MODULE-I: MANAGERIAL ECONOMICS

1.1 Introduction
Economics is the study about makin choices in the !"esence o# sca"city$ %he notions& 'Sca"city( and 'Choice( a"e )e"y im!o"tant in Economics$ I# the thin s *e"e a)ai+ab+e in !+enty then the"e *ou+d ha)e been no choice !"ob+em& you can ha)e anythin you *ant$ %he !oint is that !"ob+em o# choice a"ises because o# sca"city$ %he study o# such choice !"ob+em at the indi)idua+& socia+& nationa+ and inte"nationa+ +e)e+ is *hat Economics is about$ %hus& Economics as a socia+ science& studies the human beha)iou" as "e+ationshi! bet*een nume"ous *ants and sca"ce means ha)in a+te"nati)e uses$ Economics& as a basic disci!+ine& is use#u+ #o" ce"tain #unctiona+ a"eas o# business mana ement$ Economics cou+d be b"oad+y c+assi#ied into t*o cate o"ies: ,- Mac"o economics and .- Mic"o economics$ Mac"oeconomics is the study o# the economic system as a *ho+e$ Mic"oeconomics& on the othe" hand& #ocuses on the beha)iou" o# the indi)idua+ economic acti)ity& #i"ms and indi)idua+s and thei" inte"action in ma"kets$ Mana e"ia+ economics is an a!!+ied mic"oeconomics$ It b"id es the a! bet*een abst"act theo"ies o# economics in the mana e"ia+ decision-makin $ So& mana e"ia+ economics is an a!!+ication o# that !a"t o# mic"oeconomics& #ocusin on those to!ics o# the "eatest inte"est and im!o"tance to mana e"s$ %he to!ics inc+ude demand& demand #o"ecastin & !"oduction& cost& cost #unction& !"icin & ma"ket st"uctu"e and o)e"nment "e u+ation$ A st"on "as! o# the !"inci!+es that o)e"n the economic beha)iou" o# #i"ms and indi)idua+s is an im!o"tant mana e"ia+ ta+ent$ In ene"a+& mana e"ia+ economics can be used by the oa+-o"iented mana e" in t*o *ays$ /i"st& i)en an e0istin economic en)i"onment& the !"inci!+es o# mana e"ia+ economics !"o)ide a #"ame*o"k #o" e)a+uatin *hethe" "esou"ces a"e a++ocated bein e##icient *ithin a #i"m$ /o" e0am!+e& economist can he+! the mana ement to dete"mine i# "ea++ocatin +abou" #"om ma"ketin acti)ity to the !"oduction +ine cou+d inc"ease !"o#it$ Second these !"inci!+es he+! mana e"s "es!ond to )a"ious economic si na+s$ /o" e0am!+e& i)en an inc"ease in !"ice o# out!ut o" de)e+o!ment o# ne* +o*e" cost !"oduction techno+o y& the a!!"o!"iate mana e"ia+ "es!onse *ou+d be to inc"ease out!ut$

A+te"nati)e+y& an inc"ease in the !"ice o# one in!ut& say +abou"& may be a si na+ to substitute othe" in!uts& such as ca!ita+& #o" +abou" in !"oduction !"ocess$

1.2 Meaning and Definition of Managerial Economics

Mana e"ia+ Economics is the a!!+ication o# economic theo"y and methodo+o y to decision-makin !"ocesses *ithin the ente"!"ise$ Hailstones and Rothwell de#ined mana e"ia+ Economics as 1Mana e"ia+ Economics is the a!!+ication o# economic theo"y and ana+ysis to !"actices o# business #i"ms and othe" institutions$2 Acco"din to McNair and Merian say that 1mana e"ia+ economics consists o# the use o# economic modes o# thou ht to ana+y3e business situations2$ Spencer and Siegelman de#ined Mana e"ia+ Economics as 1the inte "ation o# economic theo"y *ith business !"actice #o" the !u"!ose o# #aci+itatin decisionmakin and #o"*a"d !+annin by the mana ement2$ Acco"din to Prof.E an !.Douglas 1Mana e"ia+ Economics is conce"ned *ith the a!!+ication o# economic !"inci!+es and methodo+o ies to the decision makin !"ocess *ithin the #i"m o" o" ani3ation unde" the conditions o# unce"tainties2 In ene"a+& Mana e"ia+ Economics cou+d be de#ined as the disci!+ine *hich dea+s *ith the a!!+ication o# economic theo"y to business mana ement$

1.". Nature of Managerial Economics

Mana ement is the uidance& +eade"shi! and cont"o+ o# the e##o"ts o# a "ou! o# !eo!+e to*a"ds some common ob4ecti)e$ It te++s about the !u"!ose o" #unction o# mana ement$ 5oont3 and O( Done++ de#ine mana ement as the c"eation and maintenance o# an inte"na+ en)i"onment in an ente"!"ise *he"e indi)idua+s *o"k to ethe" in "ou!s& can !e"#o"m e##icient+y and e##ecti)e+y to*a"ds the attainment o# "ou! oa+s$ %hus& mana ement is coo"dination& an a"t o# ettin thin s done by othe" !eo!+e$ On the othe" hand& economics due to sca"city o# "esou"ces is !"ima"i+y en a ed in ana+y3in and

!"o)idin ans*e"s to the )a"ious basic economic !"ob+ems +ike *hat to !"oduce6 7o* to !"oduce6 And #o" *hom to !"oduce6 Science o# Economics has de)e+o!ed se)e"a+ conce!ts and ana+ytica+ too+s to dea+ *ith the !"ob+em o# a++ocation o# sca"ce "esou"ce amon com!etin ends$ C+ose inte""e+ationshi! bet*een mana ement ob4ecti)es and economic !"inci!+es has +ed to the de)e+o!ment o# Mana e"ia+ Economics$ Mana e"ia+ Economics as a +ink bet*een economic theo"y and decision science& its !u"!ose is to cont"ibute to sound decision makin not on+y in business but a+so in o)e"nment a encies and Non- !"o#it o" ani3ations$ In !a"ticu+a"& mana e"ia+ economics assists in makin decisions about the o!timum a++ocation o# sca"ce "esou"ces amon com!etin acti)ities$ %he #o++o*in cha"t sho*s the natu"e o# Mana e"ia+ Economics$

Economics
%oo+s and %echni:ues

;usiness Mana ement

Choosin the best a+te"nati)e

Mana e"ia+ Economics

A!!+ication o# Economics to So+)e business !"ob+ems

SOUND ;USINESS DECISION

1.#. Scope of Managerial Economics

Sco!e o# the sub4ect is said to be an e0tent o# co)e"a e o# the sub4ect conce"ned o" bounda"ies *ithin *hich sub4ect is set in and a+so the im!o"tance o# the sub4ect$ Mana e"ia+ Economics& amon othe"s& emb"aces #o++o*in im!o"tant as!ects$ Demand Ana+ysis and /o"ecastin 8"oduction and Cost Ana+ysis

8"icin Decisions& 8o+icies and 8"actices Ca!ita+ Mana ement& and 8"o#it Mana ement

%hou h the abo)e ones a"e t"eated as sub4ect matte" o# Mana e"ia+ Economics& in the "ecent yea"s some o# the techni:ues +ike Linea" 8"o "ammin & In!ut-out!ut ana+ysis& etc$ a"e a+so become the !a"t o# the sub4ect$

,$<$, Demand Ana+ysis and /o"ecastin

Demand is a sta"tin #o"ce #o" any business #i"m to eme" e$ A business #i"m is an economic o" anism& *hich t"ans#o"ms !"oducti)e "esou"ces into oods& and se")ices that a"e to be so+d in a ma"ket$ So& a ma4o" !a"t o# mana e"ia+ decision-makin de!ends on accu"ate ana+ysis o# demand$ Demand ana+ysis he+!s identi#y the )a"ious #acto"s in#+uencin the demand #o" #i"m(s !"oduct and thus !"o)ides uide+ines to mani!u+atin demand$ 7ence& Demand ana+ysis and #o"ecastin & the"e#o"e& is necessa"y #o" business !+annin and occu!ies a st"ate ic !+ace in Mana e"ia+ Economics$

,$<$. 8"oduction and Cost Ana+ysis

In the com!etiti)e en)i"onment& business #i"ms a"e #o"ced to !"oduce oods and se")ices *ith cost e##ecti)eness$ 8"oduction #unction and cost ana+ysis enab+e the #i"ms to achie)e these oa+s$ %he #acto"s o# !"oduction may be combined in a !a"ticu+a" *ay to yie+d ma0imum out!ut$ In case the !"ices o# in!uts shoot u!& a #i"m is #o"ced to *o"k out a +east cost combination o# in!uts in !"oducin a !a"ticu+a" +e)e+ o# out!ut$ A+on *ith the abo)e& a study o# economic costs& combined *ith the data d"a*n #"om the #i"m(s accountin "eco"ds can yie+d si ni#icant cost estimates that a"e use#u+ #o" mana e"ia+ decisions$ %he suitab+e st"ate y #o" the minimi3ation o# cost cou+d be e)o+)ed$

,$<$9 8"icin Decisions& 8o+icies and 8"actices

%he success o# a business #i"m main+y de!ends on the sound !"ice !o+icy o# the #i"m$ %he !"ice !o+icy o# the #i"ms dete"mines its sa+es )o+ume as *e++ as its "e)enue$ Price $ Sales olume % &ross Re enue of the firm

<

%he"e#o"e& !"icin is )e"y im!o"tant a"ea o# Mana e"ia+ Economics$ Im!o"tant as!ects dea+t *ith unde" this a"ea a"e: 8"ice and out!ut dete"mination in )a"ious Ma"ket #o"ms& !"icin methods& Di##e"entia+ !"icin & 8"oduct +ine !"icin and so on$

,$<$< Ca!ita+ Mana ement

Ca!ita+ is one o# the most im!o"tant #acto"s o# !"oduction$ In de)e+o!in count"ies +ike India it is a +imitin #acto" on the economic de)e+o!ment$ It is to be mana ed mo"e e##icient+y #o" the o)e"a++ de)e+o!ment o# the economy as *e++ as #o" the !"os!e"ity o# the #i"m$ A #i"m(s ca!ita+ mana ement is most t"oub+esome and com!+e0 acti)ity o# business mana ement$ %his kind o# ca!ita+ mana ement im!+ies !+annin and cont"o+ o# ca!ita+ e0!enditu"e$ %he ma4o" a"eas dea+t he"e a"e: Cost o# ca!ita+& Rate o# "etu"n and se+ection o# !"o4ects$

,$<$= 8"o#it Mana ement

A++ kinds o# business #i"ms ene"a++y o" ani3ed #o" the !u"!ose o# makin !"o#its$ In the +on -"un !"o#its !"o)ide the chie# measu"e o# success$ An e+ement o# "isk dese")es !+ace at this !oint$ 8"o#it ana+ysis becomes an easy task in the absence o# "isk$ 7o*e)e" in the business it is di##icu+t to assume somethin *ithout "isk$ %he im!o"tant as!ects co)e"ed unde" this a"e: Natu"e and measu"ement o# !"o#it& 8"o#it !o+icies$ %he abo)e-mentioned as!ects "e!"esent the ma4o" unce"tainties& *hich a business #i"m has to "eckon *ith$ %hus& Mana e"ia+ Economics is a!!+ication o# economic !"inci!+es and conce!ts to*a"ds ad4ustin *ith )a"ious unce"tainties #aced by a business #i"m$

1.'. Managerial Economics and its Relationship with (ther Disciplines

Mana e"ia+ Economics is an inte"disci!+ina"y cou"se$ In #act most o# the mana ement cou"ses a"e o# that so"t$ Mana e"ia+ economics is +inked *ith )a"ious othe" #ie+ds o# study$ Sub4ects +ike Economics& Statistics& Mathematics& and Accountin dese")e "eate" em!hasis in this "e a"d$ 7o*e)e"& the "e+ation o# Mana e"ia+ Economics is not con#ined on+y to them$

1.'.1 Managerial Economics and Economics)

Mana e"ia+ Economics is *ide+y unde"stood as economics a!!+ied to mana e"ia+ decisions$ It may be )ie*ed as a s!ecia+ b"anch o# economics& #unctionin as b"id e bet*een economic theo"y and mana e"ia+ decisions$ Mic"oeconomics& one o# the main di)isions o# economics& is main sou"ce o# conce!ts and ana+ytica+ too+s #o" mana e"ia+ economists$ %o i++ust"ate& conce!ts such as e+asticity o# demand& e+asticity o# !"oduction& demand #o"ecastin & ma"ketin #o"ms& !"oduction #unction etc$ a"e o# "eat si ni#icance to mana e"ia+ economists$ %hus& it is #e+t that the "oots o# mana e"ia+ economics s!"in #"om mic"o-economic theo"y$ %he chie# cont"ibution o# mac"oeconomics is in the a"ea o# #o"ecastin o# ene"a+ business conditions$ %he mode"n theo"y o# income and ene"a+ business conditions$ em!+oyment has di"ect im!+ications #o" #o"ecastin

1.'.2 Managerial Economics and Statistics)

Economics in ene"a+& Mana e"ia+ economics in !a"ticu+a" dea+s *ith :uanti#iab+e )a"iab+es$ >uanti#ication and estimations !+ays c"ucia+ "o+e in mana e"ia+ economics$ %he"e#o"e& a!!+ication o# statistics in Mana e"ia+ Economics he+!s in decision-makin in se)e"a+ *ays$ It he+!s in the estimation o# demand #unction& *hich in tu"n he+!s in demand #o"ecastin $ Simi+a"+y statistics is a+so use#u+ in the estimation o# !"oduction and cost #unctions$ Estimation o# !"ice inde0 "e+ays hea)i+y on statistica+ too+s$ In this *ay Mana e"ia+ Economics is hea)i+y "e+y on statistica+ methods$

1.'." Managerial Economics and Mathematics:

Mathematics is anothe" im!o"tant disci!+ine c+ose+y "e+ated to Mana e"ia+ Economics$ It is a ain because mana e"ia+ economics is :uanti#iab+e$ 5no*+ed e o# eomet"y& ca+cu+us and mat"i0-a+ eb"a is not on+y essentia+ but ce"tain mathematica+ conce!ts and too+s such as Lo a"ithms and E0!onentia+s& ?ecto"s and so on a"e the too+ kits o# mana e"ia+ economists$ In addition& O!e"ations Resea"ch is a+so c+ose+y "e+ated to Mana e"ia+ Economics& used to #ind out the best o# a++ !ossibi+ities$ Linea" 8"o "ammin is an im!o"tant too+ #o" decision-makin in business and indust"y as it can he+! in so+)in !"ob+ems +ike dete"mination o# #aci+ities on machine schedu+in & dist"ibution o# commodities and o!timum !"oduct mi0 etc$ In!ut-out!ut ana+ysis is a+so )e"y much

use#u+ in mana e"ia+ economics$ %hus& the"e is c+ose "e+ationshi! bet*een Mana e"ia+ economics and Mathematics$

1.'.# Managerial Economics and *ccounting)

Accountin main+y dea+s *ith systematic "eco"din o# the #inancia+ "e!o"ts o# business #i"ms$ As a matte" o# #act accountin in#o"mation is one o# the !"inci!+e sou"ce o# data "e:ui"ed by a mana e"ia+ economist #o" his decision makin !u"!ose$ /o" e0am!+e& the !"o#it and +oss account o# a #i"m te++s ho* *e++ the #i"m has done and the in#o"mation it contains can be used by a mana e"ia+ economist to th"o* +i ht on the !"esent economic !e"#o"mance o# the #i"m and #utu"e cou"se o# action$ It is in this conte0t that the "o*in +ink bet*een mana ement accountin and mana e"ia+ economics dese")e s!ecia+ mention$ %he main task o# the mana ement accountants no* seen as bein to !"o)ide the so"t o# data *hich mana e" needs i# they a"e to a!!+y the ideas o# mana e"ia+ economists to so+)e the business !"ob+em$

1.+. ,undamental -oncepts of Managerial Economics

Mana e"ia+ Economics as e0!+ained ea"+ie"& it is the a!!+ication o# economic theo"y to mana ement decision-makin $ Economic theo"y o##e"s a )a"iety o# conce!ts and ana+ytica+ too+s& *hich can be o# conside"ab+e assistance to the mana e" in hisAhe" decision-makin !"ocess. %hese basic conce!ts o" !"inci!+es a"e #undamenta+ to the enti"e amut o# mana e"ia+ economics$ Some im!o"tant basic conce!ts a"e discussed in this section$ %he basic conce!ts discussed in this section inc+udes: ,$ O!!o"tunity cost !"inci!+e .$ 9$ <$ =$ Inc"ementa+ !"inci!+e %ime !e"s!ecti)e !"inci!+e Discountin !"inci!+e E:ui-ma" ina+ !"inci!+e

1.+.1 (pportunit. -ost Principle

O!!o"tunity cost is o# #undamenta+ im!o"tance in decision-makin !"ocess$ %he o!!o"tunity cost !"inci!+e may be stated as unde": %he cost in)o+)ed in any decision consists o# the sac"i#ices o# a+te"nati)es "e:ui"ed by that decision$ I# the"e a"e no

sac"i#ices& the"e is no cost$ Decision im!+ies makin a choice #"om amon the )a"ious a+te"nati)es$ ;y the o!!o"tunity cost o# a decision is meant the sac"i#ice o# a+te"nati)es "e:ui"ed by that decision$ A decision is cost #"ee i# it in)o+)es no sac"i#ice$ /o" e0am!+e& a businessman in)ests his o*n ca!ita+ in businessC its o!!o"tunity cost can be measu"ed in te"ms o# inte"est& *hich he cou+d ha)e ea"ned by +endin that money to somebody$ Anothe" i++ust"ation& *hen a businessman de)otes his time in o" ani3in his business& the o!!o"tunity cost may be measu"ed in te"ms o# sa+a"ies he cou+d ha)e ea"ned #"om some em!+oyment #"om e+se*he"e$ %hus& in abo)e cases& businessman com!a"es e0!ected "ate o# "etu"n D!"os!ecti)e yie+ds- #"om business *ith cu""ent "ate o# inte"estAsa+a"y and i# he #inds that !"os!ecti)e yie+ds ha!!en to be "eate" than the "ate o# inte"estAsa+a"y he *ou+d take a !ositi)e decision #o" #u"the" in)estment& othe"*ise not$ %hus& o!!o"tunity cost is the bene#it #o"e one by not se+ectin the best a+te"nati)e$

