinants of Demand

Commoditys Own Price

Prices of related goods Substitutes and Complements

Income level of consumer

Tastes & Preferences

Expectations

Population

Other exogenous factors

1.4 Demand Function

The determinants of quantity demanded when summarized in the form of
functional notations are called a demand function. A typical demand function
can be specified as follows:
Dn

= f(

Where

pn, p1, p2,.pn-1, Y,T, Ep, Ey, Ad. Exp., N, D, u)

pn = price of n product

P1Pn-1 = Prices of other products

Y

= income level of consumers

= Taste and preferences of consumers

Ep

= expected prices

Ey

= expected income

Ad. Exp.

= advertising expenditure

44

= number of consumers

= distribution of consumers

= other factors

1.5 Law of Demand

There is negative relationship between price of a product and quantity
demanded of that product, ceteris paribus i.e., other factors remaining constant.

1.6 Demand Schedule

A demand schedule is one way of showing the relationship between quantity
demanded and price, all other things being held constant.
Price($ per

Quantity demanded

dozen)

(dozen per month)

0.50

7.0

1.00

5.0

1.50

3.5

2.00

2.5

2.50

1.5

3.00

1.0

1.7 Demand Curve

Demand curve is the graphical representation of the relationship between price
and quantity demanded of a good, all other things being held constant. A
demand curve is said to be linear when its slope is constant all along the curve,

45

whereas for a nonlinear or curvilinear curve the slope never remains constant.
The linear demand curve may be written in the form of;
Q b0 @b1 P

Linear Demand
Curve

Non Linear Demand

Curve

1.8 Shift of Demand Curve v/s Movement along the demand curve
A movement along the demand curve is in response to a change in price and
leads to expansion or Contraction of Demand. This is called Change in Quantity
Demanded. On the other hand Shift in the demand curve either upward or
downward is in response to a change in one of the other determinants of
demand.

46

1.9 Effect of a Price Change

Price Effect

Income Effect A price change causes Real Income to change and

therefore consumption of both goods changes

Substitution Effect Price change of one good causes the relative price of
the two goods to change and consumers substitute the relatively cheaper
good for the more expensive one.

1.10 Elasticities of Demand

There are as many elasticities of demand as its determinants. The most
important of these elasticities are:

Price elasticity of demand

Income elasticity of demand

Cross elasticity of demand

1.10.1 The Price Elasticity of Demand

47

The price elasticity is a measure of the responsiveness of demand to changes in

the commoditys own price. For very small changes in price point elasticity of
demand is used as a measure of responsiveness of demand and arc elasticity of
demand is the suitable measure for comparatively large changes in price.
The point elasticity of demand is defined as the proportionate change in the
quantity demanded resulting from a very small proportionate change in price.
Symbolically it is written as;
dQ dP
e p ffffffffffD fffffffff
Q
P
Or
dQ P
e p ffffffffffAfffff
dP Q
If the demand curve is linear
Q bo @b1 p
Its slope is dQ/ dP @b1 Asubstituting in the elasticity formula we obtain

P
e p @b1 Afffff
Q

Which implies that the elasticity changes at the various points of the linear
demand curve?

48

The range of values of the elasticity is

0 ep 1
If e p 0, the demand is perfectly inelastic.
If e p 1 , the demand is perfectly elastic
If e p 1, the demand is unitary elastic, total expenditure remain constant with a
change in price.
If 0 < e p < 1, the demand is inelastic total expenditure total expenditure and price
change move in the same direction.
If 1< e p < 1 the demand is elastic, total expenditure and price change move in
the opposite direction.

49

1< e p < 1

0 < e p < 1,

1.10.1.1 The relationship between marginal revenue and price

elasticity
The marginal revenue is related to the price elasticity with the formula
f

1
MR p 1 @ fff
e

50

This is a crucial relationship for the theory of pricing

Proof
The total revenue is
D b cE

TR PQ f Q Q
The MR is
pQ
dQ
dP
dP
MR d fffffffffff P ffffffffff Q ffffffffff P Q ffffffffff
dQ
dQ
dQ
dQ
The price elasticity of demand is defined as
dQ
e p @ ffffffffff fffffff
dP Q
Rearranging we obtain
P dP
@ fffffffff ffffffffff
eQ dQ
Substituting dP/ dQ in the expression of the MR we have
dP
P
P
MR P Q ffffffffff P @Q fffffffff P @ fffff
dQ
eQ
e
f

1
MR p 1 @ fff
e

We may summarize this relationship as follows:

If the demand is inelastic (e < 1) an increase in price leads to an

increase in total revenue and vice versa.

If the demand is elastic (e>1) an increase in price will lead to a

decrease in total revenue and vice versa.

If the demand has unitary elasticity (e =1), total revenue is not affected
by changes in price.
51

1.10.1.2 Determinants of Price Elasticity of Demand

Number and availability of Substitutes

The proportion of income spent on the particular commodity

Nature of the need that the product satisfies

Length of time period under consideration

The number of uses to which a commodity can be put

1.10.1.3 Price elasticity and Decision Making

Information about price elasticities can be extremely useful to managers

as they contemplate pricing decisions.

If demand is inelastic at the current price, a price decrease will result in a

decrease in total revenue.

Alternatively, reducing the price of a product with elastic demand would

cause revenue to increase.

Remember TR = P*Q

1.10.2 The income elasticity of demand

The income elasticity of demand is defined as the proportionate change in the
quantity demanded resulting from a proportionate change in income. The
income elasticity is positive for normal goods. Symbolically it may be written as:
dQ dY dQ Y
e y ffffffffffD fffffffff ffffffffffAfffff
Q
Y
dY Q
52

1.10.3 The cross elasticity of demand

The cross elasticity of demand is defined as the proportionate change in the
quantity demanded of x commodity resulting from a proportionate change in
the price of y commodity. The sign of cross elasticity is negative if x and y are
complementary goods and positive if x and y are substitutes. The higher the
value of the cross elasticity the stronger will be the degree of substitutability or
complementarity of x and y. symbolically we may write it as:

dQ
dP y dQ P y
exy fffffffffxfffD ffffffffffff ffffffffffxffAffffffff
Qx
P y dP y Q x

1.11 Classification of Goods

Normal Goods Demand Increases as Income increases

Inferior Goods Demand decreases as consumer Income increases

Basic Necessities Commodities like salt, food grains etc for which
demand is relatively inelastic and does not vary with income after a point

1.12 Exceptions to the Law of Demand Upward Sloping Demand

Curve

Giffen Goods a subclass of Inferior goods for which the income effect
outweighs the substitution effect

53

Veblen Products / Snob effect Goods that have a snob value attached to
them for which demand actually increases as price goes up

Speculative Effect In periods of rising prices, anticipation of future

increases may cause consumers to demand more

Bandwagon Effect Occurs when people demand a commodity

only because others are demanding it and in order to be fashionable

Emergencies like war, famine etc.

1.13 Theory of Consumer Behaviour

The consumer is assumed to be rational. Given his income and the market prices
of the various commodities, he plans the spending of his income so as to attain
the highest possible satisfaction or utility. This is the axiom of utility
maximization. In order to attain this objective the consumer must be able to
compare the utility of the various baskets of goods which he can buy with his
income. There are two basic approaches to compare the utilities, the cardinalist
approach and the ordinalist approach.

1.13.1The Cardinal Utility Theory

The cardinal school stated that utility can be measured. Under certainty i.e.,
complete knowledge of market conditions and income levels over the planning
period utility can be measured in monetary units, called utils. There are certain
assumptions of cardinal utility theory.

Rationality of consumer
54

Constant marginal utility of money

Diminishing marginal utility

Total utility is additive

1.13.1.1 Equilibrium of Consumer

Assuming the simple model of a single commodity x, the consumer can either
buy x or retain his money income y. Under these conditions the consumer is in
equilibrium when the marginal utility of x is equated to its market price.
MU x P x
If there are more commodities, the condition for the equilibrium is the equality
of the ratios of the marginal utilities of the individual commodities to their
prices.
MU
MU
ffffffffffffxffff MU
fffffffffffffyfff
ffffffffffffnffff

Px
Py
Pn

1.13.2The Ordinal Utility Theory

The ordinalist school postulated the utility is not measurable, but is an ordinal
magnitude. It suffices for the consumer to be able to rank the various baskets of
goods according to the satisfaction derived. The main ordinal theory is known as
the indifference-curve theory is based on certain assumptions.

Rationality of consumer

Utility is ordinal

Diminishing Marginal rate of substitution

Consistency and transitivity of choice

Total utility depends on the quantities of the commodities consumed

55

1.13.2.1Equilibrium of Consumer
The consumer is in equilibrium when he maximizes his utility, given his income
and the market prices. Two conditions must be fulfilled for the consumer to be in
equilibrium.
The first condition is that the marginal rate of substitution be equal to the ratio
of commodity prices. This is necessary but not sufficient condition.
MU
P
MRS x ,y ffffffffffffxffff ffffxffff
MU y P y
The second condition is that the indifference curve be convex to the origin. This
condition is fulfilled by the axiom of diminishing marginal rate of substitution of
x for y and vice versa.