1.+.2 Incremental Principle

%he conce!t o# inc"ementa+ !"inci!+e is "e+ated to the ma" ina+ costs and ma" ina+ "e)enues conce!ts o# economics$ %he inc"ementa+ conce!t "e#e"s to the chan e in tota+$ It in)o+)es estimatin the im!act o# decision a+te"nati)es on cost and "e)enues$ %he t*o basic com!onents o# inc"ementa+ "easonin a"e inc"ementa+ cost and inc"ementa+ "e)enue$ Inc"ementa+ cost may be de#ined as the chan e in the tota+ cost due to !a"ticu+a" decision$ Inc"ementa+ "e)enue is the chan e in tota+ "e)enue caused by !a"ticu+a" decision$ %hus& *hen inc"ementa+ "e)enue e0ceeds inc"ementa+ cost "esu+tin #"om a !a"ticu+a" decision& it is "e a"ded as !"o#itab+e$ %his ce"tain+y he+!s a""i)in at a bette" decision com!a"in bet*een inc"ementa+ costs and "e)enues o# a+te"nati)e decisions$ /o" e0am!+e tab+e , i++ust"ates the "e)enue and cost o# !"oducin commodity 'E( by A;C Com!any$ %ab+e ,: Re)enue and Cost o# E Commodity 8e"tainin to A;C Com!any S+$ No$
D,-

8"oduction o# E commodity
D.-

%ota+ Re)enue
D9-

Inc"ementa+ Re)enue
D<-

%ota+ Cost
D=-

Inc"ementa+ Cost
D@-

%ota+ !"o#it
BFD9-@-

, . 9

,GGG .GGG 9GGG

.GGGG 9I=GG =H=GG

,I=GG ,IGGG

,HGGG 9BGGG =H=GG

,IGGG .,=GG

.GGG .=GG G

Inc"ease in !"oduction #"om ,GGG units to .GGG units "esu+ts hi he" inc"ementa+ "e)enue DRs$,I=GG- com!a"ed to inc"ementa+ cost DRs$,IGGG-$ %he"e#o"e& it is ad)isab+e to inc"ease !"oduction #"om ,GGG units to .GGG units$ Inc"ementa+ cost DRs$.,=GG- is mo"e than the inc"ementa+ "e)enue DRs$,IGGG- *hen the !"oduce" inc"eases his !"oduction #"om .GGG units to 9GGG units$

1.+." /ime Perspecti e Principle

%he economic conce!ts +ike sho"t-"un and +on -"un a"e !a"t o# e)e"y day +an ua e$ %his time !e"s!ecti)e o# sho"t and +on -"un !e"iod is im!o"tant in business decision-makin $ Mana e"ia+ economists a"e a+so conce"ned *ith +on and sho"t J "un e##ects o# decisions on "e)enues as *e++ as costs$ Im!o"tant !"ob+em in decision-makin is to maintain the "i ht ba+ance bet*een sho"t-"un and +on -"un conside"ations$

1.+.# Discounting Principle

%he conce!t o# discountin is a!!+ied to #utu"e costs and "etu"ns as the"e a"e )a"iations in the time !e"s!ecti)e unde"+yin di##e"ent decisions$ Discountin o"i inates #"om the conce!t o# o!!o"tunity cost and time !e"s!ecti)e$ A sim!+e e0am!+e *ou+d make this !oint c+ea"$ Su!!ose a !e"son is o##e"ed a choice to ha)e Rs$,GGG no* o" a#te" t*o yea"s$ 7eAShe *ou+d be ob)ious+y choosin the #i"st one& as the !"esent )a+ue o# Rs$,GGG is +ess a#te" t*o yea"s than it is a)ai+ab+e today$ In business decision-makin !"ocess& thus& the discountin !"inci!+e may be stated as: 1I# decision a##ects costs and "e)enues at #utu"e dates& it is necessa"y to discount those costs and "e)enues to !"esent )a+ues be#o"e a )a+id com!a"ison o# a+te"nati)es is !ossib+e2

1.+.' E0ui1Marginal Principle

E:ui-ma" ina+ !"inci!+e dea+s *ith the a++ocation o# the a)ai+ab+e "esou"ces amon the a+te"nati)e acti)ities$ Acco"din to this !"inci!+e& an in!ut shou+d be so a++ocated that the )a+ue added by the +ast unit is the same in a++ uses$ Su!!ose a #i"m has ,GG units o# +abou" at its dis!osa+$ %he #i"m en a es in th"ee economic acti)ities& *hich need se")ices o# +abou" )i3$ A& ;& and C$ It cou+d enhance any o# these acti)ities by addin mo"e o# +abou" on+y at the cost o# othe" acti)ity$ %hus& It shou+d be c+ea" that i# the ma" ina+ )a+ue !"oduct is hi he" in one acti)ity than anothe"& an o!timum a++ocation has not been I

attained$ It *ou+d the"e#o"e& be !"o#itab+e to shi#t +abou" #"om +o* ma" ina+ )a+ue !"oduct acti)ity to hi he" ma" ina+ )a+ue !"oduct acti)ity$ %he o!timum a++ocation o# +abou" cou+d be ensu"ed *hen: D?M8L-a F D?M8L- b F D?M8L-c 7e"e& ?M8L "e#e"s to the )a+ue o# ma" ina+ !"oduct o# +abou"C a& b& c a"e th"ee acti)ities$ %hus& this !"inci!+e is "eat+y use#u+ in the a++ocation o# any o# the "esou"ces amon a+te"nati)e uses$

1.2. (34ecti es of the ,irm

Each and e)e"y business #i"m st"i)es to achie)e some !"edete"mined ob4ecti)es$ In the con)entiona+ economics em!hasis *as i)en to the !"o#it ma0imi3ation ob4ecti)e$ In mode"n society& )e"y #e* e0!e"ts *i++ a" ue that a #i"m is moti)ated by the so+e ob4ecti)e o# ma0imi3ation o# !"o#it$ In the mode"n days a #i"m in)a"iab+y !u"sues mu+ti!+e ob4ecti)es e)en thou h one o" some o# them may "ecei)e !"io"ity o)e" othe"s$ %he ob4ecti)es o# the mode"n #i"m cou+d be summa"i3ed unde" the #o++o*in headin s$ ,$ 8"o#it ma0imi3ation .$ Lon "un su")i)a+ 9$ Sa+es ma0imi3ation *ith 8"o#it const"aint <$ Cost minimi3ation

1.7.1. Profit Maximisation: %he success o# any business is measu"ed by the )o+ume o#
its net income$ %he Net Income is the "esidua+ income& *hich acc"ues to a #i"m a#te" a++ othe" costs ha)e been met$ In othe" *o"ds Net Income % /otal Re enue 5/otal -ost$ It is conside"ed to be the acid test o# the !e"#o"mance o# the indi)idua+ #i"m$ Em!hasis has been i)en to this ob4ecti)e in con)entiona+ economics$

1.7.2. Long Run Survival: Economists& in the mode"n days& ho*e)e"& do not acce!t
that !"o#it ma0imisation is the on+y ob4ecti)e to be attained by the #i"m$ 5$ Rothdchi+d e0!"essed that the !"ima"y ob4ecti)e o# any business ente"!"ise is +on "un su")i)a+$ /o" the +on "un su")i)a+ to some e0tent #i"ms com!"omise *ith thei" !"o#it +e)e+$ In the

,G

mode"n days& #i"ms( aims at +imited instead o# ma0imum !"o#it #o" )a"ious "easons$ 8"o#esso" Koe+ Dean mentioned some o# the "easons #o" +imitin ma"ket cont"o+ undi+uted <$ %o maintain !+easant *o"kin condition etc$ !"o#its )i3$ ,$%o discou"a e the !otentia+ com!etito"s& .$ %o maintain costume"s ood *i++& 9$ %o kee!

1.7.3. Sales Maximization with Profit Constraint:

ma0imi3in !"o#it$ Acco"din

8"o#$ Li++iam K$ ;aumo+&

Ame"ican economist& does not a "ee *ith the t"aditiona+ )ie* that #i"ms aims at to him& the ob4ecti)e o# a mode"n #i"m is sa+es ma0imisation *ith a !"o#it const"aint$ Sa+es ma0imisation does not mean an attem!t to et +a" est !ossib+e !hysica+ )o+ume o# out!ut$ 7e"e the sa+es means the "e)enue ea"ned by se++in the !"oduct$ 7ence& sa+es ma0imisation "e#e"s to the ma0imisation o# the tota+ "e)enue that measu"es the :uantity o# !"oduct so+d in Ru!ee te"ms$ It cou+d be !"esented *ith the Su!!o"t o# the #i u"e No$,$,$ /i u"e ,$,: Sa+es ma0imi3ation *ith 8"o#it const"aint

In this #i u"e E-a0is measu"es the out!ut and M-a0is measu"es the %ota+ Re)enue D%R-& %ota+ Cost D%C- and %ota+ 8"o#it D%8-$ OM is the minimum !"o#it& *hich the #i"m ,,

intends to ea"n$ Lith the inc"ease in the out!utAsa+es +e)e+ the %R oes on inc"easin u! to a ce"tain e0tent then sta"t #a++in $ Simi+a"+y %C oes on inc"easin *ith the inc"ease in the sa+es +e)e+$ %8 is the di##e"ence bet*een the %R and %CC hence %8 is the )e"tica+ distance bet*een the %R and %C$ I# the #i"m intends to et ma0imum !"o#it it has to !"oduceA sa+e OA :uantity o# out!ut because %8 cu")e is ma0imum at !oint 7$ On the othe" hand i# the #i"m intends to ma0imi3e the sa+es it has to !"oduce and se++ OC amount o# the commodity because %R cu")e ma0imum at !oint R.$ At OC +e)e+ o# out!ut !"o#it +e)e+ DCG- is +ess than intended +e)e+ DC8-$ Acco"din to ;aumo+ the #i"m !"oduceAse++ O; amount o# out!ut$ It ma0imi3es the tota+ "e)enue sub4ected to minimum !"o#it sho*n by ML cu")e$ ;E is the !"o#it ea"ned by the #i"m at O; +e)e+ o# out!ut$ 1.2.#. Cost Minimization: Lhethe" a #i"m is !u"suin the !"o#it ma0imisation oa+ o" tota+ "e)enue ma0imisation sub4ected to !"o#it const"aint oa+ o" e)en +on "un su")i)a+ oa+ the #i"m has to !"oduce the oods o" "ende" the se")ice at the +east cost th"ou h the achie)ement o# the technica+ e##iciency$ Cost minimi3ation th"ou h the e0istin technica+ e##iciency is *ithin the cont"o+ o# the #i"m$ %ota+ "e)enue& a+on *ith :uantity o# the commodity so+d& de!ends on the ma"ket !"ice o# the commodity& *hich is many a time beyond the cont"o+ o# the #i"m$ %he cost minimi3ation enab+es the #i"m to achie)e the ob4ecti)es discussed abo)e$

1.6 ,actors *ffecting Managerial Decisions

Mana e"ia+ decision-makin is not 4ust on+y in#+uenced by economics but a+so by )a"ious othe" si ni#icant #acto"s$ Undoubted+y economic ana+ysis cont"ibutes a "eat dea+ to the !"ob+em so+)in in an ente"!"ise& at the same time it is im!o"tant to "emembe" th"ee othe" )a"iab+es& *hich ha)e e:ua+ im!act on the choices and decisions o# mana e"s$ %he"e#o"e& the ma4o" #acto"s a##ectin mana e"ia+ decisions a"e: ,$ Economic #acto"s .$ 7uman and beha)io"a+ #acto"s 9$ %echno+o ica+ #acto"s& and <$ En)i"onmenta+ #acto"s

,.

,$H$, Economic /acto"s

Economic #acto" *o"ks as backbone #o" e)e"y decision-makin !a"ticu+a"+y& in case o# comme"cia+ o" ani3ations $In the !"esent day situation it is e)en e0tended to not#o"-!"o#it o" ani3ations$ In business o" ani3ations #o" the !u"!ose o# su")i)a+ and "o*th mo"e than anythin economic #acto"s +ike& !"o#it ma0imi3ation andAo" sa+es "e)enue ma0imi3ation !+ay )ita+ "o+e$

,$H$. 7uman and ;eha)io"a+ /acto"s

It is !"o)ed beyond the doubt that economic #acto"s occu!y si ni#icant !+ace in decision-makin !"ocess$ 7o*e)e"& economic "ationa+ity may not ho+d *e++ a++ the times$ U+timate+y economics is #o" the *e++-bein o# !eo!+e conce"ned$ So& mana ement o# any o" ani3ation *i++ +ook into thei" !e"sona+ com#o"t as *e++ em!+oyees mo"a+e and moti)ation$ It can be obse")ed *ith sma++ ent"e!"eneu"s& *ho "e#use to e0!and o" di)e"si#y thei" economic acti)ity e)en thou h economic "ationa+ !"o)ides c+ea" si na+ o# the o!!o"tunities ahead that a*ait them$ Met many o# them decide to "emain sma++ since they #ee+ that such e0!ansion *i++ tend to st"ain thei" +i#esty+es o" th"eaten thei" cont"o+ o)e" the mana ement$

,$H$9 %echno+o ica+ /acto"s

%echno+o ica+ #acto"s a+so !+ay c"ucia+ "o+e in mana e"ia+ decision-makin !"ocess$ In the "esou"ce a++ocation !"ocess mana ement o# an o" ani3ation *i++ assess the techno+o ica+ a+te"nati)es& the techno+o ica+ mo)es o# com!etito"s and eme" ence o# ne* techno+o ies and !"ocesses$ No ma4o" in)estment decision is made *ithout a c+ose sc"utiny o# "e+e)ant techno+o ica+ a+te"nati)es$ %his is a!!+icab+e #o" ne* estab+ishment& e0!ansion o# an e0istin conce"n& mode"ni3ation and di)e"si#ication decisions$

,$H$< En)i"onmenta+ /acto"s

It is im!ossib+e to ima ine any business o" ani3ation in iso+ation$ It #unctions amidst o# tu"bu+ent en)i"onment consists o# socio-economic& !hysica+& !o+itica+ #o"ces etc$ En)i"onmenta+ !"essu"es o!e"atin on the ente"!"ise ha)e a bea"in on mana e"ia+ decisions e)en *hen they a"e !"ima"i+y economic in natu"e$ /o" e0am!+e& economic

,9

"ationa+ity mi ht su

est a st"on case #o" a !"ice "ise and yet the o" ani3ation mi ht be

#o"ced by !o+itica+& socia+ hosti+ity not to do the same$ In the "ecent times the #o"ce o# en)i"onmenta+ conside"ations is "o*in st"on e"$ 8ub+ic a*a"eness about the im!act o# #i"m +e)e+ decisions on society is "o*in $ 8o+iticians& consume" acti)ists& community o" ani3ations and so on a"e inc"easin +y conce"ned about the natu"e and conse:uences o# these decisions and constant+y make thei" !"esence #e+t *hich may con#+ict *ith the economic "ationa+ity$

1.7. Self Re iew 8uestions

,$ De#ine Mana e"ia+ Economics and discuss its natu"e and sco!e$ .$ 1Mana e"ia+ Economics is economics a!!+ied to decision-makin 2 E0!+ain$ 9$ E0!+ain ho* mana e"ia+ economics is "e+ated to Economics& Mathematics& Statistics and Accountin $ <$Discuss the ob4ecti)es o# a mode"n business #i"m$ =$ E0!+ain the #acto"s in#+uencin the mana e"ia+ decisions$ @$ De#ine o!!o"tunity cost6 E0!+ain its a!!+ications in mana ement decisions$ B$ Desc"ibe the im!o"tance o# e:ui-ma" ina+ !"inci!+e in Mana e"ia+ decision makin !"ocess$ H$ E0!+ain the im!o"tance o# inc"ementa+ !"inci!+e in the mana ement science$

,$,G$ Re#e"encesA Su
Ne* De+hi-,,GGG.

ested Readin s

,$ ?a"shney RL& and Mahesh*a"i 5$L: 1Mana e"ia+ Economics2& Su+tan Chand N Sons& .$ Mote& ?$ L$& Samue+ 8au+& Gu!ta&G$ S: 1 Mana e"ia+ Economics: Conce!ts and Cases2& %ata McG"a*-7i++ 8ub+ishin Com!any Limited& Ne* De+hi 9$ D$M$Mithani : 1Mana e"ia+ Economics: %heo"y and A!!+ications2& 7ima+aya 8ub+ishin 7ouse& Mumbai-<GG GG< @$ Go!a+ak"ishna& D$: 1 A Study in Mana e"ia+ Economics2 7ima+aya 8ub+ishin 7ouse& Mumbai-<GG GG<

,<

M(D9:E1II) DEM*ND *N*:;SIS *ND ,(RE-*S/IN&

.$, Int"oduction
%he success o" #ai+u"e o# a business de!ends !"ima"i+y on its abi+ity to ene"ate "e)enues by satis#yin the demand o# consume"s$ /i"ms that a"e #ai+ed to att"act the consume"s a"e soon #o"ced to be out o# the business$ Demand ana+ysis is a sou"ce o# many use#u+ insi hts #o" business decision-makin $ It se")es the #o++o*in mana e"ia+ ob4ecti)esC It he+!s in !"oduct !+annin and !"oduct im!"o)ement$ It i)es di"ection #o" demand mani!u+ation th"ou h ad)e"tisin and sa+es !"omotion st"ate ies$ It is use#u+ techni:ue #o" demand #o"ecastin *ith "eate" "e+iabi+ity$ It "e)ea+s the sco!e o# business e0!ansion$

It is& the"e#o"e& *o"th*hi+e to unde"stand some o# the conce!ts "e+ated to demand ana+ysis$ Meanin & ty!es& dete"minants o# demand& demand #unctions& e+asticity o# demand and demand #o"ecastin a"e discussed in this cha!te"$

.$. Meanin o# Demand$

Demand& o"dina"i+y& is de#ined as desi"e$ ;ut desi"e o# a be a" to t"a)e+ by ai" cou+d not be mate"ia+i3ed #o" +ack o# his abi+ity to !ay$ Desi"es come and )anish$ So a++ such desi"es cou+d not be conside"ed as demand$ A desi"e to be ca++ed demand shou+d be backed by t*o thin sC one& abi+ity to buy and t*o& *i++in ness to buy$ Thus, the demand for any commodity is the desire for that commodity backed by willingness as well as ability to pay for it and is always defined with reference to a particular time and at given price$ Demand F Desi"e O Abi+ity to !ay D!u"chasin !o*e"- O Li++in ness to !ay$ In another wa. the demand for a product could 3e defined as the amount of it< which will 3e 3ought per unit of time at a particular price. It is not out o# conte0t to int"oduce some o# the conce!ts !e"tainin )e"sus chan e in demand$ to the conce!t demand$ %he conce!t o# Indi)idua+ demand& Ma"ket demand& the +a* o# demand& and chan e in :uantity demand

,=

2.2.1 Indi idual Demand and Mar=et Demand An indi)idua+ demand "e#e"s to& othe" thin s "emainin the same& the :uantity o# a commodity demanded by an indi)idua+ consume" at )a"ious !"ices$ Ma"ket demand is the summation o# demand #o" a ood by a++ indi)idua+ buye"s in the ma"ket$ %he distinction bet*een indi)idua+ demand and ma"ket demand has been e0!+ained *ith the he+! o# indi)idua+ and ma"ket demand schedu+e as *e++ as demand cu")es$ /a312.1)Indi idual Demand Schedule ,ig 2.1 Indi idual Demand -ur e 8"ice DRs$@ = < 9 . , >uantity demanded Dunits,G .G 9G <G @G HG
7 6 5 4 3 2 1 0 0 20 40 60 80 100 Quantity Dem and

An indi)idua+ demand "e#e"s to the :uantity o# a commodity demanded by an indi)idua+ consume" at )a"ious !"ices& othe" thin s "emainin same$ An indi)idua+(s demand #o" a commodity is sho*n on the demand schedu+e D%ab+e-.$,- and demand cu")e D/i .$,-$ A demand schedu+e is a +ist o# !"ices and :uantities and its "a!hica+ "e!"esentation is demand cu")e$ It cou+d be seen #"om the demand schedu+e that as the !"ice o# the commodity oes on dec+inin the :uantity demand oes on inc"easin $ On+y ,G units o# commodity a"e demanded *hen the !"ice is Rs$ @ !e" unit *he"eas the :uantity demand inc"eased to HG units *hen the !"ice dec+ined to Rs$, !e" unit$ DD,& in #i u"e .$,& is the demand cu")e d"a*n on the basis o# the abo)e demand schedu+e$ %he dotted !oints D& >& R& S& % and U a"e the 'demand !oints($ %hey sho* the )a"ious !"ice:uantity combinations$ %he demand cu")e sho*s the e##ect o# "ise o" #a++ in the !"ice o# one commodity on the consume"(s beha)iou"$ In a ma"ket& the"e *i++ be many consume"s #o" a commodity$ %he"e#o"e& Ma"ket demand sho*s the sum tota+ o# )a"ious :uantities demanded by a++ the indi)idua+s at

,@

Price

)a"ious !"ices$ %he ma"ket demand o# a commodity is de!icted on a demand schedu+e and demand cu")e$ Su!!ose the"e a"e th"ee indi)idua+s A& ;& and C in a ma"ket *ho !u"chase the commodity$ %he demand schedu+e #o" commodity is de!icted in tab+e-.$.$ %he co+umn = o# the tab+e "e!"esents the ma"ket demand #o" the commodity at )a"ious !"ices$ It is obtained by addin the co+umn .& 9 and < *hich "e!"esent the demand o# the consume"s A& ; and C "es!ecti)e+y$ %he "e+ation bet*een co+umn ,and = sho*s the ma"ket demand schedu+e$ %ab+e .$. Ma"ket Demand #o" the E Commodity 8"ice DRs$A5 Consume" A D,@ = < 9 . , D.,G .G 9G <G @G HG >uantity demand in 5 s$ Consume" ; Consume" C D9.G <G @G HG ,GG ,.G D<<G @G HG ,GG ,.G ,@G Ma"ket Demand D=- D.O9O<BG ,.G ,BG ..G .HG 9@G

%he ma"ket demand #o" the commodity at the !"ice +e)e+ o# Rs$@ !e" unit is BG 5 $ %he ma"ket demand inc"eased to 9@G 5 *ith the #a++ in the !"ice to Rs$, !e" 5 $ In the #i u"e .$.& Dm is the ma"ket demand$ It is the ho"i3onta+ summation o# a++ the indi)idua+ demand cu")es DAOD;ODC$ %he ma"ket demand #o" a commodity de!ends on a++ #acto"s that dete"mine an indi)idua+ demand$ 2.2.2. /he :aw of Demand %he +a* o# demand desc"ibes the ene"a+ tendency o# consume"s( beha)iou" in demandin a commodity in "e+ation to the chan e in its !"ice$ %he +a* o# demand sim!+y states that the :uantity demand o# a commodity )a"ies in)e"se+y to chan e in !"ice$ 1Ceteris pari us! the higher the price of a commodit.< the smaller is the 0uantit. demand and lower the price< larger the 0uantit. demand>. %he +a* o# demand "e+ates the chan e in :uantity o# demand to the chan e in the !"ice )a"iab+e on+y$ It is a+*ays stated *ith the ceteris paribus i$e othe" thin s "emainin same$ It assumes othe"

,B

dete"minants o# demand to be constant$ %hus the +a* o# demand based on& amon othe"s& the #o++o*in ma4o" assum!tions: No chan e in the !"ice o# "e+ated oods No chan e in the consume"s income No chan e in the consume"s !"e#e"ence No chan e in the ad)e"tisement st"ate ies o# business houses ,igure 2.2) Mar=et Demand -ur e

It is a+most a uni)e"sa+ !henomenon o# the +a* o# demand that the demand cu")e s+o!es do*n*a"d #"om +e#t to "i ht$ In ce"tain cases demand cu")e may s+o!es u! #"om +e#t to "i ht$ It is because consume" may buy mo"e *hen the !"ice o# a commodity "ises and +ess *hen !"ice #a++s$ Such ci"cumstances a"e te"med as e0ce!tions to +a* o# demand$ E0ce!tiona+ cases may be cate o"i3ed asC ,.Gi##en #ound that in the ,Ith centu"y& I"e+and !eo!+e *e"e so !oo" that they s!ent a ma4o" !a"t o# thei" income on 8otatoes and sma++ !a"t on meat$ /o" them !otatoes and meat a"e in#e"io" and su!e"io" oods "es!ecti)e+y$ Lhen !"ice o# !otatoes "ose& they had to economise on meat e)en to maintain the same consum!tion o# !otatoes$ /u"the" to #i++ u! the "esu+tin a! in #ood su!!+y caused by a "eduction in meat consum!tion& mo"e

,H

!otatoes had to be !u"chased because !otatoes *e"e sti++ the chea!est #ood$ %hus the "ise in the !"ice o# !otatoes inc"eased the demand #o" !otatoes$ Such oods a"e !o!u+a"+y kno*n as Giffen goods$ .$ Some oods a"e !u"chased main+y #o" thei" snob a!!ea+$ Lhen the !"ice o# such oods "ises& thei" snob a!!ea+ inc"eases and they a"e !u"chased in +a" e :uantity and )is-P-)is$ Such oods a"e ca++ed Veblen goods$ It is named a#te" an Ame"ican economist& %ho"stein ?eb+en& *ho ad)ocated that some !u"chases *e"e made not #o" the di"ect satis#action& *hich they yie+d& but #o" the im!"ession& *hich they made on othe" !eo!+e$ 9$ In the speculative market& a #a++ in !"ice is #"e:uent+y #o++o*ed by sma++e" !u"chase and a "ise in !"ice by +a" e" !u"chases$ Lhen !"ice o# ce"tain oods "ises& !eo!+e may e0!ect #u"the" "ise and "ush to buy$ Lhen !"ice #a++& they may *ait #o" #u"the" #a++s& and sto! buyin $ 2.2.". -hange in 8uantit. Demand ersus -hange in Demand %he mo)ement a+on the demand cu")e measu"es the chan e in :uantity demand in "e+ation to the chan e in !"ice *hi+e chan e in demand is "e#+ected th"ou h shi#t in demand cu")e$ %he !h"ase 'Chan e in :uantity demand( essentia++y im!+ies )a"iation in demand "e#e""in to 'e0tension& o" 'cont"action( o# demand *hich a"e :uite distinct #"om the te"m 'inc"ease o" dec"ease in demand$ ". #xtension an$ Contra%tion of &eman$ A mo)ement a+on a demand cu")e takes !+ace *hen the"e is a chan e in the :uantity demand due to chan e in the commodity(s o*n !"ice$ %he e0tension o# demand "e#e"s to a situation *hen mo"e o# a commodity is bou ht *ith the #a++ in the !"ice$ Simi+a"+y& *hen a +esse" :uantity is demanded *ith a "ise in !"ice& the"e is a cont"action o# demand$ In sho"t& demand e0tends *hen the !"ice #a++s and it cont"acts *hen the !"ice "ises$ %he te"m e0tension and cont"action a"e technica++y used in statin the +a* o# demand$ /i u"e .$9 i++ust"ates the e0tension and cont"action o# demand$ /i $.$9: E0tension and Cont"action o# Demand

,I

In the #i u"e .$9 D,D, is the demand cu")e$ Lhen the !"ice is O8,& the :uantity demand is O>,$ Lith the #a++ in !"ice to O8. the :uantity demand "ises to O>.$ %hus& *ith the #a++ in !"ice the"e has been a do*n*a"d mo)ement #"om A to ; a+on the same demand cu")e D,D,$ %his is kno*n as e0tension in demand$ On the cont"a"y& i# *e take ; as the o"i ina+ !"ice-demand !oint& then a "ise in the !"ice #"om O8. to O8, +eads to a #a++ in the :uantity demand #"om O>. to O>,$ %he consume" mo)es u!*a"ds #"om !oint ; to A a+on the same demand cu")e D,D,$ %his is kno*n as cont"action in demand$ '. (n%rease an$ &e%rease in &eman$ %hese t*o te"ms a"e used to indicate chan e in demand$ A chan e in demand& thus& im!+ies an inc"ease o" dec"ease in demand$ An inc"ease in demand si ni#ies eithe" mo"e *i++ be demanded at a i)en !"ice o" same :uantity *i++ be demanded at hi he" !"ice$ It "ea++y means that mo"e is no* demanded than be#o"e at each and e)e"y !"ice$ Simi+a"+y dec"ease in demand indicates eithe" that +ess *i++ be demanded at a i)en !"ice o" the same :uantity *i++ be demanded at the +o*e" !"ice$ %he te"ms inc"ease and dec"ease in demand a"e "a!hica++y e0!"essed by the mo)ement #"om one demand cu")e to anothe" in #i u"e .$9A and ; "es!ecti)e+y$ ,ig. 2.") Increase in Demand ?*@ and Decrease in Demand ?A@

.G

In the case o# inc"ease in demand& the demand cu")e shi#ted to the "i ht$ In #i u"e .$9 DA- the shi#t o# demand cu")e #"om DD to D,D, sho*s an inc"ease in demand$ In this case a mo)ement #"om !oint 'A( to ';( indicates that the !"ice "emains same at O8& but mo"e :uantity DO>.- is no* demanded instead o# O>,$ 7e"e& inc"ease in demand is >,>. *hich due to the #acto" othe" than !"ice$ Simi+a"+y the shi#tin o# demand cu")e to*a"ds its +e#t de!icts a dec"ease in demand$ In the #i u"e .$9 D;- the dec"ease in demand is de!icted by the shi#t o# demand cu")e #"om D,D, to D.D.$ In this case the mo)ement #"om !oint 'A( to ';( indicates that the !"ice "emains same at O8 but :uantity demanded dec"eased by >,>.$%he dec"ease in demand by >,>. :uantity is due to the #acto" othe" than !"ice$

2." /.pes of Demand

%he demand beha)iou" o# the buye" o" consume" is di##e"ent *ith di##e"ent ty!es o# oods$ Demand cou+d be c+assi#ied in to #o++o*in ty!es #"om mana e"ia+ !oint o# )ie*$ a$ Demand #o" Consume"(s Goods and 8"oduce"(s Goods$ b$ Demand #o" 8e"ishab+e Goods and Du"ab+e Goods c$ De"i)ed Demand and Autonomous Demand d$ Koint Demand and Com!osite Demand e$ Indust"y Demand and Com!any Demand #$ Demand by %ota+ Ma"ket and by Ma"ket Se ment$ $ Sho"t-"un Demand and Com!any Demand$ a@ Demand for -onsumersB &oods and ProducersB &oods.

.,

8"oduce" oods a"e those& *hich a"e used #o" the !"oduction o# othe" oods$ E0am!+es #o" such Consume"s( oods a"e machines& too+s& "a* mate"ia+s& +ocomoti)es etc$ oods can be de#ined as those& *hich a"e used #o" #ina+ consum!tion$

E0am!+es o# consume"s( oods can be #ood items& tooth !aste& "eady-made c+oth etc$ these oods satis#ies the consume"s( *ants di"ect+y$ %he distinction bet*een consume"s( and !"oduce"s( oods is some*hat a"bit"a"y$ Lhethe" a !a"ticu+a" commodity is !"oduce" ood o" consume" ood de!end u!on *ho buys and *hat #o"$ /o" e0am!+e& su a" in the case o# a con#ectione" is a !"oduce" ood& *he"eas in case o# a househo+d it is a consume" ood$ 7o*e)e" the distinction is use#u+ because& amon othe" #acto"& demand #o" consume" oods de!ends on consume"s( income *he"eas demand #o" !"oduce" ood de!ends on demand #o" the !"oducts o# the indust"ies usin this !"oduct as an in!ut$ 3@ Demand for Perisha3le &oods and Dura3le &oods 8e"ishab+e oods a"e those& *hich can be consumed on+y once& *hi+e du"ab+e oods a"e those& *hich can be consumed mo"e than once o)e" a !e"iod o# time$ S*eets& ice c"eam& #"uits& )e etab+es& edib+e oi+& !et"o+ etc$ a"e !e"ishab+e oods$ Ca"& "e#"i e"ato"& machines& bui+din a"e du"ab+e oods$ It is im!o"tant to note that !e"ishab+e oods a"e themse+)es consumed *he"eas on+y the se")ices o# du"ab+e oods a"e consumed$ %his distinction is use#u+ because du"ab+e !"oducts !"esent mo"e com!+icated !"ob+ems in demand ana+ysis than the !"oducts o# du"ab+e natu"e$ Sa+es o# !e"ishab+e a"e made +a" e+y to meet cu""ent demand& *hich de!ends on cu""ent conditions$ Sa+es o# du"ab+es& on the othe" hand& add to the stock o# e0istin oods *hose se")ices a"e consumed o)e" a !e"iod o# time$ %hus they ha)e t*o kinds o# demand ?i3$ "e!+acement o# o+d !"oducts and e0!ansion o# the tota+ stock$ %hei" demand #+uctuates *ith business conditions$ c. Deri ed Demand and *utonomous Demand %he demand #o" a !"oduct is said to be de"i)ed demand i# demand #o" such !"oduct is tied to the !u"chase o# some !a"ent !"oduct$ /o" e0am!+e the demand #o" cement is a de"i)ed demand because it is needed not #o" it(s o*n sake but #o" satis#yin the demand #o" bui+din s$ %he demand #o" a++ !"oduce"s( ood is de"i)ed$ Autonomous demand& on the othe" hand& is not de"i)ed$ In case o# autonomous demand& demand #o" a !"oduct is inde!endent o# demand #o" othe" oods$ %oday& it is di##icu+t to #ind the ..

!"oducts *hose demand is *ho++y inde!endent o# demand #o" othe" oods$ 7o*e)e"& the de "ee o# this de!endence )a"ies *ide+y #"om !"oduct to !"oduct$ /o" e0am!+e& the demand #o" !et"o+ is #u++y tied u! *ith the demand #o" )ehic+es usin the !et"o+& *hi+e the demand #o" su a" is +oose+y tied u! *ith demand #o" d"inks$ %hus the distinction bet*een de"i)ed and autonomous demand is mo"e o# a de "ee than o# kind$ d@ !oint Demand and -omposite Demand Lhen t*o oods a"e demanded in con4unction *ith one anothe" at the same time to satis#y a sin +e *ant& they a"e said to be 4oint o" com!+imenta"y demand$ E0am!+es a"e !ens and inks& b"ead and butte"& su a" and mi+k and so on$ A commodity is said to be com!osite demand i# it is *anted #o" se)e"a+ di##e"ent uses$ E+ect"icity is needed #o" +i htin & cookin & i"onin & boi+in the *ate"& +i#tin *ate"& %$?& "adio and many othe" uses$ e@ Industr. Demand and -ompan. Demand At the outset +et us unde"stand the conce!t o# indust"y and com!any$ An indust"y is a "ou! o# com!anies o" #i"ms& *hich !"oduce simi+a" oods o" se")ices$ A com!any is a sin +e #i"m !"oducin a !a"ticu+a" ty!e o# oods o" se")ices$ Sugar industry in India consists o# a++ the com!anies o# the count"y& *hich !"oduce the su a"$ Shamanu" su a"s is a com!any o" a #i"m *hich !"oduces the su a"$ Indust"y demand denotes the demand #o" the !"oducts o# a !a"ticu+a" indust"y *hi+e com!any demand means the demand #o" the !"oducts o# a !a"ticu+a" indust"y$ /o" e0am!+e& demand #o" stee+ !"oduced by %ISCO is a com!any D%ISCO- demand *hi+e demand #o" stee+ !"oduced by a++ com!anies in India is indust"y demand #o" stee+ in India$ f@ Demand 3. /otal Mar=et and 3. Mar=et Segment. %ota+ ma"ket demand "e#e"s to the tota+ demand #o" a !"oduct *he"e as ma"ket se ment demand "e#e"s to a !a"t o# it$ Demand #o" ce"tain !"oducts has to be studied not on+y in its tota+ity but a+so by b"eakin it into di##e"ent se ments$ ?i3$ di##e"ent "e ions& di##e"ent use #o" the !"oduct& di##e"ent custome"s& di##e"ent dist"ibution channe+s and a+so its di##e"ent sub !"oducts$ Each o# these se ments may di##e" si ni#icant+y *ith "es!ect to de+i)e"y !"ice& !"o#it ma" in& com!etition and seasona+ !atte"n$ Lhen these di##e"ences

.9

a"e conside"ab+e& demand ana+ysis shou+d #ocus on the indi)idua+ ma"ket se ments$ 5no*+ed e o# these se ments( demand he+!s a unit in mani!u+atin its tota+ demand$ g@ Short1run Demand and -ompan. Demand. Sho"t-"un demand "e#e"s to demand *ith its immediate "eaction to !"ice chan es& income #+uctuations etc$ Lon -"un demand is that *hich *i++ u+timate+y e0ist as "esu+t o# chan e in !"icin & !"omotion o" !"oduct im!"o)ement a#te" enou h time has been a++o*ed to +et the ma"ket ad4ust itse+# to ne* situation$ /o" e0am!+e& i# e+ect"icity "ates a"e "educed& in the sho"t "un e0istin use"s o# e+ect"ic a!!+iances *i++ make "eate" use o# these a!!+iances but in the +on "un mo"e and mo"e !eo!+e mi ht induced to !u"chase these a!!+iances u+timate+y +eadin to sti++ "eate" demand #o" e+ect"icity$