At the
point of
tangency
(point e)
the slopes
of the budget line ( P x / P y ) and of the indifference curve (
MRS x ,y MU x / MU y ) are equal:
MU
P
MRS x ,y ffffffffffffxffff ffffxffff
MU y P y

56

1.13.2.2 Properties of Indifference Curve

An indifference curve has a negative slope

The further away from the origin an indifference curve lies, the higher the
utility it denotes

Indifference curve do not intersect

The indifference curves are convex to the origin

1.14 The consumer surplus

Consumer surplus is equal to the difference between the amount of money that
a consumer actually pays to buy a certain quantity of a commodity and the
amount that he would be willing to pay for this quantity rather than do without
it. Graphically the consumers surplus may be found by his demand curve for
commodity and the current market price, which he cannot affect by his purchase
of that commodity.

57

Consumer surplus = PCA

End Chapter quizzes :

Q.1. The demand curve of a normal commodity is
(a) Upward Sloping
(b) Downward sloping
(c) Horizontal
(d) Vertical
Q.2 What happens to demand when price of the commodity falls

58

(a) Demand expands

(b) Demand contracts
(c) No change
(d) Can expand or contract
Q.3 In case of substitute goods if the price of commodity x increases the demand of
commodity y
(a) Remain constant
(b) Increases
(c) Decreases
(d) Fluctuates
Q.4 At a downward sloping demand curve the price elasticity of demand is
(a) Equal to unity
(b) Varies at different points
(c) Equal to zero
(d) Equal to infinity
Q.5 According to the cardinal approach the marginal utility of money
(a) Increases
(b) Decreases
(c) Remain constant
(d) Fluctuates
Q.6 The shape of indifference curve is
(a) Upward Sloping and concave to the origin
(b) Downward sloping and concave to the origin

59

(c) Upward Sloping and convex to the origin

(d) Downward sloping and convex to the origin
Q.7 The shape of indifference curve implies
(a) Diminishing MRSxy
(b) Increasing MRSxy
(c) Constant MRSxy
(d) Infinite MRSxy
Q.8 The marginal utility from successive consumption of normal good
(a) Increases
(b) Decreases
(c) Remain constant
(d) Undefined
Q.9 According to the ordinal approach consumers equilibrium is where
(a)

MU
P
ffffffffffffxffff
1 ffffxffff
MU y
Py

(b)

MU
ffffffffffffxffff Pffffxffff
<
MU y P y

(c)

MU
ffffffffffffxffff Pffffxffff

MU y P y

(d)

MU
ffffffffffffxffff Pffffxffff
>
MU y P y

Q.10 Given the demand function Q = 90-3p and P = 6, Q=?

(a) Q = 67
(b) Q = 72
(c) Q = 108

60

(d) Q = 81

Chapter-IV
Cost Analysis:
Contents:
1.1 Introduction
1.2 Accounting Cost Concepts
61

1.2.1 Opportunity vs. Actual Cost

1.2.2 Explicit cost vs. implicit cost
1.3 Analytical Cost Concepts
1.3.1 Sunk vs. Incremental cost
1.3.2 Fixed and Variable Costs
1.3.3 Total, Average and Marginal Costs
1.3.3.1 Total Cost
1.3.3.2 Average cost
1.3.3.3 Marginal Cost
1.4 Properties of Short Run Cost Curves
1.5 Short-Run Output Decision
1.6 Long-Run Cost Function
1.6.1 Long Run Average Cost Curve
1.7 Economies and Diseconomies of Scale
1.7.1 Economies of Scale
1.7.1.1 Internal economies of scale
1.7.1.2 External economies of scale
1.7.2 Diseconomies of Scale
1.7.2.1 Internal diseconomies of scale
1.7.2.2 External diseconomies of scale

1.1 Introduction
Cost functions are derived functions from the production function which describes the
available efficient methods of production at any one time. The cost of production is an
important factor in almost all the business analysis and decisions, especially those
related to locating the weak points in production management, minimizing the cost,

62

finding the optimum level of output, determination of price and dealers margin,
estimation of the cost of business operation. The cost concepts can be grouped under
two categories on the basis of their nature and purpose.

1.2 Accounting Cost Concepts

1.2.1 Opportunity vs. Actual Cost
The opportunity cost may be defined as the expected returns from the second best use
of the resources which are foregone due to the scarcity of resources. It is also called
alternative cost. The concept of economic rent or economic profit is associated with it.
On the other hand actual Cost considers only explicit cost, the out of pocket cost for
items such as wages, salaries, materials, and property rentals.

1.2.2 Explicit cost vs. Implicit cost

Explicit costs are cash expenses for the payment of wages, salaries, material, license fee,
insurance premium, depreciation charges and are recorded in normal accounting
practices. In contrast implicit costs are non cash expenses. Opportunity cost is an
important example of implicit cost. The explicit and implicit costs together make the
economic cost.

1.3 Analytical Cost Concepts

1.3.1 Sunk vs. Incremental cost
The sunk costs are those which cannot be altered, increased or decreased, by varying
the rate of output. A sunk cost is an expenditure that has been made and cannot be
recovered since it accord to the prior commitment. Incremental cost is the change in cost
tied to a managerial decision associated with expansion of output or addition of new
variety of product.

1.3.2 Fixed and Variable Costs

63

Fixed costs are those which are fixed in volume for a certain given output. It does not
vary with variation in the output for a certain scale. The fixed costs include the cost of
managerial and administrative staff, depreciation of fixed assets, maintenance of land
etc. Fixed costs are associated with the short run. Variable costs are those which vary
with the variation in the total output. It include cost of raw material, cost of direct labor,
running cost of fixed capital such as fuel, repairs, routine maintenance etc.

1.3.3 Total, Average and Marginal Costs

1.3.3.1 Total Cost
Total cost is the total expenditure incurred on the production. It connotes both explicit
and implicit money expenditure and include fixed and variable costs.
b

C f X,T,P f ,K
Where

total cost

output

technology

Pf

prices of factors

fixed factors

TC TFC TVC

Total Cost Curves

64

1.3.3.2 Average cost

Average cost is obtained by dividing the total cost by the total output.

TC
AC ffffffffff
Q
Average cost further can be categorized as average fixed cost (AFC) and average variable
cost (AVC).

TFC
AFC fffffffffffffff
Q
TVC
AVC fffffffffffffff
Q

Average cost curves

65

1.3.3.3 Marginal Cost

Marginal cost is the change in the total cost for producing an extra unit of output.

MC TC/Q

Marginal Cost Curve

1.4 Properties of
Short Run Cost
Curves

Short run
cost curves get their shape from the marginal productivity of the variable factor

If capital is held constant (short run) then the marginal product of labor gives
the short run cost curves their shape.

66

The levels of cost curves are determined by market price of factor along with
technology.

AFC falls continuously

MC equals AVC and ATC at their minimum

Minimum AVC occurs at a lower output than minimum ATC due to FC

1.5 Short-Run Output Decision

Firm sets output at Q1, where MC=MR subject to checking the average condition:

If P > ATC, the firm produces Q1 at a profit

If ATC > P > AVC, the firm produces Q1 at a loss

P < AVC, the firm produces zero output

67

1.6 Long-Run Cost Function

The long-run total cost curve describes the minimum cost of producing each output
level when the firm is free to vary all input levels. One of the first decisions to be made
by the owner/manager of a firm is to decide the scale of operation (size of the firm).

1.6.1 Long Run Average Cost Curve

In the Long Run, plant size is variable, and the firm is able to adjust its scale of
operations according to demand

Therefore, corresponding to each different scale of operation is a relevant Short

Run Cost Curve.

The Long Run Average Cost Curve is then an envelope of the different SRACs.

68

1.7 Economies and Diseconomies of Scale

Economies and diseconomies are associated with long run cost functions. Economies of
scale are advantages and diseconomies of scale are disadvantages that arise due to the
expansion of production scale and lead to a fall and rise in the cost of production
respectively.

1.7.1 Economies of Scale

The economies of scale are classified as

Internal economies of scale

External economies of scale

1.7.1.1Internal economies of scale

Internal economies of scale are advantages that a firm gains from increasing the scale of
its own operations. Whereas external economies of scale are advantages that a firm
gains from the expansion and size of the industry as whole industrial clusters. It is
important to note that internal economies of scale determine the shape of the LRAC

69

curve while the position of this curve depends on external economies such as change in
technology and changes of factor prices in the industry as a whole.