2.# Determinants of Demand

Demand #o" a commodity de!ends on )a"ious #acto"s$ /acto"s in#+uencin the demand cou+d be c+assi#ied into t*o "ou!s$ /acto"s in#+uencin the indi)idua+ demand and ma"ket demand$ *@ ,actors Influencing the Indi idual Demand /acto"s in#+uencin the indi)idua+ demand a"e e0!+ained as #o++o*s:

Price of the product: No"ma++y& a +a" e :uantity is demanded at +o*e" !"ice and
)is-P-)is$

Income level of the consumer: 8u"chasin !o*e" o# an indi)idua+ consume"

de!ends on his income +e)e+$ %he"e#o"e& income +e)e+ is an im!o"tant dete"minant o# demand$ Consume"s *ith hi he" income +e)e+ demand mo"e and mo"e oods com!a"ed to the consume"s *ith +o*e" income +e)e+$

Price of the related goods: Demand #o" a !a"ticu+a" commodity de!ends on the
!"ice o# its "e+ated oods such as substitute and com!+ementa"y oods$ /o" e0am!+e i# the !"ice o# tea inc"eases the demand #o" co##ee is e0!ected inc"ease because tea and co##ee a"e substitutes #o" many consume"s$ Simi+a"+y *ith the inc"ease in the !"ice o# !et"o+ the demand #o" )ehic+es is e0!ected to dec"ease because ca" and !et"o+ a"e com!+ementa"y oods$

.<

Taste,

abit and Preferences of the consumers: 8eo!+e *ith di##e"ent taste

and habit ha)e di##e"ent !"e#e"ence #o" di##e"ent oods$ Demand #o" se)e"a+ !"oducts +ike be)e"a es& ice c"eam& choco+ates and so on a"e de!endin on the indi)idua+(s taste$ Simi+a"+y demand #o" tea& co##ee& utka bete+& ci a"ette& tobacco is a matte" o# habits o# the consume"s$ A st"ict )e eta"ian *i++ ha)e no demand #o" meat at any !"ice *he"eas a non-)e eta"ian *ho has +ikin #o" chicken may demand it e)en at hi he" !"ice$

!"pectation: Consume"(s e0!ectations about the #utu"e chan e in the !"ices o# a

i)en commodity in#+uence the demand #o" such commodity$ Lhen he e0!ects its !"ice to "ise in the #utu"e& he *i++ buy +ess at the !"e)ai+in !"ice$ Simi+a"+y& i# he e0!ects its !"ice to #a++ in #utu"e& he *i++ buy +ess at !"esent$

#dvertisement: No*adays ad)e"tisement !+ays c"ucia+ "o+e in a+te"in

cosmetics etc$ a"e "eat+y in#+uenced by the ad)e"tisements$

the

!"e#e"ences o# the consume"s$ Demand #o" !"oducts +ike tooth!aste& toi+et soa!s&

A@ ,actors Influencing the Mar=et Demand Ma"ket demand is the sum tota+ o# )a"ious :uantities demanded by a++ the indi)idua+s at )a"ious !"ices$ %he"e#o"e& #acto"s in#+uencin indi)idua+ demand a"e a+so in#+uencin the ma"ket demand$ In addition to the #acto"s e0!+ained abo)e Din section A#o++o*in #acto"s in#+uence the ma"ket demand$

$istribution of income and %ealth in the country: Ma"ket demand #o" oods
and se")ices is mo"e in count"ies *ith e:ua+ dist"ibution o# income and *ea+th com!a"ed to the count"ies *ith une:ua+ dist"ibution$

Growth of population and number of buyers in the market& Ma"ket demand

#o" the !"oducts de!ends on the numbe" o# buye"s$ Numbe" o# buye"s in the ma"ket& amon othe" #acto"s& main+y de!ends on the !o!u+ation si3e and its "o*th$ A +a" e numbe" o# buye"s *i++ usua++y constitute a +a" e demand )is-P)is$ %he"e#o"e& "o*th o# !o!u+ation o)e" a !e"iod o# time inc"eases the demand #o" oods and se")ices in the ma"ket$

#ge and se" structure of the population& A e st"uctu"e o# !o!u+ation

in#+uences the demand #o" )a"ious oods and se")ices in the ma"ket$ In the

.=

count"y *ith bottom hea)y a e st"uctu"e D"e+ati)e+y mo"e chi+d"en-& "e+ati)e+y mo"e chi+d"en& the ma"ket demand #o" toys& schoo+ ba s& choco+ates etc$ *i++ be "e+ati)e+y mo"e$ Simi+a"+y se0 st"uctu"e a+so in#+uences the demand #o" oods and se")ices in the ma"ket$ I# se0 "atio is #a)o"ab+e to #ema+es then the demand #o" oods and se")ices "e:ui"ed #o" #ema+es *i++ be "e+ati)e+y mo"e$ /o" e0am!+e demand #o" oods +ike sa"ies& ban a+s& +i!sticks etc$ is mo"e in the count"ies *ith the se0 "ation #a)ou"ab+e to #ema+es$

'limatic conditions& Demand #o" ce"tain !"oducts is dete"mined by c+imatic

conditions$ /o" e0am!+e& in "ainy season& the"e *i++ be mo"e demand #o" umb"e++as& "ain coats et$ Simi+a"+y demand #o" coo+ d"inks& ice c"eams& #ans etc$ a"e mo"e in summe" season$

2.' Demand ,unction

A demand #unction states the #unctiona+ "e+ationshi! bet*een the demand #o" a commodity o" se")ices and the #acto"s o" )a"iab+es a##ectin it$ %he demand #unction #o" commodity E can be symbo+ica++y stated as #o++o*s: D0 F #D80Lhe"e& D0 F Demand #o" E 80 F 8"ice o# 0 commodity %he #unction .$, demand #o" commodity E de!ends on the !"ice o# the commodity$ It does not conside" the demand in#+uencin #acto"s othe" than the !"ice$ %his is a sin +e )a"iab+e mode+$ Mu+ti!+e )a"iab+e mode+s a"e !"esented in the #o++o*in #unction D.$.-$ D0 F # D80& I& 8"& A& ULhe"e D0 F Demand #o" E 80 F 8"ice o# E I F Income o# the consume" 8" F8"ice o# the "e+ated oods A FAd)e"tisement o" sa+es !"omotiona+ acti)ities U FE""o" te"m .$. .$,

.@

%he demand #unction .$. sho*s that the :uantity demand o# E in#+uenced by the !"ice o# commodity E& income o# the consume"s& !"ice o# its "e+ated oods and ad)e"tisement o" sa+es !"omotion acti)ities$ %he demand #o" commodity E mi ht be in#+uenced by the #acto"s othe" than these #acto"s a+so$ %he in#+uence o# the )a"iab+es othe" than those inc+uded in the mode+ is "e!"esented by e""o" te"m DU-$ It is a ene"a+ #o"m o# demand #unction because the inde!endent )a"iab+es inc+uded in the mode+ DR7Sa"e conside"ed to be in#+uencin the :uantity demand o# commodity E but it does not "e)ea+ in *hat di"ection and to *hat e0tent they a"e in#+uencin $ %he em!i"ica+ demand #unction sho*s the :uantitati)e "e+ationshi! bet*een the demand #o" a !a"ticu+a" commodity and its dete"minants$ Em!i"ica+ demand #unction a+so "e)ea+s the di"ection o# "e+ationshi! bet*een the de!endent )a"iab+es D>uantity demand o# a commodity- and inde!endent )a"iab+es DDemand dete"minants- th"ou h the si n Di$e O o" --$

2.+ Elasticit. of Demand

Demand usua++y )a"ies *ith )a"iation in the !"ice$ %he +a* o# demand states that *ith the #a++ in the !"ice o# commodity& the :uantity demand inc"eases and )is-P-)is$ ;ut it does not states by ho* much the :uantity demand inc"eases as a "esu+t o# ce"tain #a++ in the !"ice o# the commodity$ E+asticity o# demand is a use#u+ too+ to unde"stand the e0tent o# chan e in :uantity demand due to chan e in !"ice o" othe" demand in#+uencin #acto"s +ike income& !"ice o# "e+ated oods and ad)e"tisement$ 2.+.1 Meaning of Elasticit. of Demand. %he te"m e+asticity o# demand& )e"y o#ten& used as a synonymous o# !"ice e+asticity o# demand$ %his is a +oose inte"!"etation o# the te"m$ In the st"ict sense o# the te"m the %on%ept of elasti%it) of $eman$ refers to the responsiveness of the *uantit) $eman$ to the %hange in $eman$ $eterminants$ It can be de!icted as

8e"centa e chan e in :uantity demand E+asticity o# Demand F 8e"centa e chan e in demand dete"minant

.B

%he demand dete"minants main+y inc+ude the !"ice o# the commodity& !"ice o# "e+ated ood& income o# the consume"$ 2.+.2 /.pes of Elasticit. of Demand. %he"e a"e as many ty!es o# !"ice e+asticity o# demand as the"e a"e demand dete"minants$ 7o*e)e"& conside"in its ma4o" dete"minants economists b"oad+y c+assi#ied the e+asticity o# demand into #o++o*in ty!es$ 8"ice e+asticity o# demand Income e+asticity o# demand C"oss e+asticity o# demand

2.+." Price Elasticit. of Demand. In the *o"ds o# 8"o#$ Li!sey 18"ice e+asticity o# demand may be de#ined as the "atio o# the !e"centa e chan e in :uantity demand to the !e"centa e chan e in !"ice$2 8"ice e+asticity o# demand may be *"itten as 8e"centa e chan e in :uantity demand 8"ice E+asticity o# Demand F 8e"centa e chan e in 8"ice In the a+ eb"aic #o"m it cou+d be !"esented as E! F [>A>] / [8A8] Lhe"e E! F Coe##icient o# 8"ice E+asticity o# Demand > F Chan e in demand > F Initia+ demand 8 F Chan e in 8"ice E! is the coe##icient o# !"ice e+asticity o# demand$ %he coe##icient o# !"ice e+asticity o# demand is a+*ays ne ati)e because !"ice and :uantity demand )a"ies in)e"se+y *ith the chan e in the !"ice o# the commodity$ It is& ho*e)e"& customa"y to dis"e a"d the ne ati)e si n$ Usin the abo)e #o"mu+a& the nume"ica+ coe##icient o# !"ice e+asticity o# demand can be measu"ed #o" any i)en data$ Ob)ious+y& de!endin on the ma nitudes and !"o!o"tionate chan es in)o+)ed in data on demand and !"ices& one can obtain )a"ious nume"ica+ )a+ues "an in #"om 3e"o to in#inity$ 8"ice e+asticity o# demand de!endin on the )a+ue o# coe##icient cou+d c+assi#y into di##e"ent ty!es$

.H

2.+.".1 /.pes of Price Elasticit. of Demand. *. Perfectl. Elastic Demand In case o# !e"#ect+y e+astic demand& a s+i ht o" in#inite+y sma++ buyin "ise it$ in !"ice o# a commodity& consume"s %he sto! ,ig 2.#) Perfectl. Elastic Demand

nume"ica+

coe##icient o# !e"#ect+y e+astic demand is in#inity DE!F) The demand curve, in this .! is case, will be a horizontal straight line. In figure "" demand curve horizontal to #$ a%is.

A. Perfectl. Inelastic Demand 8e"#ect+y ine+astic demand is one #o" *hate)e" the chan e in !"iceC the"e is abso+ute+y no chan e in demand$ In this case& the :uantity demand sho*s no "es!onse to a chan e in !"ice$ %hus& !e"#ect+y e+astic demand has 3e"o coe##icient DE!FG-$ In #i u"e .$= DD demand cu")e is a )e"tica+ +ine$ In this case& *hate)e" may be the !"ice +e)e+ the :uantity demand "emains same at OD$ ,ig 2.') Perfectl. Inelastic Demand

.I

-. Relati el. Elastic Demand I# a "eduction in !"ice +eads to mo"e than !"o!o"tionate chan e in :uantity demand& the demand is said to be "e+ati)e+y e+astic$ /o" e0am!+e i# = !e" cent dec+ine in !"ice +eads to ,G !e" cent inc"ease in :uantity demand& the demand is said to be "e+ati)e+y e+astic$ In this case coe##icient o# e+asticity o# demand is "eate" than , but it is not in#inite$ In #i u"e .$@ DD, demand cu")e is "e+ati)e+y #+atte"$ ,ig 2.+) Relati el. Elastic Demand

D. Relati el. Inelastic Demand I# a dec+ine in !"ice +eads to +ess than !"o!o"tionate inc"ease in :uantity demand& the demand conside"ed to be "e+ati)e+y ine+astic$ /o" e0am!+e i# a = !e" cent dec+ine in !"ice +eads to 9 !e" cent inc"ease in :uantity demand then demand conside"ed to be "e+ati)e+y ine+astic$ In this case the coe##icient o# e+asticity o# demand +ies bet*een 3e"o and one$ DD, demand cu")e in #i u"e .$B is "e+ati)e+y stee!e"$ ,ig 2.2) Relati el. inelastic Demand

E. 9nitar. Elastic Demand 9G

8"ice e+asticity o# demand is unity *hen the chan e in demand is e0act+y !"o!o"tionate to the chan e in !"ice$ /o" e0am!+e i# a = !e" cent inc"ease in !"ice +eads to = !e" cent dec"ease in :uantity demand then demand conside"ed to be unita"y e+astic$ In this case the coe##icient o# e+asticity o# demand is one$ DD demand cu")e in #i u"e .$H is a "ectan u+a" hy!e"bo+a$

,ig 2.6) 9nitar. Elastic Demand

2.+.".2 ,actors Influencing Price Elasticit. of Demand. a- The availability of substitutes: %he demand #o" a commodity is mo"e e+astic i# the"e a"e c+ose substitutes #o" the commodity$ b- The nature of the need that the commodity satisfies: In ene"a+ +u0u"y oods a"e !"ice e+astic& *hi+e necessities a"e !"ice ine+astic$ c- The time period: Demand is mo"e e+astic in the +on "un than in the sho"t "un$ d- The number of uses to which a commodity can be put: %he mo"e the !ossib+e uses o# a commodity the "eate" its !"ice e+asticity *i++ be$ e- The proportion of income spends on the particular commodity: %he demand is ine+astic i# a )e"y sma++ !"o!o"tion o# income is s!ent on a !a"ticu+a" commodity$ 2.+.# Income Elasticit. of Demand. %he income e+asticity is de#ined as a "atio o# !e"centa e o" !"o!o"tionate chan e in :uantity demand to !e"centa e o" !"o!o"tionate chan e in income$ %he coe##icient o# income e+asticity o# demand cou+d be measu"ed by the #o++o*in #o"mu+a:

8e"centa e chan e in :uantity demand Income E+asticity o# Demand F 8e"centa e chan e in Income In the a+ eb"aic #o"m it cou+d be !"esented as 9,

Ey F [>A>] / [MAM] Lhe"e Ey > > M M F F F F F Coe##icient o# Income E+asticity o# Demand Chan e in demand Initia+ demand Chan e in income Initia+ income

%he coe##icient o# income e+asticity o# demand *i++ be !ositi)e #o" the no"ma+ oods$ Some economists ha)e used income e+asticity in o"de" to c+assi#y the oods into +u0u"ies and necessities$ A commodity is conside"ed to be a +u0u"y i# its income e+asticity is "eate" than unity$ A commodity is a necessity i# its income e+asticity is sma++D+ess than unity-$ 2.+.#.1 ,actors Influencing Income Elasticit. of Demand. a- %he natu"e o# the need that the commodity co)e"s: %he !e"centa e o# income s!ent on #ood dec+ines as income +e)e+ inc"eases *hi+e the !e"centa e o# income s!ent on the +u0u"ies inc"eases *ith inc"ease in income +e)e+$ b- %he initia+ +e)e+ o# income o# a count"y: %? is a +u0u"y in a !oo" count"y *hi+e it is a necessity in a count"y *ith hi h !e" ca!ita income$ c- %ime !e"iod: %ime !e"iod in#+uence the income e+asticity o# demand because consum!tion !atte"n ad4ust *ith a time +a to chan es in income$ 2.+.#.2 9ses of Income Elasticit. of Demand. a- (usiness planning: In India& !e" ca!ita income is +o* and it has been s+o*+y inc"easin $ Since income e+asticity o# income #o" +u0u"y !+an out its business acco"din +y$ b)arketing strategy: Income e+asticity o# demand is he+!#u+ in de)e+o!in the ma"ketin st"ate y$ oods is mo"e& the !"os!ect #o" +on "un "o*th in sa+es #o" these oods is )e"y b"i ht$ %he #i"ms can

2.+.' -ross Elasticit. of Demand.

9.

%he c"oss e+asticity o# demand "e#e"s to the de "ee o# "es!onsi)eness o# demand #o" a commodity to a i)en chan e in the !"ice o# some "e+ated commodity$ %he "e+ated commodity may be substitute o" com!+ementa"y$ %he coe##icient o# c"oss e+asticity o# demand cou+d be measu"ed by the #o++o*in #o"mu+a: 8e"centa e chan e in :uantity demand o# E C"oss E+asticity o# Demand F 8e"centa e chan e in 8"ice o# M In the a+ eb"aic #o"m it cou+d be !"esented as Ey F [>0A>0/ [&'/&'] Lhe"e Ec F >0 F >0 F &' F 8y F Coe##icient o# C"oss E+asticity o# Demand Chan e in >uantity Demand o# 0 Initia+ >uantity demand o# 0 Chan e in !"ice o# M Initia+ !"ice o# M

%he conce!t o# c"oss e+asticity o# demand can be use#u+ in dete"minin com!etiti)e !"ice st"ate y and !o+icy in the substitute oods o" com!+ementa"y oods such as coco co+a o" 8e!si& tea o" co##ee$ Coe##icient o# c"oss e+asticity o# demand he"e is taken& as a measu"e o# e##ect o# a chan e in the !"ice o# coco co+a on the demand #o" 8e!si$ Simi+a" is the case *ith "es!ect to tea o" co##ee$

2.2 Demand ,orecasting

In the business !"oduction o# oods o" se")ices is o# no use i# the"e is no demand #o" oods o" se")ices !"oduced by the business houses$ Demand #o"ecastin is an use#u+ too+ in antici!atin the #utu"e demand *hich enab+e the business house to take the a!!"o!"iate business decisions$ In this section meanin & ty!es& !u"!ose and methods o# demand #o"ecastin a"e discussed$

2.2.1 Meaning of Demand forecasting

99

Demand #o"ecastin means an estimation o# the +e)e+ o# demand that mi ht be "ea+i3ed in #utu"e unde" i)en ci"cumstances$ It is not a s!ecu+ati)e e0e"cise into the unkno*n$ It is based on mathematica+ +a*s o# !"obabi+ity$ It can(t be hund"ed !e" cent !"ecise$ ;ut it i)es a "easonab+e accu"acy$ %hus& demand #o"ecastin in)o+)es !"edictin #utu"e economic condition and assessin thei" e##ect on the o!e"ation o# the #i"m and its demand$ %he ob4ecti)e o# demand #o"ecastin is to !"edict the #utu"e demand$ 2.2.2 -lassification of Demand ,orecasting Demand #o"ecastin can be c+assi#ied into di##e"ent ty!es based on the di##e"ent c"ite"ion$ Demand #o"ecastin #o"ecastin #o"ecastin can be c+assi#ied into sho"t-"un and +on "un demand based on the time !e"iod$ Simi+a"+y based on the "o+e o# the demand #i"m demand #o"ecast can be c+assi#ied into acti)e demand #o"ecast and

!assi)e demand #o"ecast$ ;ased on the +e)e+ o# demand #o"ecastin it cou+d be c+assi#ied into mac"o& indust"y and #i"m +e)e+ demand #o"ecastin $ a- Short*period and +ong period demand forecast: Sho"t-"un #o"ecastin & usua++y& co)e"s any !e"iod u! to one yea"$ Lon !e"iod& on the othe" hand& *i++ co)e" any !e"iod mo"e than one yea"$ No"ma++y it co)e"s the !e"iod o# =& ,G o" e)en .G yea"s$ Sho"t-"un #o"ecastin use#u+ in takin decision conce"nin the day to day *o"kin o# the #i"m *he"eas +on "un #o"ecastin #aci+itates ma4o" st"ate ic decisions$ b- Passive and active demand forecasting: 8assi)e demand #o"ecastin !"edicts the #utu"e demand in the absence o# any action by the #i"m$ Lhi+e acti)e #o"ecastin estimate the #utu"e demand takin into conside"ation o# the +ike+y #utu"e action o# the #i"m$ /o" e0am!+e& Samsun e+ect"onic com!any takes no !o+icy actions to in#+uence its #utu"e sa+es& *hat *ou+d be sa+es in the yea" .G,G6 Such #o"ecasts a"e !assi)e demand #o"ecasts$ 7o*e)e"& #o"ecasted +e)e+ o# sa+es may not be desi"ab+e +e)e+ and so the com!any may be initiated some sa+es !"omotion actions *ith a )ie* to inc"ease its #utu"e sa+es$ %he !"edicted sa+es i# such !+anned sa+es !"omotion acti)ities a"e unde"taken denote the acti)e #o"ecast$

9<

c- )acro, Industry and ,irm level demand forecastingC Mac"o-economic #o"ecastin "e#e"s to the #o"ecastin A "e ate demand #o" o# business conditions o)e" the enti"e economy$ oods and se")ices in the enti"e economy can be

#o"ecasted$ Such #o"ecast is ca++ed as mac"o-economic #o"ecastin $ /o"ecastin the demand #o" the !"oducts o# a !a"ticu+a" indust"y is the indust"y +e)e+ demand #o"ecastin $ Gene"a++y& it is unde"taken by the t"ade association and the "esu+ts a"e made a)ai+ab+e to the membe" #i"ms$ A #i"m can #o"ecast the demand #o" its !"oducts at its o*n +e)e+$ It is ca++ed #i"m +e)e+ demand #o"ecastin $ It is most im!o"tant #"om the !oint o# )ie* o# mana e"ia+ decisions$ 2.2." Purpose of Demand ,orecasting) %he !u"!ose o# demand #o"ecastin cou+d be c+assi#ied into !u"!ose o# sho"t-te"m and +on -te"m demand #o"ecastin $ %hey a"e se!a"ate+y e0!+ained he"eunde": * Purpose of Short1/erm Demand ,orecasting) o It is use#u+ in a!!"o!"iate !"oduction Schedu+in : %o a)oid the !"ob+em o# o)e" !"oduction and the !"ob+em o# sho"t su!!+y a!!"o!"iate !"oduction schedu+in is essentia+ #o" *hich demand #o"ecastin is use#u+$ o It he+!s in !u"chase !+annin to "educe the cost o# o!e"ation: Demand #o"ecastin enab+es the #i"ms to unde"stand the "i ht :uantity o# "esou"ces "e:ui"ed to the #i"m at di##e"ent !oints o# time& *hich in tu"n& "educes the cost o# o!e"ation$ o It is use#u+ in ado!tin suitab+e ad)e"tisin and !"omotiona+ !"o "amme$ A sho"t-te"m demand #o"ecastin is use#u+ in e)o+)in suitab+e sa+es !o+icy in )ie* o# the seasona+ )a"iation o# demand$ o It is use#u+ in #o"ecastin sho"t-te"m #inancia+ "e:ui"ements$ A #i"m(s need #o" cash de!ends on its !"oduction +e)e+$ Lithout sa+es #o"ecastin a "ationa+ #inancia+ !+annin is not !ossib+e$ o It is use#u+ in dete"minin a!!"o!"iate !"ice !o+icy: Sho"t-te"m sa+es #o"ecastin *i++ he+! the #i"m in dete"mination o# a suitab+e !"ice !o+icy to

9=

c+ea" o## the stocks du"in the o##-season& and to take ad)anta e in the !eak season$ A Purpose of :ong1/erm Demand ,orecasting) o Lon -te"m demand #o"ecastin e0!ansion o# an e0istin unit$ o It is use#u+ in !+annin +on te"m #inancia+ "e:ui"ements o It is use#u+ in !+annin the man!o*e" "e:ui"ements$ Man!o*e" de)e+o!ment "e:ui"es +on time$ Man!o*e" de)e+o!ment !"ocess has to sta"t *e++ in ad)ance to meet the #utu"e man!o*e" "e:ui"ements$ 2.2.# Methods of Demand ,orecasting Demand #o"ecastin main+y in)o+)es t*o im!o"tant methodo+o ica+ as!ects )i3$ data co++ection and ana+ytica+ methods$ Demand #o" any oods o" se")ices cou+d be #o"ecasted based on the a)ai+ab+e in#o"mation o" data on the "e+ated !a"amete"$ Demand #o"ecastin may be based on t*o ty!es o# data sou"ces )i3 !"ima"y sou"ces and seconda"y sou"ces$ 8"ima"y data o" in#o"mation is o"i ina+ in natu"e *hich is co++ected #o" the #i"st time #o" the !u"!ose o# ana+ysis$ Seconda"y data& on the othe" hand& a"e those *hich a"e obtained #"om someone e+se "eco"ds$ %hese data a"e a+"eady in e0istence in the "eco"ded o" !ub+ished #o"m$ In case o# !"ima"y data& demand #o"ecaste" has to co++ect the data th"ou h some so"t o# su")ey method$ %he co++ected data has to !"ocess th"ou h some statistica+ techni:ue$ Method o# demand #o"ecastin & the"e#o"e& has been discussed unde" t*o headin s )i3$ , Su")ey Method and .$ Economet"ic Method 2.2.#.1. Sur e. Method. In the demand #o"ecastin su")ey !+ays )ita+ "o+e$ %he data "e:ui"ed #o" the demand #o"ecastin cou+d be co++ected th"ou h the su")ey method$ /o" the !u"!ose o# demand #o"ecastin su")ey method cou+d be c+assi#ied into #o++o*in ty!es DCha"t .$,-: i- !"perts .pinion Survey )ethod: In this method the #utu"e demand #o" a !a"ticu+a" commodity is estimated based on the o!inions o# e0!e"ts in the ma"ketin o# that !a"ticu+a" commodity$ Since sa+esmen a"e in c+ose contact *ith custome"s in thei" is use#u+ #o" !+annin o# a ne* unit o"

9@

"es!ecti)e a"eas& they can #o"ecast consume" beha)io" in the ma"ket in the #utu"e$ 7ence& unde" this method sa+esmen a"e to estimate the e0!ected sa+es in thei" "es!ecti)e a"ea$ %hese estimates o# indi)idua+ sa+esmen a"e to be conso+idated in o"de" to obtain the tota+ estimated sa+es #o" the #utu"e$ Cha"t .$,: %y!es o# Su")ey Method o# Demand /o"ecastin

Su")ey Meyhod Method Su")ey

E0!e"ts( O!inion Su")ey

Consume"s Inte")ie*

Census Method

Sam!+e Su")ey

End Use Method

%he to! e0ecuti)es o# the #i"m a"e to #u"the" e0amine the tota+ estimated sa+es in the +i ht o# the #acto"s +ike !"o!osed chan e in the se++in !"ice& !acka in desi n& ad)e"tisement !"o "amme& chan e in mac"o )a"iab+e +ike !u"chasin !o*e" o# the !eo!+e etc$ %h"ou h these !"ocesses a #i"m cou+d come out *ith its #ina+ demand #o"ecast$ %his method is a+so kno*n as the 'co++ecti)e o!inion method( because it takes the ad)anta e o# the co++ecti)e *isdom o# the sa+esmen(s& co"!o"ate heads& dea+e"s etc$ %his method is chea!e" and easy to hand+e$ It is +ess time consumin a+so$ %he main +imitation o# this method is that it tends to substitute o!inion #o" ana+ysis o# the situation$ It is !u"e+y sub4ecti)e and di##e"ent e0!e"ts may ha)e si ni#icant+y di##e"ent #o"ecasts$

9B

ii- Consume"s Su")ey Method: Consume"s& the !otentia+ #utu"e buye"s a"e #oca+ !oint #o" the demand #o"ecastin $ Unde" this method& consume"s a"e di"ect+y asked about thei" #utu"e !+an o# !u"chase$ %his may be done in any o# the #o++o*in *ays: a- Com!+ete enume"ation method b- Sam!+e su")ey method c- End use method a- 'omplete !numeration )ethod: Unde" this method #o"ecaste" has to co++ect in#o"mation #"om a++ consume"s o# the commodity #o" *hich he *ishes to #o"ecast the demand$ 7e asks e)e"y consume" the :uantity o# that commodity he *ou+d +ike to buy in the #o"ecastin !e"iod$ Once this in#o"mation is co++ected& demand cou+d be #o"ecasted by sim!+y addin the !"obab+e demand o# a++ consume"s$ /o" e0am!+e the"e a"e 'n( numbe" o# consume"s and thei" !"obab+e demand #o" commodity E in the #o"ecast !e"iod a"e E ,& E.& E9QEn then the demand #o"ecast *ou+d be E F E, OE. O E9 OQEn In this method the #o"ecastin a ency cou+d not int"oduce any bias o# its o*n$ Kust it has to co++ect the in#o"mation and tabu+ate them$ Re!o"t has to be !"e!a"ed acco"din +y$ ;ut it is an e0!ensi)e and time-consumin method #o" the !"oducts ha)in +a" e numbe" o# consume"s$ b- Sample Survey )ethod: In sam!+e su")ey method #o"ecaste" aimed to asce"tain the cha"acte"istics o# !a"amete" based on the cha"acte"istics o# statistic$ /o" e0am!+e& A;C com!any intended to #o"ecast demand #o" its E commodity$ Su!!ose A;C #i"m has about one +akh consume"s$ E0!ected a "e ate :uantity demand o# these one-+akh consume"s in the #o"ecastin !e"iod Dsay in the yea" .G,G- is !a"amete" o# this demand #o"ecastin $ Demand #o"ecaste" can d"a* conc+usion about this !a"amete" by t*o di##e"ent methods$ ,- Com!+ete enume"ation method and .- Sam!+e su")ey method$ In com!+ete enume"ation method #o"ecaste" co++ect in#o"mation #"om a++ the one+akh consume"s about thei" e0!ected :uantity demand #o" #o"ecastin !e"iod and #o"ecast the demand based on this in#o"mation Dthe detai+s o# this method discussed in the ea"+ie" section-$ In case o# sam!+e su")ey method #o"ecaste" need not co++ect in#o"mation #"om a++

9H

the one-+akh consume"s$ 7e has to choose some sam!+e "es!ondents out o# one-+akh consume"s usin a!!"o!"iate sam!+in method and sam!+e si3e$ 7e may ado!t sim!+e "andom sam!+in method o" st"ati#ied "andom sam!+in method o" c+uste" sam!+in method o" e)en sno*ba++ sam!+in method acco"din to the natu"e o# the !o!u+ation dist"ibution$ /o"ecaste" may choose ,GG o" =GG sam!+e "es!ondents o" ,GGG o" mo"e sam!+e "es!ondents based on the a)ai+ab+e time& bud et& e0!ected +e)e+ o# accu"acy o# the "esu+t etc$ /o" this e0am!+e +et us assume that the #o"ecaste" has se+ected =GG "es!ondents usin the sim!+e "andom sam!+in method$ A#te" co++ectin in#o"mation #"om the sam!+e "es!ondents he can ca+cu+ate the e0!ected a)e"a e demand o# these se+ected "es!ondents #o" the #o"ecastin !e"iod$ %he )a+ue ca+cu+ated #o" the sam!+e is kno*n as the sam!+e statistics$ E E,OE.OQQQ$E=GG F ------ F E =GG 7e"e& E is the sam!+e statistics because it is estimated #o" the sam!+e "es!ondents$ In this e0am!+e E $N F A "e ate demand #o" the #o"ecastin !e"iod$ In this e0am!+e N "e#e"s to the !o!u+ation si3e i$e$ one +akh$ %hus conc+usion about the a "e ate demand by the one-+akh consume"s is estimated by usin "es!ondents$ %his method o# demand #o"ecastin is +ess e0!ensi)e and "e:ui"es +ess time *hen com!a"ed to com!+ete enume"ation method$ I# sam!+e is !"o!e"+y chosen the sam!+e su")ey method *i++ yie+d ood "esu+ts$ 7o*e)e" it is not so sim!+e to choose the "e!"esentati)e sam!+e$ I# sam!+e is not ood "e!"esentati)e o# the !o!u+ation conce"ned then the "esu+ts *i++ mis+ead the !"oduce"s$ C- !nd use )ethod of $emand ,orecasting: %his method o# demand #o"ecastin is suitab+e i# the !"oduce"A#i"m desi"e to obtain use-*ise o" secto" *ise demand #o"ecasts$ In this method o# demand #o"ecastin & the demand #o" a !a"ticu+a" commodity is estimated th"ou h a su")ey o# its use"s o# di##e"ent uses$ /o" e0am!+e a commodity may be used #o": i$ /ina+ consum!tion ii$ 8"oduction o# some othe" commodity 9I the data co++ected #"om the =GG sam!+e

iii$ E0!o"t In this method demand #o"ecaste" is to obtain se!a"ate demand #o"ecast #o" these di##e"ent uses$ /o" e0am!+e a stee+ #i"m *ants to #o"ecast demand #o" stee+ in the yea" .G,G$ It can be obtained as Sd.G,G F Sc.G,G O Se.G,G O asi$DEi-.G,G Lhe"e Sd.G,G Sc.G,G asi$ F %ota+ demand #o" the stee+ in the yea" .G,G F Consum!tion demand #o" stee+ in the yea" .G,G F Stee+ "e:ui"ement o# ith indust"y !e" unit o# its out!ut

Se.G,G F E0!o"t demand #o" stee+ in the yea" .G,G DEi-.G,G F Out!ut o# ith indust"y usin stee+ as an in!ut Consum!tion demand and e0!o"t demand cou+d be di"ect+y estimated by usin the a!!"o!"iate method$ Demand #o" inte"mediate use cou+d be #o"ecasted th"ou h the su")ey o# its use" indust"ies "e a"din thei" !"oduction !+an and in!ut-out!ut coe##icients$ %he !"inci!+e ad)anta e o# this method is that it !"o)ides use-*ise demand #o"ecast$ I# the numbe" o# end use"s o# a !"oduct is +imited it *i++ de con)enient to use this method$ %he ma4o" *eakness o# this method is that the indi)idua+ indust"y *i++ ha)e to "e+ay on some othe" method to estimate the #ina+ demand o# its !"oducts #o" #ina+ consum!tion and e0!o"t$

.$B$<$. Economet"ic Method

%he te"m Economet"ics means& +ite"a++y& Economic measu"ement$ Economet"ic methods inte "ate statistics& mathematics and economic theo"y in o"de" to measu"e "e+ationshi! amon economic )a"iab+es$ Economet"ic mode+s !"o)ide insi hts into the "e+ationshi! bet*een the )a"iab+es$ %hese insi hts can be )e"y use#u+ to the mana e"s in e)a+uatin the !"obab+e e##ect o# a+te"nati)e decisions$ /o" e0am!+e& an economet"ic study that estimate the im!act o# ad)e"tisin on the demand cou+d be used to ad)e"tisin st"ate ies$ %he im!o"tant ste!s in)o+)ed in the #o"mu+ation o# economet"ic mode+s a"e: ,$ De)e+o!ment o# a theo"etica+ mode+& . Data co++ection& 9 Choice o# #unctiona+ #o"m& and < Estimation and inte"!"etation o# "esu+ts$ Economet"ic method cou+d be #u"the" c+assi#ied into: <G

iiiiii-

Re "ession method %"end method Leadin indicato" method

i-. /egression )ethod: Re "ession is a statistica+ de)ise *ith the he+! o# *hich it is !ossib+e to estimate the unkno*n )a+ue o# one )a"iab+e #"om the kno*n )a+ue o# anothe" )a"iab+e$ %he )a"iab+es *hich isAa"e used to !"edict the )a+ue o# othe" )a"iab+e isAa"e ca++ed inde!endentAe0!+anato"y )a"iab+eA)a"iab+es$ %he )a"iab+e *e t"ied to !"edict is ca++ed de!endent )a"iab+e$ Estimated "e "ession e:uation "e)ea+s the cause and e##ect "e+ationshi! bet*een the de!endent and inde!endent )a"iab+es$ It sho*s the e0tent to *hich the )a+ue o# de!endent )a"iab+e chan es *ith the chan e in the )a+ueAs o# inde!endent )a"iab+eAs$ In economic theo"y it is *e++-estab+ished #act that the :uantity demand o# a commodity de!ends on )a"ious #acto"s$ In sim!+e a+ eb"aic #o"m it cou+d be sho*n as: D0 F # D80& I& 8s& 8c& A& ULhe"e D0 F Demand #o" E 80 F 8"ice o# E I F Income o# the consume" 8s F8"ice o# the substitute oods 8c F8"ice o# the com!+imenta"y oods A FAd)e"tisement o" sa+es !"omotiona+ acti)ities U FE""o" te"mAin#+uence o# othe" une0!+ainab+eAuncont"o++ab+e )a"iab+es E:uation .$9 "e)ea+s that the :uantity demand o# commodity de!ends on its o*n !"ice& income +e)e+ o# the consume"s& !"ice o# its substitutes& !"ice o# com!+ements& e0!enditu"e on ad)e"tisin E commodity& and uncont"o++ab+e o" une0!+ainab+e )a"iab+es$ In this e:uation U indicates the "andom e""o" o" the in#+uence o# othe" une0!+ainab+e o" uncont"o++ab+e )a"iab+es$ It is a ene"a+ #o"m o# demand #unction because the inde!endent )a"iab+es inc+uded in the mode+ DR7S- a"e conside"ed to be in#+uencin the :uantity demand o# commodity E but it does not "e)ea+ in *hat di"ection and to *hat e0tent they .$9