Technological advantage

Advantages of division of labor and specialization

Economies in marketing

Managerial economies

Economies in transport and storage

1.7.1.2 External economies of scale

Large scale purchase of raw material

Large scale acquisition of external finance

Massive advertisement campaign

Growth of ancillary industries

Change of factor prices in the industry

1.7.2 Diseconomies of Scale

Like economies, diseconomies may be internal or external.

1.7.2.1 Internal diseconomies of scale

Managerial inefficiency

Labor inefficiency

1.7.2.2 External diseconomies of scale

Natural constraints especially in agriculture and extractive industries

Pressure on inputs market due to increasing demand

70

Pressure on inputs prices due to bulk purchase

End Chapter Quizzes

1. Change in the total cost for producing an extra unit of output is know as
A: Incremental Cost
B: Marginal Cost
C: Variable cost
D: Both A & B
2. Over a range of output, Marginal Cost equates with
A: First AVC and then ATC
B: First ATC and then AVC
C: Never equates with ATC
D: Never Equates with AVC
3. The shape of SATC necessarily reflects the operation of
A: Law of Variable Proportion,
B: Economies of Scale,
C: Diseconomies of scale
D: None of the above
4. When MC is rising and is more than AVC
A: The ATC may be rising
B: The ATC may be falling
C: Either of the two cases mentioned above is possible,
D: Difficult to say as information is inadequate.
5. The nature and shape of AFC is
A: A rectangular Hyperbola
B: A horizontal Line
C: It is U shaped
D: A vertical Line
6. Which one of the statement is correct
A: All costs are variable costs in the long run except LMC
B: TFC is inverse SShaped reflecting Laws of Returns.
C: Over a very long range of Operation, AFC is Zero.
D: None of the above is correct.
7.

Explicit cost is also known as

71

A: Imputed Cost
B: Implied Cost
C: Accounting Cost
D: Opportunity Cost
8. TCn - TCn-1 = TC/ Output = Marginal Cost { Where denotes small change}
A:
B:
C:
D:
9.

The above statement is correct.

The above statement is incorrect.
The statement is Vague & irrelevant
The above statement is partially true.

Gain from the increasing scale of production can be viewed as

A: External economies of scale
B: Internal economies of scale
C: Externalities
D: Internalities

10. An Envelop Curve is drawn from

A: Short run Average Cost Curves
B: Long run Average Cost Curves
C: Planning Curves
D: None of the above

72

Chapter-V
Production Analysis
Contents:
1.1Production Function
1.2 Short Run Analysis
1.2.1 Marginal Product of Labor
1.2.2 Average Product of labor
1.3 Laws of Production
1.3.1 Law of variable proportions
1.3.2 Laws of Returns to Scale
1.3.2.1 Constant returns to scale
1.3.2.2 Increasing returns to scale
1.3.2.3 Diminishing Returns to Scale
1.4 Isoquant
1.5 Equilibrium of the Firm
1.6 Isocost
1.7 Isocost Curve and Optimal Combination of L and K
1.8 Production with Two (or more) Outputs-Economies of Scope

73

1.1Production Function
The creation of any good or service that has value to either producers or consumers is
termed as production. Production function is a technical relation between factor inputs
and outputs. It describes the laws of proportion that is the transformation of factor
inputs into outputs at any particular time period. The production function includes all
the technically efficient methods of production.

X f L, K, R, S, v, y

` a

X f L

L
In the process of production, the manager is concerned with efficiency in the use of
inputs (Labor, Capital, Land and Entrepreneurship)
Technical Efficiency Occurs when it is not possible to increase output without
increasing inputs

74

Economic Efficiency Occurs when a given output is being produced at the lowest
possible cost. Improvement of Technology is reflected in an upward shift in the
Production Function. The same amount of input leads to a higher output

` a

f1 L

` a

f L

L
1.2 Short Run Analysis
Short Run is the period of time in which one (or more) of the factors of production
employed in a production process is fixed or incapable of being varied. We usually
assume Capital (K) to be fixed and analyze how output varies with changes in Labor (L)
` a

X f L

1.2.1 Marginal Product of Labor

The change in output resulting from a very small change in Labor keeping all other
factors constant.
MPL = X L
If MP > 0, total production is rising

75

If MP < 0, total production is falling

Total production is maximum when MP = 0

1.2.2 Average Product of labor

APL = X / L
If MP > AP, then AP is rising
If MP < AP, then AP is falling
MP = AP when AP is maximum

APL

MPL L
76

1.3 Laws of Production

The laws of production analyze the technically possible ways of increasing the level of
production. Output may increase in various ways. In the short run output may be
increased by using more of the variable factors while keeping other constant. This is
referred to as Law of variable proportions. While in long run output expansion may be
achieved by varying all factors and it is known as laws of returns to scale.

1.3.1 Law of variable proportions

In general if one of the factors of productions (usually capital K) is fixed after a certain
range of production additional output (i.e., marginal product) starts to diminish. It is
also known as the Law of diminishing returns. The range of output over which the
marginal products of the factors are positive but diminishing is considered as
equilibrium range of output. The range of increasing returns to a factor and the range of
negative productivity are not suitable for equilibrium.

Three stages of production

77

APL
Stage I Capital is
Underutilized and
Successive units of
L add greater
Amounts to TP

Stage II Addition to
TP due to increase in
L continues to be
positive but is falling
with each unit

MPL

Stage III Fixed Input capacity

is reached and additional L
causes output to decline

1.3.2 Laws of Returns to Scale

In the long run expansion of output may be achieved by varying all factors by the same
proportion or by different proportions. The laws of returns to scale refer to the effects of
scale relationship. Three types of returns to scale are observed.

Constant returns to scale

Increasing returns to scale

Decreasing returns to scale

1.3.2.1 Constant returns to scale

If the quantity of all inputs used in the production is increased by a given proportion
and we have output increased in the same proportion; it is termed as constant returns to
scale.

78

1.3.2.2 Increasing returns to scale

If output increases by a greater proportion in comparison to a change in the scale of
inputs it is termed as increasing Returns to Scale. The causes of increasing returns to
scale are:

Specialization of labor

Inventory Economies

Managerial indivisibilities

Technical indivisibilities

79

1.3.2.3 Diminishing Returns to Scale

If output increases by a smaller proportion in comparison to the change in the scale of
inputs, it is described as diminishing returns to scale. The reasons of diminishing
returns to scale are:

Managerial inefficiency

Exhaustible natural resources

Increased bureaucratic

Labor inefficiency

Pressure on inputs market due to increasing demand

Pressure on inputs prices due to bulk purchase

80

1.4 Isoquant
An isoquant is the locus of all the technically efficient methods or all the combinations
of factors of production for producing a given level of output given the state of
technology.

A higher isoquant refers to a larger output, while a lower isoquant refers to a

smaller output.

The slope of Isoquant shows diminishing marginal rate of input substitution.

C shaped isoquants are common and imply imperfect substitutability

Isoquants may take various shapes depending on the degree of substitutability of

inputs. However continuous isoquants (an approximation to the realistic form of kinked
isoquant) has mostly been adopted because they are mathematically simpler to be
handled. In case the two inputs are imperfectly substitutable, the optimal combination
of inputs depends on the degree of substitutability and on the relative prices of the
inputs.

81

The degree of imperfection in substitutability is measured with marginal rate of

technical substitution (MRTS):

MRTS l ,k @K/L X/L D X/K

MRTS l ,k

MP
ffffffffffflffff
MP k

1.5 Equilibrium of the Firm

A profit maximizing firm will be using optimal amount of an input at the point at
which the monetary value of the inputs marginal product is equal to the additional cost
of using that input. Monetary value of the input is;
b

MP l Px MP l

82

Profit Maximization requires

w Px CMP l

Px

Price of final output

Wage rate (Cost of input)

1.6 Isocost
The isocost line is the locus of all combinations of factors the firm can purchase with a
given monetary cost outlay. If a firm uses only L & K, the total cost or expenditure of the
firm can be represented by:

C wL rK

One can solve Optimization problem for the combination of inputs that either
minimizes total cost subject to a given constraint on output
OR
maximizes output subject to a given total cost constraint.

1.7 Isocost Curve and Optimal Combination of L and K

83

Optimal input Combination Depends on the relative prices of inputs and the degree to
which they can be substituted for each other represented by the point of tangency
between Isocost and Isoquant.

MP
ffffffffffflffff w
fffff
MP k r

1.8 Production with Two(or more) Outputs-Economies of Scope

Economies of scope exist when the unit cost of producing two or more
products/services jointly is lower than producing them separately,
producing related products, and the products that are complementary.

The average total cost of production decreases as a result of increasing the

number of different goods produced

84

End Chapter quizzes :

Q.1. Production function states
(a) Qualitative relationship between input and output
(b) Quantitative relationship between input and output
(c) Technical relationship between input and output
(d) No relationship between input and output
Q.2 Total output is maximum where
(a) Marginal production is maximum
(b) Marginal production is zero
(c) Average production is maximum
(d) Average production is zero

85

Q.3 The law of variable proportions states that given at least one input constant the
marginal product of variable factor
(a) Increases
(b) Decreases
(c) Remain constant
(d) Fluctuates
Q.4 Returns to scale means
(a) Change in output due to change in one variable factor of production
(b) Change in output due to change in one constant factor of production
(c) Change in output due to change in all variable factors of production
(d) Change in output due to change in all constant factor of production
Q.5 The slope of isoquant is called
(a) Marginal rate of technical substitution
(b) Marginal rate of factor substitution
(c) Marginal rate of production substitution
(d) Marginal rate of input substitution
Q.6 The shape of isoquant curve is
(a) Upward Sloping and concave to the origin
(b) Downward sloping and concave to the origin
(c) Upward Sloping and convex to the origin
(d) Downward sloping and convex to the origin
Q.7 Economies of scale are related with
(a) Size of plant

86

(b) Size of fixed factor

(c) Size of variable factor
(d) Choice of technique
Q.8 which of the statements is false
(a) At the point of producers equilibrium, the isoquant is tangent to the
Isocost line
(b) Constant returns to scale means proportionate change in output due to
Proportionate change in inputs
(c) When average product falls, marginal product also falls and lies below
Average product
(d) The elasticity of technical substitution is measured by the slope of
Isoquant
Q.9 Producers equilibrium is where
(a)

MP
ffffffffffflffff w
> fffff
MP k r

(b)

MP
ffffffffffflffff w
< fffff
MP k r

(c)

MP
ffffffffffflffff w
fffff
MP k r

(d)

MP
ffffffffffflffff w
1 fffff
MP k
r

Q.10 Which of the statements about the Isocost line is false

(a) The budget constraint of the producer
(b) The budget constraint of the seller
(c) Shows all the combinations of inputs which may be purchased

87

(d) It touches both the axis compulsorily

Chapter-VI
Pricing Policy of the Firm
Contents:
1.1 Introduction
1.2 Objectives of Pricing Policies
1.3 Factors affecting Pricing Policies
1.4 Price Forecasting
1.5 Prospective supply and demand
1.5.1 Prospective Supply

88

1.5.2 Prospective Demand

1.6 Pricing Methods
1.6.1 Introduction
1.6.1.1 Skimming Pricing
1.6.1.2 Penetration Pricing
1.6.2 Growth
1.6.3 Maturity
1.6.4 Saturation
1.6.5 Decline
1.7 The various Pricing methods are:
1.7.1 Cost-plus or full-cost pricing:
1.7.2 Rate of Return pricing
1.7.3 Marginal cost pricing
1.7.4 Limit Pricing
1.7.5 Going Rate Pricing
1.7.6 Team pricing
1.7.7 Mark-up and Mark - down pricing
1.7.8 Peak Load Pricing

89

1.1 Introduction
Managerial decision making consists of a number of procedures at each individual
stage of the product manufacturing. They are related to the product development
depending on the market requirement, product manufacturing, product distribution
and marketing of the same to realize the company's sales targets.
One of the important factors which assist the company in realizing its profits through
targeted sales is the Pricing Policy, it formulates. As a result the method of the
company's Pricing Policy plays an important role in the Managerial decision making.
Price, in fact, is the source of revenue which the firm seeks to maximize. Also it is the
most important device a firm can use to expand its clientele base. The company should
fix the price reasonably because if the price is set too high, it may lead it to loose its
market share. On the other hand, if the price is set too low the company may not recover

90

its cost. so the right choice of the Price fixation would depend on number of factors and
wide variety of conditions prevailing in the market. Moreover the pricing decisions have
to be reviewed and formulated from time to time.
Some of the factors which affect the choice of the pricing policies are:

Business Objectives: This relates to rate of growth, establishing and increasing its
market share and maintenance of control and finally profit realization. All these
concepts play an important role in pricing policy formulation.

Competition level: It is important for a company to offer the product which

satisfies the wants and desires of the consumer than the one which sells at the
lowest price.

4P's: Pricing happens to be one of the core concepts of marketing but a firm must
consider it together with Product, Place & Promotion.

Price sensitivity: Factors like variability in the consumer behavior consumer

income level, marketing effect, nature of product and after sales service among
others affect the price sensitivity.

Available information: The demand supply gap goes a long way in affecting the
choice of the pricing policy determination for as company.

Pricing hence is more a matter of judgment since every pricing situation is

different from each other and as such there is no formula existing for the price
fixation.

1.2 Objectives of Pricing Policies

Pricing policies form an integral part of the company's overall business strategy.
Some of the important objectives, which the company should take into
consideration, are:

Profit maximization for the company's products

Relation of long term goals of the company.

Successfully thwart the competitors.

91

Flexibility in pricing to meet the changes in the market.

Achieving a satisfactory rate of return

1.3 Factors affecting Pricing Policies

The company should determine its pricing policies in such a way that depending on the
market trends, the company is able to adapt itself to the changes occurring in the
market.
Few of the factors are enlisted below:

Cost involved

Demand elasticity

Consumer psychology

Price changes

Type of product

Competitors in the market

Product segmentation and positioning.

Market structure and promotional policies

Degree of integration

Business Expansion

Complementary and substitution products and

Other considerations
a.

Individual

b.

Firm's

c.

Economic

1.4 Price Forecasting

A Business unit is constantly faced with the risk of a substantial change in the prices of
raw materials as 'well as its products, these changes may be a part of general economic
fluctuations but, at times the prices may change during the period of economic stability

92

also The first step towards successful price forecasting is the understanding of nature of
the commodity and its market. We should have the knowledge of the demand -supply
conditions, i.e.

Demand elasticity: Where the demand is elastic; a given change in supply will
bring a less sever change in price than where the demand is inelastic.

Change in supply of commodity: When the change in demand for commodity

takes place price change will depend on the supply conditions, which in turn
will depend on the conditions of production e.g. supply manufactured product
can be altered according to the demand condition. The price tends to vary for
that product where the supply of a product cannot be in accordance with that of
demand.

Influence of supply and demand on the price: There are many products
particularly agricultural, whose demands remains constant but where the
supply may change continuously. So that analysis should be made from the
supply side and for the manufactured product the rapid demand change can be
matched with the supply adjustments.

Related Commodities: The prices of many manufactured goods depend on

prices of raw material particularly on the current prices. The manufacturer while
pricing the product will take only this pricing into consideration.

Type of product: The price of commodity will depend on the other one specially
if it is a by product. In that case supply of that by product will depend on the
main product and not on its (By-product's) demand conditions.

Supply - Controllable and predictable: It may be possible for the supply of a

commodity to change substantially but this change may be unpredictable and
beyond control e.g. an increase in the supply of crude oil will depend on the oil
striking capacity.

Competitive situations: In case where a dominant producer leads the market, his

93

probable price policy becomes a significant factor in making the price forecast.
In case of a severe price competition, resorting to the price cutting would be
frequent and uncertain, specially in the buyer's market.

1.5 Prospective supply and demand

In price forecasting a knowledge about the prospective supply and demand conditions
is also essential. In fact, besides estimating the supply and demand conditions
prevailing at the time of the forecast it is imperative to find the probable demand and
supply conditions during the next six months.

1.5.1 Prospective Supply

The current value of production of commodity should be compared with the total
productive capacity in order to ascertain the extent of excessive productive capacity in
the market. An excess of capacity creates a persistent tendency towards over production
and acts as a restraint upon a rise in the price. The existing cost -Price relationship may
also determine the prospective supply. There will be a tendency among the firms
producing a commodity to curtail the production if price decreases over the cost of
production. On the other hand, when the price exceeds the variable cost they would
enter the industry once again.

1.5.2 Prospective Demand

The prospective demand is determined by the nature of need for that commodity and
the willingness of the buyer to buy the commodity and their purchasing power. An
analysis of a price movement of a commodity over a period of time will reveal certain
fluctuation. These fluctuations and their relationships are helpful in price forecasting.
Some of the fluctuations observed are:

Seasonal price variation: These are common in case of number of commodities

notably agricultural and food products such variations would take place in

94

markets having seasonal cycles. These variations may take place due to seasonal
fluctuation in the price of raw materials also.

Cyclical price variation: During the business cycle, price of all commodities
would generally record fluctuations. So it becomes essential to realize this effect
on the commodities in different ways. The general business conditions influence
the commodity prices through changes in the demand supply relationships in
the market for each individual commodity.

Cob -Web Cycle: These cycles occur on account of the cumulative effect of the
price expectations of the millions of independent producers. When farmers
expect higher prices in future, they plan independently to producer more. Also
new ones enter the field.
As a result, the aggregate output, when the future date arrives, is so large that
the price falls. When the prices fall, all the producers plan to produce less, once
they have suffered losses on the account of non-materialization of their expected
prices. This time the cumulative effect of smaller output plan leads to the
shortage of products which in turn increases the prices.