<,

a"e in#+uencin $ %he abo)e ene"a+ #o"m o# #unction cou+d be !"esented in any o# the #o++o*in s!eci#ic #o"m o# #unctions$ D0 F a - b,80 O b.I O b98s - b<8c Ob=A O U O" D0 F a - 80 b, O I b.O 8s b9 - 8c b< OA b= O U .$= .$<

%he e:uation numbe" .$< and .$= a"e the +inea" and !o*e" #unction #o"ms "es!ecti)e+y #o" the )a"iab+es i)en in the e:uation numbe" .$9$ %hey a"e nothin but di##e"ent #unctiona+ #o"ms o# "e "ession e:uations$ In .$< and .$= e:uations D0& 80& I& 8s& 8c& A and U "e#e" to the same meanin as in the e:uation .$9$ In the e:uation .$< bi(s a"e the coe##icients o# the "es!ecti)e )a"iab+es and 'a( is the )a+ue o# inte"ce!t$ %he estimated coe##icient )a+ues sho* the e0tent to *hich :uantity demand chan es *ith the chan e in the )a+ues o# the "es!ecti)e )a"iab+es by one unit$ In this e:uation some coe##icients a"e ha)in the O si n *hi+e othe"s ha)in the J si n$ %he coe##icient o# the )a"iab+es *hich a"e ha)in the O si n a"e in#+uencin the :uantity demand !ositi)e+y *hi+e the coe##icient o# the )a"iab+es *hich a"e ha)in the - si n a"e in#+uencin the :uantity demand ne ati)e+y$ In the e:uation .$= a++ the symbo+s and +ette"s a"e used to indicate the same thin as in the e:uation .$<$ ;ut the on+y di##e"ence is that the estimated coe##icient )a+ues sho* the e0tent to *hich :uantity demand chan es *ith the chan e in the )a+ues o# the "es!ecti)e )a"iab+es by one per%ent$ In the "e "ession e:uations estimated coe##icients a"e o# )ita+ im!o"tance$ %hey sho* the e0tent o# "es!onsi)eness o# :uantity demand to the chan e in the )a+ue o# the )a"iab+es$ In o"de" to unde"stand the "e "ession method o# demand #o"ecastin +et us take the #o++o*in .GG<$ nume"ica+ e0am!+e$ %ab+e .$9 !"o)ides the data on e+ect"ic !o*e" consum!tion Din bi++ion 5 L-D;- and GN8 Din mi++ion Ru!ees-D$- #o" the !e"iod ,II= to

<.

%ab+e .$9$ E+ect"ic 8o*e" Consum!tion and GN8 Mea" E+ect"ic consum!tion D;G N 8 D$@ DIn ;i++ion 5 LDIn Mi++ion Rs$,II= <GB I<< ,II@ <<B II. ,IIB <BI ,GBB ,IIH =,, ,,H= ,III ==< ,9.@ .GGG === ,<9< .GG, =H@ ,=I< .GG. @,9 ,B,H .GG9 @=. ,I,H .GG< @BI .,@9 Re "ession e:uation cou+d be estimated #o" this e0am!+e in o"de" to unde"stand the e0tent to *hich the GN8 in#+uences the e+ect"icity consum!tion$ Lith the he+! o# the estimated "e "ession e:uation *e cou+d #o"ecast the demand #o" the e+ect"icity #o" any #utu"e date i)en the )a+ue o# inde!endent )a"iab+e #o" any #utu"e date$ /o" this nume"ica+ e0am!+e "e "ession e:uation o# M on E o# the #o++o*in #o"m cou+d be estimated$ M F a O bE O u .$@ In o"de" to estimate the )a+ues o# constants i$e$ a and b #o++o*in no"ma+ e:uations a"e to be so+)ed$ M F Na O b E .$B . EM F a E O b E Sum o# )a"iab+es& thei" !"oducts and s:ua"es i)en in tab+e .$< a"e substituted #o" these no"ma+ e:uations$ =<H9 F ,G a O ,<9=,b Q, Q. H,H=I== F ,<9=,a O..,G9@9I b E:uation , E ,<9=$, J E:uation . BH@H@=9$9 F ,<9=,a O .G=I=,.G$,b H,H=I== F ,<9=,a O ..,G9@9Ib D-D-D--9,B9G,$B F -,=GH=,H$Ib -9,B9G,$B bF -,=GH=,H$I FG$.,G

<9

Substitutin the )a+ue o# b to e:uation , =<H9 =<H9 F ,G a F ,G a O ,<9=, DG$.,GO 9G,9$B,

=<H9 - 9G,9$B, F ,Ga ,Ga F .<@I$.I a F .<@I$.IA,G F .<@$I.I M F .<@$I9 O G$.,GE

%ab+e .$< Sum ?a"iab+es& thei" 8"oducts and S:ua"es$ ;ear ,II= ,II@ ,IIB ,IIH ,III .GGG .GG, .GG. .GG9 .GG< Sum ; <GB <<B <BI =,, ==< === =H@ @,9 @=. @BI =<H9 $ I<< II. ,GBB ,,H= ,9.@ ,<9< ,=I< ,B,H ,I,H .,@9 ,<9=, $; 9H<.GH$G <<9<.<$G =,=HH9$G @G==9=$G B9<@G<$G BI=HBG$G I9<GH<$G ,G=9,9<$G ,.=G=9@$G ,<@H@BB$G H,H=I==$G $2 HI,,9@$G IH<G@<$G ,,=II.I$G ,<G<..=$G ,B=H.B@$G .G=@9=@$G .=<GH9@$G .I=,=.<$G 9@BHB.<$G <@BH=@I$G ..,G9@9I$G

M F .<@$I9 O G$.,E is the estimated "e "ession e:uation$ In this e:uation .<@$I9 is the )a+ue o# the inte"ce!t$ G$.,G is the "e "ession coe##icient o# E DGN8- )a"iab+e. It shows that with the increase in the &NP 3. one million ?i.e the unit ta=en in the independent aria3le@ the consumption or demand for electricit. increases 3. the C.21C 3illion D E. /o" this e0am!+e the same "esu+ts cou+d be obtained by the most *ide+y used so#t *a"e Mic"oso#t E0ce+$ %he summa"y out!ut o# the Mic"oso#t e0ce+ is i)en in the tab+e .$=$ Inte"ce!t and coe##icient )a+ues a"e a+most as same as *e obtained in the abo)e ca+cu+ation$ ;esides these )a+ues Mic"oso#t e0ce+ ene"ate the estimated )a+ue o# the R.& / )a+ue and a+so t )a+ue #o" each coe##icients$ %he estimated R . DG$I<=."e)ea+s that the inde!endent )a"iab+e DGN8- e0!+ains the I<$=. !e" cent )a"iation in the de!endent )a"iab+e$ / )a+ues a"e used to d"a* in#e"ence about the o)e"a++ si ni#icance o#

<<

the estimated "e "ession e:uation$ t )a+ues a"e used to kno* the si ni#icance o# the estimated coe##icients$ %ab+e .$= Summa"y o# Out!ut Obtained by Mic"oso#t E0ce+ /egression Statistics Mu+ti!+e R G$IB@H R S:ua"e G$I=<. Ad4usted R S:ua"e G$I<H= Standa"d E""o" .G$GG.H Obse")ations ,G ANO?A $f SS Re "ession Residua+ %ota+ , H I @@B<,$.G 9.GG$HI @II<.$,G

)S @@B<, $.GG <GG$,,.

, ,@@$HG@

-oefficient s
Inte"ce!t Coe##icient o# GN8 DEStandard !rror .<@$<<, .<$.,9 G$.,G G$G,@ t Stat ,G$,BH ,.$I,= P*value B$<<E-G@ ,$..E-G@

/o" same nume"ica+ e0am!+e "e "ession e:uation o# M on E o# the following form cou+d be estimated$ M F a Eb .$H E:uation numbe" .$@ is +inea" "e "ession e:uation *he"eas this one is !o*e" #unction$ In o"de" to estimate the )a+ues o# constants i$e$ a and b it has to be con)e"ted into +o +inea" #o"m o# the #o++o*in ty!e +nM F +na O b+nE O u %he no"ma+ e:uations to estimate the constants Di$e$ a and b- a"e as #o++o*s: +nM F N+na O b +nE .$I +nE+nM F +na +nE O b D+nE-. Sum o# )a"iab+es& thei" !"oducts and s:ua"es i)en in tab+e .$@ a"e substituted #o" these no"ma+ e:uations$

<=

@.$I<BI F ,G$GGGG+n a O B.$9.H@ b <==$BG@, FB.$9.H@+n a O=.9$H@9, b E:uation , E B$.9.H@ J E:uation . *e et <==$.I99 F B.$9.H@+n a O =.9$,<.@ b <==$BG@, F B.$9.H@+n a O =.9$H@9, b D-D-D--G$<,.H F -G$B.G=b -G$<,.H bF -G$B.G= Substitutin the )a+ue o# b to e:uation , @.$I<BI @.$I<BI F ,G +n a F ,G +n a O B.$9.H@ DG$=B.IO <,$<9BG= F G$=B.I

Q, Q.

@.$I<BI J <,$<9BG= F ,G +n a ,G +n a F .,$=,GH= +na F .,$=,GH=A,G F .$,=,GH= M F .$,=, R EG$=B9 O" +nM F +n.$,=, O G$=B9 +n E

%ab+e .$@ Sum o# ?a"iab+es& thei" 8"oducts and S:ua"es$ ;ear ,II= ,II@ ,IIB ,IIH ,III .GGG .GG, .GG. .GG9 .GG< Sum ; <GB <<B <BI =,, ==< === =H@ @,9 @=. @BI =<H9 $ I<< II. ,GBB ,,H= ,9.@ ,<9< ,=I< ,B,H ,I,H .,@9 ,<9=, ln;
6.0088 6.1026 6.1717 6.2364 6.3172 6.3190 6.3733 6.4184 6.4800 6.5206 62.9479

ln$
6.8501 6.8997 6.9819 7.0775 7.1899 7.2682 7.3740 7.4489 7.5590 7.6793 72.3286

ln$ln;
41.1611 42.1060 43.0904 44.1379 45.4199 45.9277 46.9969 47.8099 48.9829 50.0735 455.7061

?ln$@2
46.9242 47.6062 48.7474 50.0910 51.6950 52.8271 54.3759 55.4864 57.1391 58.9709 523.8631

<@

In this e:uation +n.$,=, is the )a+ue o# the inte"ce!t$ G$=B9 is the "e "ession coe##icient o# E DGN8- )a"iab+e. It shows that with the increase in the &NP 3. one percent the consumption or demand for electricit. increases 3. the C.'2" per cent. /o" this e0am!+e the same "esu+ts cou+d be obtained by the most *ide+y used so#t *ea" Mic"oso#t E0ce+$ %he summa"y out!ut o# the Mic"oso#t e0ce+ is i)en in the tab+e .$B$ %ab+e .$B:SUMMARM OU%8U% O;%AINED ;M MICROSO/% EECEL /egression Statistics Mu+ti!+e R G$IH,@ R S:ua"e G$I@9= Ad4usted R S:ua"e G$I=IG Standa"d E""o" G$G99< Obse")ations ,G ANO?A df SS )S Re "ession , G$.9@. G$.9@. Residua+ H G$GGHI G$GG,, %ota+ I G$.<=, 'oefficients Standard !rror .$,=,H G$.H=, G$=B.H G$G9I< t Stat B$=<@= ,<$=9I<

, .,,$9I9,

Inte"ce!t D+naCoe##icient o# GN8 Db-

P*value G$GGGG@@9 G$GGGGGG=

In the abo)e e0am!+e *e conside" on+y one inde!endent )a"iab+e mode+$ In !"actice& :uantity demand o# any commodity *i++ not be in#+uenced by on+y one )a"iab+e$ It may be in#+uenced by se)e"a+ )a"iab+es$ In the "e "ession mode+ *e cou+d use t*o o" mo"e than t*o inde!endent )a"iab+es$ I# *e use t*o o" mo"e inde!endent )a"iab+es in the "e "ession mode+s such "e "ession mode+ is te"med as mu+ti!+e "e "ession mode+$ In case o# the mu+ti!+e "e "ession manua+ estimation o# the coe##icients is tedious 4ob$ No*adays )a"ious com!ute" so#t*a"es a"e a)ai+ab+e to estimate the coe##icients in case o# mu+ti!+e "e "ession mode+s$ %he abo)e e0am!+e has been e0tended to t*o inde!endent )a"iab+e mode+ by inco"!o"atin one mo"e inde!endent )a"iab+e i$e$ !"ice o# the e+ect"icity$ %ab+e .$H !"o)ides the data on e+ect"ic !o*e" consum!tion Din bi++ion 5 L-D;- and GN8 Din mi++ion Ru!ees-D$1- and !"ice o# the e+ect"icity Din Rs$ 8e" unit- D$2@ #o" the !e"iod ,II= to .GG<$ /o" this nume"ica+ i++ust"ation income e+asticity and !"ice e+asticity o# demand #o" e+ect"icity cou+d be estimated th"ou h the #o++o*in #o"m o# e:uation$ <B

M F a E, b, E. b.

.$,G

In this e:uation a "e!"esent the inte"ce!t )a+ue& b, and b. sho*s the "e "ession coe##icients o# income and !"ice on e+ect"ic consum!tion& *hich a"e same as income and !"ice e+asticity o# demand #o" e+ect"icity$ %he )a+ue o# these constants has been estimated by usin the Mic"oso#t e0ce+$ %he summa"y o# out!ut is i)en in tab+e .$I$ %ab+e .$H: Consum!tion& GN8 and 8"ice o# E+ect"ic 8o*e"$ Mea" E+ect"ic G N 8 DE,8"ice o# consum!tion D;- DIn Mi++ion Rs$- E+ect"icity DE.DIn bi++ion 5 LDRs$AUnit,II= ,II@ ,IIB ,IIH ,III .GGG .GG, .GG. .GG9 .GG< <GB <<B <BI =,, ==< === =H@ @,9 @=. @BI I<< II. ,GBB ,,H= ,9.@ ,<9< ,=I< ,B,H ,I,H .,@9
2.09 2.10 2.19 2.29 2.38 2.83 3.21 3.45 3.78 4.03

%ab+e .$I: SUMMARM OU%8U% O;%AINED ;M MICROSO/% EECEL /egression Statistics Mu+ti!+e R G$II.< R S:ua"e G$IH<I Ad4usted R S:ua"e G$IHG@ Standa"d E""o" G$G.9G Obse")ations ,G ANO?A $f SS )S , Re "ession . G$.<,< G$,.GB ..H$@<HH Residua+ B G$GG9B G$GGG= %ota+ I G$.<=, 'oefficients Standard !rror t Stat P*value -G$<I@ G$H@.H -G$=B<H G$=H9< ,$GGH G$,<GH B$,@G9 G$GGG. -G$<I= G$,=B. -9$,=,. G$G,@,

Inte"ce!t Coe##icient o# G N 8 D$1@ Coe##icient o# 8"ice o# E+ect"icity DE.-

M F -G$<I@ E, ,$GGH E. JG$<I= <H

In the summe"y o# the "e "ession out!ut the income e+asticity o# demand #o" e+ect"icity *as *o"ked out to be ,$GGH& *hich means #o" e)e"y one !e" cent inc"ease in GN8 the"e *i++ be ,$GGH !e" cent inc"ease in the demand #o" e+ect"ic !o*e"$ Simi+a"+y !"ice e+asticity o# demand #o" e+ect"icity *as *o"ked out to be -G$<I= *hich means #o" e)e"y one !e"cent inc"ease in the !"ice o# e+ect"ic !o*e" the"e *i++ be #a++ in the e+ect"ic !o*e" consum!tion o" demand by G$<I= !e" cent$ %he !"inci!+e ad)anta e o# this method is that the )a"iation in demand is e0!+ained th"ou h the )a"iation in its casua+ )a"iab+es$ Demand has )a"ied by a ce"tain amount o" !e"centa e because its dete"minin )a"iab+es ha)e )a"ied by ce"tain amount o" !e"centa e$ %his is indicated by the "e "ession e:uation itse+#$ Any socia+ scientist !ossessin su##icient kno*+ed e o# economic theo"y and economet"ic methods can use this method #o" #o"ecastin !u"!ose$ %he ma4o" +imitation o# this method is that it "e:ui"es the use o# some othe" #o"ecastin method to estimate the )a+ue o# the e0!+anato"y )a"iab+es in the !"ediction !e"iod$ %he e0tent o# "e+iabi+ity o# the "esu+ts de!ends on the e0tent o# the "e+iabi+ity o# the estimated #utu"e )a+ues o# e0!+anato"y )a"iab+es$ ii$ +eading Indicator )ethod: %he !"e)ious section dea+t *ith the "e+ationshi! bet*een the t*o o" mo"e coincident se"ies& *hich enab+es us to #o"ecast the demand$ Coincident )a"iab+es a"e those the )a+ues o# *hich )a"y a+on *ith some othe" )a"iab+es$ /o" e0am!+e i# E and M a"e c+ose substitutes& inc"ease in the !"ice o# E +eads to inc"ease in the demand #o" M on the day itse+#$ %he"e a"e some )a"iab+es the )a+ues o# *hich mo)e u! o" do*n ahead o# some othe" )a"iab+e and such )a"iab+es a"e ca++ed +eadin )a"iab+es o" se"ies$ A "icu+tu"a+ income Dha")est- in the yea" in#+uences the demand #o" a "icu+tu"a+ in!uts in the subse:uent yea"$ 7e"e a "icu+tu"a+ income is a +eadin indicato" because it indicates the #act that the"e *i++ be mo"e demand #o" a "icu+tu"a+ in!ut in the subse:uent yea"$ Demand #o" a "icu+tu"a+ in!ut& in this e0am!+e& is +a in )a"iab+e because its )a+ue mo)es u! o" do*n behind the )a+ue o# a "icu+tu"a+ income$ %his "e+ationshi! cou+d be e0!"essed in the #o++o*in *ay: Mt F a O bEt-, Lhe"e& Mt F >uantity demand o# #o"ecastin )a"iab+e in time t .$,,

<I

Et-,

F ?a+ue o# e0!+anato"y )a"iab+e in time t-,

a N b "e!"esent the inte"ce!t and coe##icient o# inde!endent )a"iab+es "es!ecti)e+y %he )a+ue o# inte"ce!t and coe##icient )a+ue cou+d be estimated by usin the method discussed in the !"e)ious section$ ;ut on+y di##e"ence is that the )a+ue o# e0!+anato"y )a"iab+e !e"tains to time !e"iod t-,$ I# the ca+cu+ated )a+ue o# 'b( is G$B= it im!+ies that e)e"y one-unit inc"ease in the )a+ue o# inde!endent )a"iab+e in this yea" +eads to inc"ease in the :uantity demand by G$B= unit$ %he main ad)anta e o# this method is that !"esent !e"iod )a+ue o# e0!+anato"y )a"iab+e cou+d be used to !"edict the demand #o" D+a in )a"iab+e- commodity in the ne0t !e"iod& may be ne0t month o" yea" o" decade$ %he ma4o" +imitation o# this method is that it is not !ossib+e to #ind +eadin indicato" #o" )a"iab+e unde" #o"ecast$ iii. Trend )ethod: %ime se"ies ana+ysis o" the t"end method is one o# the most #"e:uent+y used methods o# demand #o"ecastin $ %ime se"ies data "e#e"s to the )a+ues o# a )a"iab+e a""an ed ch"ono+o ica++y by days& *eeks& months o" yea"s$ %ime se"ies ana+ysis attem!ts to #o"ecast #utu"e )a+ues o# time se"ies by e0aminin the !ast obse")ation o# the data on+y$ %his method is main+y based on the assum!tion that the time se"ies *i++ continue to mo)e as in the !ast$ /o" this "eason this method is a+so ca++ed naS)e #o"ecastin $ %ime se"ies data can be !"esented eithe" in the tabu+a" #o"m o" "a!hica+ #o"m$ %he #o++o*in tab+e& #o" e0am!+e& sho*s the sa+es o# the te+e)ision sets o# E com!any Din thousand units-$ %ab+e.$,G Sa+es o# % ? sets 8e"tains to E Com!any
Mea" Sa+es o# %$ ?$ Din thousand,IIH HG ,III IG .GGG I. .GG, H9 .GG. I< .GG9 II .GG< I.