1.6 Pricing Methods

Before we proceed with the various pricing methods, it is essential for us to understand
the Life cycle concept. Many products generally have a characteristic known as
'Perishable distinctiveness. The product cycle begins with the invention of a new
product followed by patent protection and further development to make it saleable.
This is usually followed by a rapid expansion in its sales as the product gains its market
acceptance. Then the competitor enters the field with the imitation and the rival
products and the distinctiveness of the new product starts diminishing. The speed of
degeneration differs from product to product. The innovation of new product and its
degeneration into a common product is termed as Life Cycle of the Product."

95

There are five distinct stages in the Life Cycle of the product'. They are as follows:

1.6.1 Introduction
Research or engineering skills lead to the product development. There are high
promotional costs involved, volume of sales is low and there may be heavy losses.
Pricing Policies in Introductory phase largely depend on the close substitutes available
in the market. Generally two kinds of pricing policies are suggested,
1.6.1.1 Skimming Pricing: This pricing strategy is adopted when close substitutes of a
new product are not available in the market. To extract the consumer surplus, setting up
a very high price initially and then a subsequent lowering of prices in a series of
reduction.
1.6.1.2 Penetration Pricing: This pricing policy is generally adopted in case of the
availability of close substitutes of the new product in the market. To penetrate in the
market, initially a lower price is designed, as soon the product captures the market,
price is gradually raised up.

1.6.2 Growth
Due to the cumulative effects of introduction stage the product begins to make rapid
sales gain. High and sharply rising profits may be witnessed. Consumer satisfaction has
to be ensured.

1.6.3 Maturity
Sales growth continue, but at a diminishing rate, because of the declining number of the
potential customers who remain unaware of the product or have taken no action. Profit
margin slips despite rise in the sale.
During Maturity stage, firm should move in the direction of Product improvement and

96

market segmentation.

1.6.4 Saturation
Sales reach and remain on a plate marked by the level of the replacement demand.
There is a little additional demand to be stimulated.

1.6.5 Decline
Sales begin to diminish absolutely as the customers begin to tire of the product and the
product is gradually edged out by better products or the substitutes.

The life cycle broadly gives the different stages through which a product passes
through. There are changes taking place in the price and promotional elasticity of
demand as also in the production and distribution cost of the product. Pricing Policy,
therefore, must be properly adjusted over the various phases of the life cycle of the
product.

1.7 The various Pricing methods are:

Marginal cost pricing,
Full Cost method pricing,
Limit pricing
Mark-up and Mark-down pricing,
Rate of Return pricing,
Going rate pricing,
Team pricing,
Value pricing,
Position based pricing,
Exports pricing,
Dual pricing

97

 Administered pricing,
Skimming pricing,
Penetration pricing,
Peak load priding,
Charm pricing,
Discrimination pricing.,
Product mix pricing.

1.7.1 Cost-plus or full-cost pricing:

This is the most common method used for pricing. Under this method, the price is set to
cover the costs (materials, labour and overhead) and a predetermined percentage for
profit. The percentage differs from industry to industry. This may reflect differences in
competitive intensity, differences in cost base, differences in rate of turnover and risk.
Ordinarily the profits are kept at a margin sensitive to the market conditions. Mark-ups
may be determined by trade associations either by the means of advisory price-list or by
actual list of mark ups distributed to members. Usually profit margins under price
control are so set as to make it possible for even the least efficient firms to survive.
This method ignores the demands -there is no necessary relationship between the costs
and what the people pay for the product. Also it fails to reflect the forces of the
competition adequately.
Example: All the stationery products are priced in this way.

1.7.2 Rate of Return pricing

It is a refined variant of full cost pricing. Under this method a firm starts with a rate of
return they consider satisfactory and then set a price that allows them to earn that
return when there plant utilization is at some standard rat. In other words the company
determines the standard cost at standard volume and adds the margins necessary to
return a target rate of profit over the long run.

98

This can be broadly grouped under the following:

1. Fixing prices to maintain constant percentage mark up over the cost,
2. Fixing prices to maintain the profit as constant percentage of sale, and
3. Fixing prices to maintain a constant return on the investment capital.
Example: Most products are priced I this way for instance Philips audio systems are
currently priced based on what the manufacturers estimate the returns to be.

1.7.3 Marginal cost pricing

Both under the full cost pricing and rate of return pricing, the prices are based on total
cost comprising fixed and variable cost. Under marginal cost pricing, the fixed costs are
ignored and prices determined on the basis of marginal cost. The firm uses only those
costs that are directly attributable to the output of a specific product. With marginal cost
pricing, the firm seeks to fix its prices so as to maximise its total contribution to fixed
cost and profit. Unless the manufacturer's products are in direct competition with each
other, this objective is achieved by considering each product in isolation and fixing its
price at a level which is calculated to maximize its total contribution.
With marginal cost pricing, the prices are never rendered up-competitively because of a
higher fixed cost are higher than those of the competitor. The firm's prices will be
rendered un- competitive by high variable cost, and these are controllable in short run
marginal cost more accurately reflects future as distinct from present cost level and
relationship. This method also helps the manufacturer to develop a far more aggressive
pricing policy than the full cost pricing.
In a period of business recession, firm's using marginal cost pricing may lower prices in
order retain its market share. This may lead other firms to reduce their prices leading to
cut- throat competition. The price cut may be up to such an extent that the fixed cost is
not covered and thus a fair return on the investment is not obtained.
Example: Nestle Tea is priced based on this method.

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1.7.4 Limit Pricing

Bain explained why firms over a long period of time were keeping their price at a level
of demand where the elasticity was below unity, that is, they did not charge the price
which would maximize their revenue. Traditional theory was concerned only with
actual entry of the firms and not the potential entry. Bain argued that in the long run
because of the existence of barrier to entry the price do not fall to the level of LAC. This
behaviour can be explained by assuming that there are barriers to entry and the existing
firms do not set the monopoly price but the limit price, i.e., the highest price that the
established firms believe they can charge without inducing entry.
The level at which limit will be set depends on the estimation of the costs of the
potential entrant, market elasticity of demand, shape and level of LAC, size of the
market and number of firms in the industry.

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1.7.5 Going Rate Pricing

Here instead of cost, the emphasis is on the market. The firm adjusts its own price
policy to general pricing structure in the industry. This may seem to be a rational
pricing policy when the costs are difficult to measure. Many cases of this type are
situations of price leadership. Where price leadership is well established, charging
according to what competitors are charging, is the only safe policy.
It must be noted that this pricing is not quiet the same as accepting the price
impersonally set by a near perfect market. Whether it would seem that the firm has
some power to set its own price and could be a price maker if it chooses to face all the
consequences.
Example: Since Nescafe is the market leader in the instant coffee segment, hence every
manufacturer wanting to enter this segment has to be Nescafe's line.

1.7.6 Team pricing

According to this method, the companies sometimes assign special roles to the various
products they sell. Some items may be used as promotional items which are priced and
advertised with prime purpose of attracting the customers and other may be intended
to make up for the low margin obtained on the promotional items.
Example: Several retailers give free items with certain items. Pantaloon, Allen Solly &
Van Heusen are examples, for instance with a Van Heusen Blazer you can choose Van
Heusen tie for free.

1.7.7 Mark-up and Mark - down pricing

When a retailer follows the practice of fixing the price over the one at which he has
obtained the product, such that it covers the cost and leaves a reasonable profit margin
he is said to follow the mark-up policy. In case certain goods are not sold within a

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reasonable time, the retailer pulls the price down i.e. "marks down" the product price.
Example: During Diwali as the day approaches the firecracker prices increase and on
the diwali afternoon the prices are significantly marked down.

1.7.8 Peak Load Pricing

There are certain perishable products which are being demanded in varying
quantities at different point of time. E.g. During evening hours, restaurants face
peak demand and during day time, the demand falls. For these kinds of
products, a double pricing system is adopted. A higher price, called peak-load
price is charged during the peak-load period and a lower price is charged during
the off-peak period.

End Chapter quizzes :

1. Under marginal cost pricing, which cost is ignored
(a) Variable Cost
(b) Fixed Cost
(c) Marginal cost
(d) Opportunity Cost
2 Cost- Plus pricing methods ignores
(a) Labor cost
(b) Percentage for profit
(c) Demand for the product
(d) Supply price of Raw materials

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3. Setting up higher prices initially to extract the consumer surplus is known as

(a) Penetration Pricing
(b) Limit Pricing
(c) Skimming Pricing
(d) Team Pricing
4. In which Pricing method, the firm adjusts its own price policy to general pricing
structure in the industry:
(a) Team Pricing
(b) Going Rate Pricing
(c) Penetration Pricing
(d) Mark-up Pricing
5. Increase in Sales along with gain in profits is witnessed during
(a) Introductory Stage
(b) Growth Stage
(c) Maturity stage
(d) Decline Stage
6. Peak Load pricing strategy involves fixing higher price when
(a) The product is launched in the market.
(b) the demand is reaching at its highest point.
(c) The product is in decline stage.
(d) the product has no close substitutes.
7. In this Pricing strategy, the company determines the standard cost at standard
volume and adds the margins necessary to return a target rate of profit over the long
run:

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(a) Rate of Return pricing

(b) Cost plus Pricing
(c) Marginal cost Pricing
(d) Mark up Pricing
8. Which factor affects the determination of Price for a product
(a) Demand elasticity
(b) Consumer psychology
( c) Price changes
(d) all of the above

9. In case certain goods are not sold within a reasonable time, the retailer pulls the
price down, it is known as
(a) Adjustment pricing
(b) Administered pricing
(c) Mark-down pricing
(d) Mark-up pricing
10. This pricing strategy acts as a barrier to entry to new firms
(a) Limit Pricing
(b) Administered Pricing
(c) Peak Load Pricing
(d) Skimming Pricing

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Chapter-VII
Objectives of the Firm
Contents:
1.1 Introduction
1.2 Baumols Sales Revenue Maximization Theory
1.3 Marriss model of the managerial enterprise
1.4 Williamson Model of Managerial Discretion
1.5 Satisficing Behavior Theory of the Firm

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1.1 Introduction
Traditional theories of the firm advocated that profit maximization is the goal of the
firms. This objective was based on the single entity of ownership and management.
With the course of development simple business activities turned into complex
organizations dealing with specialized and classified activities. This development has
led to the separation of ownership and management. Further with this division the
utility functions of both parties faced confrontation in certain areas and profit
maximization did not remain the single objective of the firm. In this wake several
objectives were identified and proved to be true in real business practices. Coordination
and compromise between organizational parameters of concern and their managerial
counterparts is necessary. Organization could aim at profits, net worth, growth and

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diversification and managers may aim at Salary, Perks, Promotion, Job Security and
Career.

1.2 Baumols Sales Revenue Maximisation Theory

Managers rewards are more closely linked to Sales rather than Profits.

Firms aim to maximize Sales Revenue, but subject to a Profit Constraint.

Profit constraint is exogenously determined by the demand and expectations of

the shareholders, banks and other financial institutions.

A Sales Revenue Maximizing firm, in general, produces a greater output than a

Profit Maximizing Firm and sells at a price lower than the profit maximizer.

The maximum sales revenue will be where e = 1 (and hence MR = 0) and will be
earned only if the profit constraint is not operative.

If the profit constraint is operative the sales revenue maximizer will operate in
the area where price elasticity is greater than unity.

Profit Maximizing Output

QS

Sales Maximizing Output

QRS

Constrained Sales Maximizing Output

Profit Curve

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1.3 Marriss model of the managerial enterprise

The growth of an organization depends on the separate but

interdependent Utility functions of both owners and managers

Utility of Owners Profits, market Share, Public Esteem etc.

Utility of Managers Salaries, Status, Job Security etc.

Long Term goal of an organization is assumed to be Balanced Rate of

Growth

Job Security is important for Managers which imposes a constraint on the

diversification and growth of the firm

On the other hand, there is a trade off between retained profits

(reinvested for growth) and profits declared as dividends.

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1.4 Williamson Model of Managerial Discretion

Managers have discretion in pursuing policies which maximize their own utility rather
than attempting the maximization of profits which maximizes the utility of owners.
This is attained by the expense preference such as staff expenditure on emoluments,
funds available for discretionary investment. It gives managers a positive satisfaction
because these expenditures are a source of security and reflect the power, status,
prestige and professional achievement of managers. It emphasizes the ability of
managers to maximize their own Utility function (Owners Utility acts as a constraint).

U m f S, M, I d

Where

staff expenditure

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M managerial emoluments
Id

discretionary investment

An important aspect is the non pecuniary components of the Managers Utility

reflected in Emoluments and Managerial Slack in the form of expense
accounts, luxurious offices etc.

Also important are the funds available to managers for Discretionary

Investment

1.5 Satisficing Behaviour Theory of the Firm

Behavioral economists argue that any corporation is composed of various

groups

110

a. Employees
b. Managers
c. Shareholders
d. Customers

Each group has different goals such as production goal, inventory goal,
sales goal, profit goal etc.

People possess limited cognitive ability and so can exercise only

Bounded Rationality when making decisions in complex uncertain
situations.

Decisions are taken in conditions of uncertainty and ignorance. Rather

than an exhaustive search for the best or ideal solution, decision makers
seek an acceptable or satisfactory outcome.

Maximizing behavior may be replaced by Satisficing, i.e., setting

minimum acceptable levels of achievement.

End Chapter quizzes :

Q.1. Traditionally the objective of the firm was

111

a) Sales maximization
b) Profit maximization
c) Barriers to new entrants

d) Maximization of managers utility function

Q.2 The equilibrium of the traditional firm is where
(a) MR > MC
(b) MR = MC
(c) MR < MC
(d) MR MC
Q.3 Sales revenue maximizer is successful when
a) Profit constraint is too high
b) Profit constraint is non operative
c) Profit constraint is zero
d) Profit constraint is too low
Q.4 Which of the statements is false about sales revenue maximisation
a) Output is more than profit maximiser

b) Prices are lower than profit maximizer

c) Sales revenue is maximum where elasticity = 1
d) Prices are higher than profit maximizer
Q.5 According to Marris the utility functions of manager and owner are
a) Always same
b) Always separate
c) Interdependent

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d) Separate but interdependent

Q.6 Maximisation of balanced rate of growth means
a) (a) g < gd < gc
b) (b) g gd gc
c) (c) g > gd > gc

6 gd a
6 gc
d) (d) g a
Q.7 The relationship between discretionary investment and managers utility
maximization is
a) Positively high
b) Positively low
c) Negatively high
d) Negatively low
Q.8 Owners utility maximization is determined by
a) Revenue maximization
b) Profit maximization
c) Investment maximization
d) Prices maximization
Q.9 Satisficing behavior theory states that
a) Firm is a coalition of harmonized interest groups
b) Firm is a coalition of conflicting interest groups
c) Firm is not a coalition of interest groups
d) Firm is a single goal entity
Q.10 Satisficing behavior theory focuses on

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a) Decision making process of small single product firms under imperfect

market conditions
b) Decision making process of large multiproduct firms under imperfect
market conditions
c) Decision making process of large multiproduct firms under perfect
market conditions
d) Decision making process of small single product firms under perfect
market conditions

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Chapter-VIII
Market Structure
Contents:
1.1 Introduction
1.2 Meaning of market
1.3 Classification of Market Structure
1.3.1 Perfect Competition
1.3.1.1 Price Output Determination Under Perfect
Competition
1.3.1.2 Equilibrium in Short Run
1.3.1.3 Perfect Competition in the Long Run
1.3.1.4 Perfect Competition and Plant Size
1.3.1.5 Perfect Competition and the LR Supply Curve
1.3.1.6 Long Run Equilibrium
1.3.2 Monopoly Market
1.3.2.1 Why do Monopolies exist?
1.3.2.2 Equilibrium of the Firm
1.3.2.3 Price Discrimination
1.3.3 Monopolistic Competition
1.3.3.1 Structure
1.3.3.2 Short Run Equilibrium
1.3.3.3 Long Run Equilibrium
1.3.3.4 Efficiency under Monopolistic Competition
1.3.4 Oligopoly Market
1.3.4.1 Structure
1.3.4.2 Mutual Interdependence
1.3.4.3 Collusion is difficult if
1.3.4.4 Explicit Collusion Cartels
1.3.4.5 Sweezeys Model of Kinked Demand Curve
1.3.4.6 Price Stability with a Kinked Demand
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Curve
1.3.4.7 Tacit Collusion: Price Leadership
1.3.4.7.1 Dominant Firm Price Leadership
1.3.4.7.2 Barometric Price Leadership

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1.1 Introduction

Maximization of output or optimization of cost or optimization of resource allocation is

only one aspect of the profit maximizing behavior of the firm. Another and equally
important aspect of Profit Maximization is to find the price from the set of prices
revealed by the demand schedule that is in agreement with the profit maximization
objective of the firm.

The profit maximizing price does not necessarily coincide with minimum cost of
production. Besides, the level of profit-maximizing price also depends on the nature of
competition prevailing in the market. Therefore, while determining the price for its
product, a firm has to take into account the degree of competition.

1.2 Meaning of market

A market is a group of people and firms which are in contact with one another for the
purpose of buying and selling some product. It is not necessary that every member of
the market be in contact with each other.
Market structure refers to the number and size distribution of buyers and sellers in the
market for a good or service. The market structure for a product not includes firms and
individuals currently engaged in Buying and selling but also the potential entrants.