%he data sho*n in the tab+e .$,G !"esented th"ou h the "a!h .$I$ It is e)ident #"om the "a!h that the sa+e o# the % ? sets o# the abo)e #i"m has been #+uctuatin o)e" the yea"s$ In spite of such fluctuation there is a general increasing trend $ %ime se"ies #+uctuation can be e0!+ained th"ou h the di##e"ent com!onents$ -omponents of time series =G

Seasonal Variation: Chan es that ha)e taken !+ace du"in a !e"iod o# one yea" as a "esu+t o# chan es in season i$e$ chan e in the c+imate& *eathe" condition& #esti)a+ etc$

'yclical Variation: It "e#e"s to "ecu""ent u! and do*n mo)ements o# business acti)ities a"ound some so"t o# statistica+ t"end +e)e+ o" no"ma+ business conditions$

Irregular variation: Chan es that ha)e taken !+ace as a "esu+t o# such #o"ces that cou+d not be !"edicted +ike #+oods& ea"th:uake etc$ they a"e a+so ca++ed e""atic )a"iations

Secu+a" t"end: Chan es that ha)e occu""ed as a "esu+t o# ene"a+ tendency o# data to inc"ease o" dec"ease is kno*n as secu+a" t"end$

Chan es that ha)e taken !+ace du"in a !e"iod o# one yea" as a "esu+t o# chan es in season i$e$ chan e in the c+imate& *eathe" condition& #esti)a+ etc$

,ig. 2.7 Sales of / F sets Pertains to $ -ompan.

120 100
Sales in thousand

80 60 40 20 0 1 2 3 4 Time in Years 5 6 7

%he most im!o"tant as!ect o# time se"ies ana+ysis is the !"o4ection o# t"end o# the time se"ies$ A t"end +ine can be #itted th"ou h se"ies eithe" )isua++y i$e$ #"eehand method =,

based on the !e"sona+ 4ud ment o" by means o# statistica+ techni:ue$ %he most !o!u+a" statistica+ method that is used in the time se"ies ana+ysis is +east s:ua"e method$ %he st"ai ht +ine cou+d be "e!"esented by the #o++o*in e:uation Mt F a O bt .$,. 7e"e& Mt and t a"e the )a"iab+es "e!"esent the )a+ue o# the time se"ies to be #o"ecasted #o" !e"iod t& and the time !e"iod "es!ecti)e+y$ & a is the inte"ce!t and b is the coe##icient o# the t"end e:uation *hich sho*s the abso+ute amount o# "o*th !e" !e"iod$ %"end e:uation cou+d be estimated as #o++o*s #o" the e0am!+e i)en in the tab+e .$,G$ %he t"end e:uation o# the #o"m .$,. cou+d be estimated to the e0am!+e i)en in the tab+e .$,G by so+)in the #o++o*in no"ma+ e:uation$ Mt F Na O b t tMt F a t O b t. /o" #ittin the st"ai ht-+ine t"end by the +east s:ua"e method *e must s!eci#y the yea"& *hich is taken as the o"i in$ Le can measu"e t by takin eithe" #i"st yea" o" the mid !oint in the time !e"iod as the o"i in$ 7e"e the t"end e:uation has been estimated by takin the #i"st yea" as the o"i in$ %ab+e .$,, Sum o# ?a"iab+es& thei" 8"oducts and S:ua"es Mea" ,IIH ,III .GGG .GG, .GG. .GG9 .GG< Sum Mt DGGGsHG IG I. H9 I< II I. +"C % DMea" J ,IIHG , . 9 < = @ 21 t Mt G IG ,H< .<I 9B@ <I= ==. 17#+ t. G , < I ,@ .= 9@ 71 .$,9

Substitute the )a+ues to the no"ma+ e:uation .$,9 @9G F Ba O.,b Q, ,I<@ F .,a O I,b Q. E:uation , D -9- J E:uation . -,HIG F -.,a - @9b ,I<@ F .,a O I,b =.

=@ =@ bF .H

F F.

.Hb

Substitutin the )a+ue o# b to e:uation , @9G F B a O ., Db@9G F B a O ., D.@9G F B a O <. @9G - <. F B a =HH F B a a F =HHAB F H< M F H< O .Dt%he t"end e:uation "e)ea+s that #o" e)e"y one yea" the"e *i++ be inc"ease in the sa+es o# % ? sets o# the E Com!any by .GGG units$ Usin #o"ecasted #o" any #utu"e !e"iod$ It is a )e"y !o!u+a" method o# demand #o"ecastin not on+y because o# its this coe##icient demand cou+d be

sim!+icity but a+so because it yie+ds ood "esu+ts$ /u"the"& most o# the time se"ies data #o++o* a !a"ticu+a" t"end in the +on "un$ ;esides it is "e+ati)e+y easy to #o"ecast the demand th"ou h this method& as it does not "e:ui"e the kno*+ed e o# economic theo"y and the ma"ket$ It needs on+y time se"ies data on the )a"iab+e *hose #utu"e )a+ue is to be #o"ecasted$ %his method is based on the assum!tion that the !ast "ate o# chan e o# the )a"iab+e unde" conside"ation *i++ continue in the #utu"e a+so *hich is a ma4o" +imitation o# this method$ Its assum!tion that the t"end e:uation obtained by the best #it on the !ast data ho+ds ood in the !"ediction !e"iod is not a+*ays a!!"o!"iate$ In the +on "un& it may be ood assum!tion but su"e+y sho"t "un #+uctuations in most time se"ies do not *a""ant this method$ %he"e#o"e& this method :uite o#ten #ound a!!"o!"iate #o" the +on !"ediction not #o" the sho"t "un$ 2.2.' Demand ,orecasting for New Products "un

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As *e ha)e discussed in the !"e)ious section& the"e a"e many di##e"ent demand#o"ecastin methods$ Le can make use o# any o# these methods *hi+e #o"ecastin the demand #o" e0istin !"oduct$ Demand #o"ecastin is )e"y di##icu+t #o" ne* !"oducts ested some o# !ossib+e a!!"oaches to because #o"ecaste" cou+d not et !"e)ious data$ No !"e)ious e0!e"ience on the sa+es o# such !"oduct etc$ In this "e a"d Koe+ Dean has su #o"ecast demand #o" ne* !"oducts$ 8"o4ect the demand #o" ne* !"oduct as an out "o*th o# an e0istin o+d !"oduct$ It means *hen a !"oduct is e)o+)ed #"om the o+d one& the demand condition o# the o+d !"oduct shou+d be taken into account *hi+e assessin demand #o" a ne* !"oduct De)o+utiona"y a!!"oach-$ Ana+y3e the ne* !"oduct as a substitute #o" same e0istin !"oduct$ 7o* #o" a ne* !"oduct se")es the !u"!ose as substitute to an e0istin !"oduct6 I# ne* !"oduct is c+ose substitute #o" e0istin !"oduct$ Demand #o" ne* !"oduct can be #o"ecasted based on the !"e)ious e0!e"ience o# sa+es t"ends o# a+"eady e0istin substitute !"oducts Dsubstitute and "o*th Estimate the demand by makin su")ey method$ O##e" the ne* !"oduct #o" sa+e in a sam!+e ma"ket$ %ota+ demand is !"edicted on the basis o# sa+e in the sam!+e ma"ket i$e$ Sa+es e0!e"ience a!!"oach$ Su")ey o# consume"(s "eaction to a ne* !"edict indi"ect+y th"ou h the eyes o# s!ecia+i3ed dea+e"s *ho a"e su!!osed to be a*a"e o# consume"s( need and a+te"nati)e o!!o"tunity i$e$ o!inion su")ey method$ 2.2.+ -riteria of a &ood ,orecasting Method di"ect en:ui"y #"om the u+timate

!u"chase"s& eithe" by the use o# sam!+es o" on a #u++ sca+e i$e$ Consume"s

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Di##e"ent methods o# demand #o"ecastin

sho*s conside"ab+e di##e"ence *ith

"es!ect to !"ocedu"e o# #o"ecastin & cost& +e)e+ o# accu"acy& etc$ %he"e#o"e& it is di##icu+t to choose a best method #o" a !a"ticu+a" situation$ %he"e a"e ce"tain c"ite"ia *hich cou+d be used to 4ud e the suitab+e o" not o# a !a"ticu+a" method o# Demand /o"ecastin $ Such c"ite"ia a"e: #ccuracy: %he accu"acy o# the #o"ecast is measu"ed by the de "ee o# de)iation bet*een #o"ecasted and actua+ )a+ues o# a !a"amete"$ Lesse" the de)iation bet*een these t*o accu"ate is the demand #o"ecast )ice-)e"sa$ It is necessa"y to check the accu"acy o# !ast #o"ecast a ainst !"esent !e"#o"mance and o# !"esent #o"ecast a ainst #utu"e !e"#o"mance$ Simplicity: It shou+d be sim!+e to unde"stand$ Mana ement must be ab+e to unde"stand and ha)e con#idence in the techni:ues used$ C+ea" unde"standin is necessa"y #o" !"o!e" inte"!"etation o# the "esu+ts$ !conomy: Cost must be com!a"ed *ith the im!o"tance o# the #o"ecast to the o!e"ation o# the business$ Cost must be +ess than the im!o"tance o# the #o"ecast to the #i"m$ It is not desi"ab+e to ha)e a #o"ecast in *hich cost is "eate" than the im!o"tance o# #o"ecast to the #i"m$ #vailability: %he techni:ues em!+oyed shou+d be ab+e to !"oduce meanin #u+ "esu+ts :uick+y$ %echni:ues& *hich take +on time to *o"k out& may !"oduce use#u+ in#o"mation$ ;ut it may be too +ate #o" mana ement decisions hence it is o# use+ess in#o"mation$ ,le"ibility& %he techni:ues used #o" #o"ecastin must be ab+e to

accommodate and abso"b #"e:uent chan es acc"uin in the economy$ %he method o# demand #o"ecastin *hich !oses the abo)e :ua+ities *i++ ha)e "eate" use#u+ness$ It is di##icu+t to !oint out the method& *hich !oses a++ the :ua+ities$ 7o*e)e"& demand #o"ecastin #unctiona"ies !"e#e" such method o# demand #o"ecastin *hich !oses mo"e numbe" o# these :ua+ities$

==

2.6. Self Re iew 8uestions

,$ De#ine the conce!t o# demand$ .$ Distin uish indi)idua+ demand and ma"ket demand 9$ Distin uish e0tension and cont"action o# demand <$ Lhat is de"i)ed demand6 Gi)e an e0am!+e =$ Lhat is demand #unction6 @$ Lhat is !"ice e+asticity o# demand6 B$ De#ine c"oss e+asticity o# demand$ H$ Lhat is demand #o"ecastin 6 I$ E0!+ain the +a* o# demand ,G$ Discuss the di##e"ent ty!es o# Demand ,,$ Desc"ibe the dete"minants o# demand ,.$ E0!+ain the #acto"s in#+uencin !"ice e+asticity o# demand$ ,9$ C"itica++y e0amine the use#u+ness o# Demand #o"ecastin ,<$ Discuss the di##e"ent methods o# demand #o"ecastin ,=$ E0!+ain ho* do you #o"ecast the demand #o" ne* !"oducts ,@$ Desc"ibe the c"ite"ia o# a ood #o"ecastin method ,B /o++o*in tab+e i)es the data on the sa+es +e)e+ o# E commodity at di##e"ent !"ice +e)e+$ Gi)en these data estimate the !"ice e+asticity o# demand #o" E commodity& assumin othe" thin s "emainin same$ 8"ice o# E Commodity ,G$G ,G$= ,,$G ,.$G ,9$G >uantity o# E Commodity So+d in the Ma"ket .G .. .= .H 9,

.$I$ Re#e"encesA Su

ested Readin s

,$ ?a"shney RL& and Mahesh*a"i 5$L: 1Mana e"ia+ Economics2& Su+tan Chand N Sons& Ne* De+hi-,,GGG.

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.$ Mote& ?$ L$& Samue+ 8au+& Gu!ta&G$ S: 1 Mana e"ia+ Economics: Conce!ts and Cases2& %ata McG"a*-7i++ 8ub+ishin Com!any Limited& Ne* De+hi 9$ D$M$Mithani : 1Mana e"ia+ Economics: %heo"y and A!!+ications2& 7ima+aya 8ub+ishin 7ouse& Mumbai-<GG GG< <$ Dominick Sa+)ato"e: 1Mana e"ia+ Economics2& McG"a*-7i++ Inte"nationa+ Editions& Sin a!o"e = Ahu4a& 7$ L$: 1Ad)anced Economic %heo"y2& S$Chand N Com!any Ltd$ Ne* De+hi,,G G== @$ Khin an& M$L$: 1Ad)anced Economic %heo"y2& ?"inda 8ub+ications D8- L%D&De+hi-,,G GI,

M(D9:E III) PR(D9-/I(N *ND -(S/ *N*:;SIS

8"o#it ma0imi3ation is one o# the main ob4ecti)es o# a++ ty!es o# business #i"ms$ 8"o#it F %ota+ Re)enue-%ota+ Cost$ In o"de" to ma0imi3e the !"o#it& #i"m t"ies to inc"ease

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its "e)enue and +o*e" its costs$ %o*a"ds this end& they t"y to !"oduce o!timum +e)e+ o# out!ut and a+so to use the +east cost combination o# in!uts$ %hese as!ects a"e studied in !"oduction Dtheo"ies- ana+ysis$ Demand and su!!+y a"e t*o sides o# the ma"ket& *hich dete"mines the !"ice o# the commodities$ In the +ast cha!te" *e ha)e discussed about the demand side o# the ma"ket$ 8"oduction and cost ana+ysis Dthis Cha!te"- conce"ned *ith su!!+y side o# the ma"ket$ 8"oduction ana+ysis is done in !hysica+ te"ms *hi+e cost ana+ysis is discussed in moneta"y te"ms$ 8"oduction ana+ysis "e+ates !hysica+ out!ut to !hysica+ in!uts in the !"oduction and studies the +east cost combination o# #acto" in!uts& #acto" !"oducti)ity and "etu"ns to sca+e$ Cost ana+ysis dea+s *ith )a"ious ty!es o# costs and thei" "o+e in decision-makin & dete"minants o# costs etc$

".1 Production ,unction)

A !"oduction #unction e0!"esses the techno+o ica+ Do" en inee"in - "e+ationshi! bet*een the out!ut o# a commodity and its in!uts$ In othe" *o"ds it can be de#ined as& a technica+& mathematica+ "e+ationshi! that te++s the ma0imum amount o# out!ut that can be !"oduced *ith a i)en set o# in!uts& i)en the cu""ent state o# technica+ kno*+ed e symbo+ica++y it can be denoted as #o++o*s$ MF# DE,& E.& E9Lhe"e& M F >uantity o# out!ut o# a commodity$ E, F Land used in the !"oduction o# commodity E. F Labou" used in the !"oduction o# commodity E9 F Ca!ita+ used in the !"oduction o# commodity It is the ene"a+ #o"m o# !"oduction #unction$ >uantity o# out!ut o# a commodity !"oduced de!ends on the :uantity use o# +and& +abou" and ca!ita+$ ;ut it does not te++ the manne" and e0tent to *hich out!ut chan es due to chan e in in!ut use +e)e+$ %o kno* the di"ection and e0tent to *hich out!ut chan es due to chan e in in!ut use +e)e+ *e must