1.3 Classification of Market Structure

On the basis of the degree of competition, Markets are traditionally classified as:

Perfect Competition

Imperfect Competition

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1.3.1 Perfect Competition

Characteristics of Perfect Competition:

Large number of small sellers and buyers: The number of buyer as well as
seller is so large that the share of each buyer in total market demand and the
share of each seller in total market supply is insignificant and hence no
individual buyer or seller can influence the market price.

Homogeneous products: Products supplied by the firms are identical and are
regarded as perfect substitute to each other.

Perfect mobility of factors of production: For a market to be perfectly

competitive, the factors of production must be in the position of moving freely
into or out of the industry and from one firm to another.

Free entry and free exit of the firms: No legal or otherwise restrictions on the
entry and exit of the firms.

Perfect dissemination of the information: to the buyers and sellers.

No government intervention and Absence of collusion.

Examples: Agricultural commodities and Stock market

1.3.1.1 Price Output Determination Under Perfect Competition

In a perfectly competitive market, where large number of sellers selling homogeneous
product, no single seller can influence the market price. Similarly, each buyer has too
small share in total market demand to influence the price. Market Price is therefore
determined by the market demand and market supply for the industry and is given for
each individual firm and for each buyer. Thus, a seller in a perfectly competitive market
is a price-taker not a price maker. This means the individual firm will face a
horizontal demand curve. It will be horizontal at the market price, established by
supply and demand on the market as a whole.

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1.3.1.2 Equilibrium in Short Run

A Short run is a period in which firms can neither change their size nor quit, nor can
new firms enter the industry. Firms can increase (or decrease) the supply of the product
by increasing (or decreasing) the variable inputs. Therefore, supply curve is elastic in
short run.
The determination of market price in the short run is illustrated in the Fig. 4.1(a) and
adjustment of output by the firms to the market price and firms equilibrium are shown
in Fig. 4.2(b). Fig. 4.1(a) shows the price determination for the industry by the demand
curve D and supply curve S at the price OP. This price is fixed for all the firms in the
industry. Given the Price OP, an individual firm can produce and sell any quantity at
this price. To determine the profit maximizing output, firms cost curves are required to
be studied.

The process of firms output determination and its equilibrium are shown in the Fig
4.2(b). Profit maximizing condition for a firm is MR=MC. Since price is fixed at OP,

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firms average revenue AR= OP and also if AR is given, MR=AR. Firms upward sloping
MC curve intersects MR

1.3.1.3 Perfect Competition in the Long Run

In the long run, entry and exit become possible. Why? Because potential firms can buy
fixed inputs and become actual firms. And existing firms can sell off or stop renting
their fixed inputs and go out of business.
Firms will choose to enter the industry if the existing firms in the industry are making
economic profits. The profits are an incentive to enter. As a result the total market
supply will increase and, therefore, the market supply curve must shift to the right. It
drives down the price on the market, thereby reducing the profits of each firm.

Now the firms are making profits, but smaller profits than before. But if there are still
economic profits being made, more firms will enter. This must continue until there are
no economic profits. What has to be true when profits equal zero?
TR = TC
p*q = qATC
p* = ATC
So entry finally stops when firms are producing at their lowest average total cost. Here
is a diagram of the final, long-run equilibrium under perfect competition:

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What if typical firm is making losses? Then the reverse process will take place. Firms
will exit the market, causing a left shift of market supply, causing a rise in market price,
causing a reduction of losses. This continues until losses are zero. Thus, Long Run
competitive equilibrium consists of two conditions:
p* = MC
p* = minimum ATC
The first condition is caused purely by profit maximization, and its true in both the SR
and the LR. The second condition, however, is caused by entry and exit in the LR. It
wont necessarily be true in the SR.
These two conditions have important efficiency implications. Marginal-cost pricing (p*=
MC) means that consumers who buy the product face the true opportunity cost of their
choices. They will only buy the good if the value to them is greater than the price,
which represents the value of the resources that went into making the product.
Minimum average cost pricing (p* = minimum ATC) means that the product is being
made at the lowest average cost possible, so that no resources are being wasted in its
production.
The conclusion that firms make zero profit in the LR may seem odd, given the profits
that many firms earn in reality. What could explain the difference between theory and
reality? (1) Reality may differ from the perfectly competitive model, and to that extent

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economic profits can be made. But also, (2) the profits we generally hear about are
accounting profits, not economic profits. To find out whether these profitable firms
are really making economic profits, wed need more information about their implicit
costs.
Finally, (3) we may be observing short-run profits, not long-run profits.

1.3.1.4 Perfect Competition and Plant Size

It turns out that the perfectly competitive firm produces not just at the minimum of its
SRATC, but also its LRATC. Why? Because any PC firm not at its minimum LRATC will,
in the LR, change its input combination to take advantage of lower average costs. If
firms are able to make positive profits by moving outward on the LRATC curve, those
profits will attract entrants into the industry in the usual fashion. So by the same
arguments as before, profits will eventually dissipate to zero. The price must be at the
bottom of the LRATC, not just the SRATC.

1.3.1.5 Perfect Competition and the LR Supply Curve

As we have seen, changes in demand in a PC market create profits and losses for firms.
In the SR, this has no effect on the supply curve; but in the LR, firms enter for profits
and leave to escape losses, leading to supply curve shifts. We want to use this
information to derive a LR supply curve. A LR supply curve, just like a SR supply curve,
shows the total quantity that will be supplied in a market at different prices; but unlike
the SR supply curve, it shows the quantity supplied after all long-term changes,
including entry and exit of firms, have been taken into account.
In the basic supply-and-demand framework, notice that we can use demand
curves and equilibrium points to trace out the supply curve. If you look at three
different demand curves, and then mark the equilibrium point on each one, you can
connect the equilibrium points to find where the supply curve must be.
Now were going to use the same basic technique to trace out the LR supply curve. We
can do this by changing demand, and then finding the equilibrium points after allowing
LR adjustments, including entry and exit. Start with an initial (short-run) supply and

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demand. If we are in long-run equilibrium, profits are zero. Now, let demand shift to
the right. In the short-run, price rises a lot. But the higher price creates profits, and
profits attract entry in the long run. So eventually supply shifts to the right as well,
pushing price back down (though possibly not as low as it was before). Once profits are
back to zero again, youre in a new long-run equilibrium. Do this all again to find a
third long run equilibrium, and then connect the dots to get the long-run supply curve.

The interpretation of the LR supply curve is pretty much the same as the SR supply
curve: it shows the willingness of producers to sell at each price. But the LR supply
curve measures this willingness in the broadest sense, including all firms that might
potentially supply this product.
Notice that the LR supply curve is flatter than the SR supply curve. This must be so,
since the LR supply curve takes into account the quantity responses of all firms, not just
the ones currently in the market, but potential firms as well. It is even possible that the
LR supply curve can be downward-sloping. Why?

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Consider what must happen if entry and exit do not affect the cost curves of individual
firms. Then after all adjustment to a change in demand has taken place, the market price
must have returned to the lowest point on the LRATC, which is exactly where it was
before. So in this case, the LR supply curve must be horizontal. We call this a constant-cost industry. This is most likely to be the case when the industry in question constitutes
only a small portion of the demand for its inputs.
If the industry in question has a large impact on the markets for its inputs, then the LR
supply curve may slope upward or downward. If the effect of entry into the industry is
to bid up the price of inputs, so that a firms cost curves rise as a result of the entry of
new firms, then the market price after adjustment will be higher than it was before. In
this case, the LR supply curve must be upward-sloping as in the picture above; this is
called an increasing-cost industry, which results from external diseconomies. On the
other hand, if entry into the industry creates a greater demand for inputs that allows
those inputs to be produced through mass production techniques (i.e., at lower average
cost), then the industry can benefit from lower costs of production. In this case, the LR
supply curve is downward-sloping. This is called a decreasing-cost industry, which
results from external economies. They face a perfectly elastic demand curve Market
prices change only if demand and supply change

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1.3.1.6 Long Run Equilibrium

Normal profit is necessary to attract and maintain capital investment

Marginal Analysis

MR = MC => Normal Profits

Output will settle at the point where;

P = MC = AC = MR

1.3.1.7 Supply Curve under Perfect Competition

Short Run Firm Supply MC curve is the SR supply curve so long as P > AVC

Long Run firm Supply LMC curve is the LR supply curve so long as P > ATC

In the LR, the firm must cover all necessary costs of production and earn a
normal profit

1.3.2 Monopoly Market

A monopoly market is one in which there is only one seller of a product having no close
substitutes. The firm has substantial control over the price. Further, if product is
differentiated and if there are no threats of new firms entering the same business, a
monopoly firm can manage to earn excessive profits over a long period.

Only one firm produces the product

Low cross elasticity of demand between the monopolists product and any other
product; that is no close substitute products.

Substantial barriers to entry that prevents competition from entering the

industry.

1.3.2.1 Why do Monopolies exist?

Barriers to Entry

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a) Control of scarce resources or input

b) Economies of scale natural monopolies
c) Technological superiority
d) Govt. created barriers
e) Patents

1.3.2.2 Equilibrium of the Firm

Monopoly firms ability to set price is limited by the demand elasticity

Supernormal profits may be earned in the Long Run since there is no entry

P > competitive price

Q < competitive quantity

The monopolist will always try to operate on the elastic portion of the demand
curve

1.3.2.3

Price Discrimination
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Price discrimination means selling the same or slightly differentiated product to

different sections of consumers at different prices. The necessary conditions for
price discrimination are:

Different markets must be separable

The elasticity of demand must be different in different markets

There must be imperfect competition in the market

Profit maximizing output is much larger than the quantity demanded in a

single market

Price discrimination can be categorized into three types:

First degree of price discrimination Charging two different prices in

different markets having demand curves with different elasticities.

Second degree of price discrimination Charging more than two

different prices from each customers block

Third degree of price discrimination Charging different prices from

each consumer. The demand curve becomes the marginal revenue curve
of the seller.

1.3.3 Monopolistic Competition

It implies a market structure with a large number of firms selling differentiated
products. The differentiation may be real like brand name, trade mark, colour , shape,
design, packaging, credit terms etc, or is perceived so by the customers like product
image. Two brands of shampoos may just be identical but perceived by customers as
different on some fancy dimension like freshness. Firms in such a market structure have
some control over price.

1.3.3.1 Structure
127

Several firms in the market.

Producing differentiated products.

Free entry and exit.

Full and symmetric information.

Consumers have brand preference but can be induced to change brands

Advertising often plays a big role in monopolistically competitive markets

1.3.3.2 Short Run Equilibrium

The firm under Monopolistic Competition acts just as a monopolist in the Short Run

1.3.3.3 Long Run Equilibrium

Free Entry and Exit drive Long Run Profits to the level of Normal profits

Firm demand will be tangent to its LR Average Cost Curve

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1.3.3.4 Efficiency under Monopolistic Competition

Excess Capacity under Monopolistic Competition

Compared to perfect competition:

less will be sold at a higher price

firms will not be producing at the least-cost point (i.e. min AC) => firms have
excess capacity

On the other hand it is often argued that these wastes are insignificant and
perhaps well compensated to the consumer by the greater variety of products to
choose.

1.3.4 Oligopoly Market

It is a market structure in which a small number of firms account for the whole
industry's output. The product may or may not be differentiated. For example only 5 or
6 firms in India constitute 100% of the integrated steel industry's output. All of them

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market almost identical products. On the other hand, passenger car industry with only
three firms is characterized by marked differentiation in products The nature of
products is such that very often one finds entry of new firms difficult. Oligopoly is
characterized by vigorous competition where firms manipulate both prices and
volumes in an attempt to outsmart their rivals. No generalization can be made about
profitability scenarios.

1.3.4.1 Structure

In an oligopoly there are very few sellers of the good.

The product may be differentiated among the sellers (e.g. automobiles) or

homogeneous (e.g. petrol).

Homogenous product Pure Oligopoly

Entry is often limited

by legal restrictions (e.g. banking in most of the world)

by a very large minimum efficient scale

by strategic behavior.

1.3.4.2 Mutual Interdependence

The essence of an oligopolistic industry is the need for each firm to consider how
its own actions affect the decisions of its relatively few competitors

To predict the outcome in such a market, economists need to model the

interaction between firms.

Oligopoly may be characterized by Collusion Cartels Or Non - Cooperation

1.3.4.3 Collusion is difficult if

There are many firms in the industry

The product is not standardized

Demand and cost conditions are changing rapidly

130

There are no barriers to entry

Firms have surplus capacity

1.3.4.4 Explicit Collusion Cartels

A Cartel is a formal organization of sellers that seeks to restrict competition

Maximum possible profits that can accrue as a result of a cartel is the amount
that would prevail under Monopoly

If the firms compete vigorously on the basis of price, lowest possible equilibrium
price that could prevail is the competitive price and output

1.3.4.5 Sweezeys Model of Kinked Demand Curve

Explains Price Rigidity under Oligopoly

Starts with a predetermined Price Output

Demand Curve is kinked at current price:

The firm may expect rivals to respond if it reduces its price so, demand in
response to a price reduction is likely to be relatively inelastic

For a price rise, rivals are less likely to react, so demand may be relatively elastic

1.3.4.6 Price Stability with a Kinked Demand Curve

For any MC between a and b, the profit maximizing price and output remain
unchanged.

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1.3.4.7 Tacit Collusion : Price Leadership

One firm sets the price and others follow three types of leaders:

Dominant firm price leadership

Barometric Price Leadership

Price Leadership by a low cost firm

1.3.4.7.1 Dominant Firm Price Leadership

Dominant Firm sets the price for the industry but lets followers sell all they want
at that price

The Dominant firm will provide the rest of the market demand

Followers, like in Perfect Competition, accept the price as given

1.3.4.7.2 Barometric Price Leadership

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There is no one dominant firm

Price changes are in response to changes in some underlying market conditions,

obvious to all the firms

The critical requirement for being a leader is the ability to interpret market
conditions and propose price changes that other firms are willing to follow

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End Chapter quizzes

Q.1. Banking Sector is an example of
(a) Perfect Market
(b) Monopolistic Market
(c) Oligopoly Market
(d) Monopoly Market
Q.2 Which is not the characteristic of a perfect market
(a) Large number of small buyers and sellers
(b) Restricted entry and exit
(c) Homogeneous Products
(d) Free mobility of factors of production
Q.3. Profit maximizing condition for a firm is
(a) MR=MC.
(b) MR>MC
(c) MR<MC
(d) MC = AC
Q.4. In a Monopoly market, Barriers to Entry may be existing due to
(a) Control of scarce resources or input
(b) Technological superiority
(c) Patents
(d) All of the above
Q.5. Sweezeys Model of Kinked Demand Curve determines
(a) Price Rigidity in Oligopoly market
(b) Price discrimination in Monopoly market

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(c) Profit maximizing Output in Oligopoly market

(d) Profit maximizing Output in Monopoly market
Q.6. A formal organization of sellers that seeks to restrict competition is known as
(a) Sellers Association
(b) Cartel
(c) Trade Union
(d) Trade Association
Q.7. Which condition is false in case of a monopoly firm to earn excessive profits over
a long period
(a) Only one firm produces the product
(b) Low cross elasticity of demand between the monopolists product and any
other product; that is no close substitute products.
(c) Free entry of new firms
(d) Substantial barriers to entry that prevents competition from entering the
industry.
Q.8. Price Discrimination under Monopoly is not possible if
(a) Different markets are separable.
(b) Elasticity of demand is same in different markets.
( c) Market is imperfect.
(d) Elasticity of demand is different in different markets.

Q.9. In a Perfectly competitive market, in long run, firm earns

(a) Abnormal Profits
(b) Supernormal Profits
(c) Normal Profits
(d) Economic Profits

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Q.10. Demand curve of a firm in perfect competitive market is

(a) Upward sloping
(b) Downward sloping
(c) Horizontal
(d) Vertical

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Key to End Chapter Quizzes

Chapter I Managerial Decision Making

1 (b ); 2(a ); 3(c ); 4(a ); 5(a ); 6(c ); 7(b ); 8(b ); 9(a ); 10(d )
Chapter II Business Forecasting
1 (c ); 2(a ); 3(d ); 4(d ); 5(d ); 6(a ); 7(d ); 8(b ); 9(b ); 10(c )
Chapter III Demand Analysis
1 (b ); 2(a ); 3(b ); 4(b ); 5(c ); 6(d ); 7(a ); 8(b ); 9(c ); 10(b )
Chapter IV Cost Analysis
1 (b ); 2(a ); 3(a ); 4(c ); 5(a ); 6(b ); 7(c ); 8(a ); 9(b ); 10(a )
Chapter V Production Analysis
1 (c ); 2(b ); 3(b ); 4(b ); 5(a ); 6(d ); 7(a ); 8(d ); 9(c ); 10(b )
Chapter VI Pricing Policy of the Firm
1 (b ); 2(c ); 3(c ); 4(b ); 5(b ); 6(b ); 7(a ); 8(d ); 9(c ); 10(a )
Chapter VII Objectives of the firm
1 (b ); 2(b ); 3(b ); 4(d ); 5(d ); 6(b ); 7(a ); 8(b ); 9(b ); 10(b )
Chapter VIII Market Structure
1 (c ); 2(b ); 3(a ); 4(d ); 5(a ); 6(b ); 7(c ); 8(b ); 9(c ); 10(c )

137

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