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estimate the s!eci#ic #o"m o# !"oduction #unction i$e$ s!eci#ic statistica+ !"oduction #unction$ ".1.1 Statistical Production ,unction Statistica+ !"oduction #unction can be estimated by statistica+ techni:ues o" economet"ic methods usin eithe" c"oss sectiona+ data o" time se"ies data on in!uts and out!ut$ %he"e a"e many di##e"ent #o"ms o# !"oduction #unction$ Cob Dou +as !"oduction #unction is most *ide+y a!!+icab+e #o"m o# !"oduction #unction$ MF5LT C U Lhe"e& M F >uantity o# out!ut !"oduced L F >uantity o# +abou" em!+oyed C F >uantity o# ca!ita+ em!+oyed 5& T& and U F a"e constants Cob-Dou +as a"e !ionee"s in estimatin a !"oduction #unction o# this #o"m #o" Ame"ican manu#actu"in indust"y usin annua+ time se"ies data #o" the !e"iod ,HII J ,I..$ %hei" estimated statistica+ !"oduction #unction *asC M F ,$G, LG$B= CG$.= In the +o a"ithmic #o"m it can be *"itten as: +o MF +o ,$G, O G$B= +o L O G$.= +o C In this !"oduction #unction G$B= is !"oduction e+asticity o# +abou"$ It sho*s e)e"y , !e" cent inc"ease in +abou" +eads to G$B=V inc"ease in !"oduction$ Simi+a"+y G$.= is !"oduction e+asticity o# ca!ita+$ In this !"oduction #unction sum o# !"oduction e+asticities is DG$B= O G$.=F,-$ It means& , !e" cent simu+taneous inc"ease in both in!uts +eads to ,!e" cent inc"ease in !"oduction$ It sho*s that Cob J Dou +as !"oduction #unction assumes constant "etu"ns to sca+e$ Lith this ty!e o# !"oduction #unction tota+ out!ut can be estimated #o" any i)en )a+ue o# L and C$ /o" e0am!+e& i# unit o# +abou" in!ut used is ,GGG units and units o# ca!ita+ in!ut used is .GGG units then& out!ut !"oduction *i++ be: +o M F ,$G, O G$B= +o ,GGG O G$.= +o .GGG F ,$G, O .$.= O G$H.=9 +o M F <$GH=9

=I

M F Anti+o <$GH=9 M F ,.,BG I# in!ut use +e)e+ inc"eased by ,GV i$e +abou" in!ut inc"eased #"om ,GGG units to ,,GG units and ca!ita+ in!ut inc"eased #o"m .GGG units ..GG units then the "esu+tin out!ut chan e is as #o++o*s$ +o M F,$G, O G$B= +o ,,GG O G$.= +o ..GG F,$G, O .$.H,G< O G$H9=@, +o M F <$,.@@= M F Anti+o <$,.@@= M F ,99H@ Due to inc"ease in in!ut use +e)e+ by ,G !e" cent out!ut has inc"eased #"om ,.,BG to ,99H= i$e a!!"o0imate+y by ,G !e" cent inc"ease in out!ut$ It sho*s that Cab Dou +as !"oduction #unction assumes constant "etu"ns to sca+e$ So !"oduction #unction is techno+o ica+ "e+ationshi! desc"ibin the manne" and e0tent to *hich a !a"ticu+a" !"oduct "es!onds to chan e in :uantity o# in!ut& at the i)en +e)e+ o# techno+o y$ Lhi+e estimatin the e##ect o# in!ut use on the !"oduction +e)e+ *e assume that techno+o y "emains constant$ ;ut in !"actice techno+o ica+ chan es a+so in#+uences the !"oduction "o*th& #o" e0am!+e im!"o)ement in seeds techno+o y b"ou ht about conside"ab+e "o*th in c"o! yie+d$ Statistica+ !"oduction #unction c+ea"+y "e)ea+ed the #act that the !"oduction #unction is the techno+o ica+ "e+ationshi! e0!+ainin in!uts& in the i)en state o# technica+ kno*+ed e$ 8"oduce"s ha)e to #ace )a"ious !"oduction decision !"ob+ems$ 8"oduction #unction is use#u+ in such !"oduction decision-makin !"ocess$ 8"oduce" has to decide *hat is the most !"o#itab+e amount o# "esou"ce to use in the !"oduction o# a commodity$ ;ecause *ith the chan e in the in!ut use +e)e+ #acto" !"oducti)ity oes on chan in $ %his *i++ be discussed in the #acto" !"oduct- "e+ationshi! o" +a*s o# !"oduction$ the ma0imum amount o# out!ut ca!ab+e o# bein !"oduced by each and e)e"y set o# s!eci#ied

@G

?a"ious combinations o# t*o o" mo"e in!uts can !"oduce a !a"ticu+a" out!ut +e)e+ o# a !"oduct$ 7ence& !"oduce" has to decide the +east cost combination o# in!uts to !"oduce a s!eci#ic amount o# a i)en commodity$ %his *e sha++ discuss in the 1+east cost combinations o# in!uts2$

7a)in

ce"tain amount o# "esou"ces a !"oduce" can !"oduce )a"ious

combinations o# out!ut o# di##e"ent commodities$ So he has to choose the most !"o#itab+e !"oduct mi0 to !"oduce in o"de" to ma0imi3e his !"o#it$ %he ne0t section dea+s *ith the in!ut-out!ut "e+ation Di$e$ +a*s o# !"oduction-$ 8"oduction ana+ysis Do" theo"y o# !"oduction- conside"s t*o ty!es "e+ationshi!s )i3$ Sho"t-"un "e+ationshi!s and +on -"un "e+ationshi!s$ Short1run is +on enou h to a+te" the )a"iab+e but not the #i0ed "esou"ces #o" !"oduction$ In this time !e"iod ce"tain in!uts a"e #i0ed and othe"s a"e )a"iab+e$ It is ca++ed +a*s o# "etu"ns$ :ong run is +on enou h to a+te" both the )a"iab+e and the #i0ed "esou"ces #o" !"oductionC but cannot a+te" the techno+o y$ In this time !e"iod a++ in!uts a"e )a"iab+e the"e *i++ be no #i0ed in!uts$ It is ca++ed +a*s o# "etu"ns to sca+e$

".2 :aw of Returns

It is the in!ut-out!ut "e+ationshi! *hen one #acto" o# !"oduction Din!ut- is )a"iab+e *hi+e othe"s a"e ke!t constant$ I# *e o on inc"ease the use o# )a"iab+e in!ut *hi+e kee!in the othe" #acto"s o# !"oduction constant& the !"o!o"tion bet*een )a"iab+e in!ut and #i0ed in!ut oes on chan in and a+so the )a"iab+e #acto" !"oducti)ity oes on chan in $ %he"e#o"e& It is a+so ca++ed the +a* o# )a"iab+e !"o!o"tion$ Since it dea+s *ith in!ut-out!ut "e+ationshi! in the sho"t "un it is a+so kno*n as #acto"-!"oduct "e+ationshi! in the sho"t "un$ %his theo"y states that in the be innin )a"iab+e #acto" !"oducti)ity oes on inc"easin a#te" a ce"tain !oint o# )a"iab+e in!ut use +e)e+ its !"oducti)ity sta"ts diminishin $ 8"oduction and !"oducti)ity o# an in!ut can be e0!"essed th"ou h the #o++o*in measu"es$

@,

Total Physical Productivity 0TPP-: %88 o# a #acto" is the tota+ !"oduction a !"oduce" can obtain by em!+oyin di##e"ent amount o# that #acto"& kee!in a++ othe" #acto"s constant$

#verage Physical Productivity 0#PP-: A88 o# a #acto" is the tota+ !hysica+ !"oduct di)ided by the :uantity o# that #acto"& *ith a++ othe" #acto"s he+d constant

)arginal Physical Productivity 0)PP-: M88 o# a #acto" is the e0t"a !hysica+ !"oduct !"oduce" obtains by addin an e0t"a unit o# that #acto"& *ith a++ othe" #acto"s constant$ In othe" *o"ds it is an addition made to tota+ !hysica+ !"oducti)ity by usin an additiona+ unit o# in!ut$

%he in!ut out!ut "e+ation sho*in tota+& a)e"a e& and ma" ina+ !"oducti)ity& *hen one in!ut is )a"iab+e& say #o" e0am!+e +abou"& *hi+e othe"s a"e constant can be di)idend into th"ee sta es in such a *ay that one can +ocate the "ationa+ sta e o# !"oduction in o"de" to ensu"e the "esou"ce use e##iciency D/i u"e 9$,-$ In #i u"e 9$, %8L& A8L and M8L sho*s the %ota+& a)e"a e and ma" ina+ !hysica+ !"oduct o# )a"iab+e in!ut i$e$ +abou"$ ,irst Stage: DO to L, %he #i"st sta e e0tends #"om the !oint o# o"i in to !oint o# ma0imum a)e"a e !"oduct$ At this !oint A8L FM8L$ DA8L FM8L *hen A8L ma0imumM8L ma0imum at !oint 'M($ %he co""es!ondin !oint on %8L is ca++ed !oint o# in#+ection$ In#+ection !oint indicates the chan e in "ate o# inc"ease in %8L$ U! to this !oint %8L inc"ease at inc"easin "ate beyond this !oint at dec"easin "ate$ E+asticity o# !"oduction is mo"e than unity in the I sta e !"oduction DE!W,-$ A8L inc"eases th"ou hout this sta e& indicatin the inc"easin e##iciency o# )a"iab+e in!uts on the !"oducti)ity *ith the inc"easin use o# the )a"iab+e in!ut$ Second Stage) DL, to L9 %his sta e "an es #"om the !oint o# ma0imum a)e"a e !"oduct to the !oint o# ma0imum %8L o" the !oint o# 3e"o M8L$

@.

In this sta e %8L inc"eases at dec"easin "ate In the be innin o# this sta e i$e$ *hen A88FM8L& E8 F,& at the end o# this sta e i$e$ *hen %8L is ma0imum o" M8L is 3e"o E8 F G& bet*een these t*o !oints E! *i++ be +ess than one but "eate" than 3e"o$

/i u"e 9$,: %ota+& A)e"a e and Ma" ina+ 8"oduct o# ?a"iab+e In!ut DLabou"-

/hird Stage)D;eyond L9 %his sta e e0tends #"om the !oint o# 3e"o M8L to o)e" the enti"e "an e o# dec+inin %8L$ M8L c"osses 3e"o !oint and become ne ati)e$ E! is +ess than 3e"o$

I and II sta e a"e conside"ed as i""ationa+ sta e o# !"oduction& In I sta e& the a)e"a e !"oducti)ity o# )a"iab+e in!ut inc"easin continuous+y indicatin the inc"ease in

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its e##iciency *ith the use o# additiona+ unit o# this in!ut$ It is not "easonab+e to sto! usin an additiona+ unit o# an in!ut *hen its e##iciency on a++ units used is inc"easin $ 7ence i# a !"oduce" is inte"ested in ma0imi3in his !"o#it it is ad)isab+e to use the )a"iab+e in!ut at +east to the !oint o# hi hest A8L$ In the III sta e o# !"oduction #unction& the tota+ !"oduct D%8L- is dec+inin and M8L is ne ati)e$ 7ence& it is not !"o#itab+e 3one$ 8"oduce"s o!e"atin in this 3one *i++ incu" doub+e +osses$ One is dec+inin !"oduction and anothe" is unnecessa"y additiona+ cost o# in!uts$ %he"e#o"e& !"oduce" shou+d !"e#e" to !"oduce in the second sta e o# !"oduction *he"e the OXE!X,$%he o!timum +e)e+ o# in!ut use *ithin this sta e can be +ocated *ith the he+! o# #acto" !"oduct !"ice$ %he +a* o# )a"iab+e !"o!o"tion is a+so ca++ed +a*s o# "etu"ns because in these di##e"ent sta es o# !"oduction *e ha)e seen di##e"ent "etu"ns +e)e+ #o" the di##e"ent +e)e+ )a"iab+e in!ut use$ In the abo)e #i u"e *e cou+d #ind inc"easin "etu"ns& diminishin "etu"ns and a+so ne ati)e "etu"ns$ No "ationa+ *ou+d !"e#e" to o!e"ate in the sta e o# ne ati)e "etu"ns$ In bet*een inc"easin and diminishin "etu"ns *e cou+d a+so #ound constant "etu"ns$ %hou h it is not )isib+e in the cu")e& the conce!t o# constant "etu"ns is )e"y !o!u+a" in !"actice$ %h"ee im!o"tant +a*s o# "etu"ns a"e e+abo"ated in the #o++o*in section$ Inc"easin "etu"ns Dec"easin "etu"ns Constant "etu"ns

I. Increasing /eturns: I# each additiona+ unit o# )a"iab+e in!ut adds mo"e and mo"e to the tota+ !"oduction than thei" !"e)ious unit o# in!ut& then it may be ca++ed as +a* o# inc"easin "etu"ns$ In othe" *o"ds the +a* o# inc"easin "etu"ns said to e0ist i# M8 oes on inc"easin *ith the inc"ease in the )a"iab+e in!ut use +e)e+$ rM, ArE, X rM. ArE. X rM9 ArE9X QQQQrMn ArEn M8 o# second unit o# in!ut is "eate" than the M8 o# #i"st unit o# in!ut and simi+a"+y M8 o# 9"d unit o# in!ut is mo"e than the ma" ina+ !"oducti)ity o# . nd unit o# in!ut and so on$ Ma" ina+ !"oducti)ity oes on inc"easin *ith use o# additiona+ unit o# in!ut unde" this +a*$

@<

ii $ecreasing /eturns: I# each additiona+ unit o# )a"iab+e in!ut adds +ess and +ess to the tota+ !"oduction than thei" !"e)ious unit o# in!ut then it may be ca++ed as +a* o# dec"easin "etu"ns$ In othe" *o"ds i# ma" ina+ !"oducti)ity oes on dec"easin *ith the inc"ease in the )a"iab+e in!ut use +e)e+ #o" that *e ca++ed as +o* o# dec"easin "etu"ns$ rM, ArE, W rM. ArE. WrM9 ArE9W QQQQrMn ArEn Ma" ina+ !"oducti)ity o# second unit o# in!ut is +ess than the ma" ina+ !"oducti)ity o# #i"st unit o# in!ut and simi+a"+y ma" ina+ !"oducti)ity o# thi"d unit o# in!ut is +ess than the ma" ina+ !"oducti)ity o# second unit o# in!ut and so on ma" ina+ !"oducti)ity oes in diminishin $ iii$ 'onstant /eturns: I# the amount o# out!ut inc"eases by the same ma nitude #o" each additiona+ unit o# in!ut then it may be ca++ed as +a* o# constant "etu"ns$ 7e"e M8 "emains same at a++ +e)e+s o# )a"iab+e in!ut use$ rM, ArE, F rM. ArE. FrM9 ArE9 F QQQQrMn ArEn Ma" ina+ !"oducti)ity o# second unit o# in!ut is e:ua+ to the ma" ina+ !"oducti)ity o# #i"st unit o# in!ut and simi+a"+y ma" ina+ !"oducti)ity o# thi"d unit o# in!ut is e:ua+ to the ma" ina+ !"oducti)ity o# second unit o# in!ut and so on ma" ina+ !"oducti)ity "emains constant #o" di##e"ent +e)e+ o# )a"iab+e in!ut use +e)e+$

"." :aws of Returns to Scale

It "e#e"s to the beha)io" o# out!ut in "es!onse to the chan e in the sca+e o# !"oduction$ Chan e in the sca+e o# !"oduction means that a++ in!uts o" #acto"s chan ed simu+taneous+y in the same !"o!o"tion$ In othe" *o"ds an inc"ease in the sca+e o# !"oduction means that a++ in!uts o" #acto"s a"e inc"eased in the same !"o!o"tion$ %he study o# chan e in out!ut as a conse:uence o# chan e in the sca+e #o"ms the sub4ect matte" o# "etu"ns to sca+e$ %he conce!t o# "etu"ns to sca+e is as o+d as economics itse+#$ 7o*e)e"& they *e"e not ca"e#u++y de#ined ti++ the time o# A+#"ed Ma"sha++$ 7e used the conce!t o# "etu"ns to sca+e to ca!tu"e the idea that #i"ms may a+te"nati)e+y #ace Yeconomies o# sca+eY Di$e$ ad)anta es to si3e- o" Ydiseconomies o# sca+eY Di$e$ disad)anta es to si3e-$

@=

:aws of Returns Gs :aws of Returns to Scale

:aws of Returns Chan e in out!ut in "es!onse to chan e in the )a"iab+e in!uts La* o# "etu"ns is a sho"t "un !henomenon In the sho"t "un they cou+d not )a"y a++ #acto"s o# !"oduction$ %hey cou+d )a"y on+y )a"iab+e #acto"s o# !"oduction in o"de" to )a"y thei" out!ut +e)e+$ :aws of Returns to Scale Chan e in the out!ut in "es!onse to chan e in the sca+e o# !"oduction$ La* o# "etu"ns to sca+e is a +on -"un !henomenon In the +on "un a++ #acto"s o#

!"oduction a"e )a"iab+e$ E)en the !+ant si3e can be )a"ied in o"de" to )a"y the out!ut +e)e+$

Retu"ns to sca+e a"e technica+ !"o!e"ties o# the !"oduction #unction& y F # D0,& 0.& $$$& 0n-$ I# *e inc"ease the :uantity o# all #acto"s em!+oyed by the same D!"o!o"tiona+amount& out!ut *i++ inc"ease$ %he :uestion o# inte"est is *hethe" the "esu+tin out!ut *i++ inc"ease by the same !"o!o"tion& mo"e than !"o!o"tiona++y& o" +ess than !"o!o"tiona++y$ In othe" *o"ds& *hen *e doub+e all in!uts& does out!ut doub+e& mo"e than doub+e o" +ess than doub+e6 %hese th"ee basic outcomes can be identi#ied "es!ecti)e+y as increasing returns to scale& constant returns to scale and decreasing returns to scale$ Increasing /eturns to Scale: It is a situation *he"e doub+in o# in!uts +eads to mo"e than doub+in o# out!ut$ i$e$ i# the inc"ease in a++ #acto"s *ithout a+te"in the !"o!o"tion bet*een them +eads to a mo"e than !"o!o"tionate inc"ease in out!ut& "etu"ns to sca+e is said to be inc"easin $ /o" e0am!+e i# a++ in!uts a"e inc"eased by .=V and out!ut inc"eases by 9GV then *e conside" this as inc"easin "etu"ns$

@@

'onstant /eturns to Scale: It is a situation *he"e doub+in o# in!uts +eads to e0act+y doub+in o# out!ut$ i$e$ i# the !"oduce" inc"eases a++ #acto"s in a i)en !"o!o"tion and the out!ut inc"ease in the same !"o!o"tion& "etu"ns to sca+e is said to be constant$ /o" instance& i# a++ in!uts a"e inc"eased by .=V and "esu+tin out!ut a+so inc"eases by .=V then *e can say that the"e is a constant "etu"n to sca+e$

$ecreasing /eturns to Scale: It is situation in *hich doub+in o# in!uts +eads to +ess than doub+in o# out!ut$ I$e$ I# the inc"ease in a++ #acto"s *ithout a+te"in the !"o!o"tion bet*een them +eads to a +ess than !"o!o"tion inc"ease in out!ut& "etu"ns to sca+e is said to be dec"easin "etu"ns to sca+e$ /o" instance& i# a++ in!uts a"e inc"eased by .=V and "esu+tin out!ut inc"eases by .GV then *e can say that the"e is a dec"easin "etu"n to sca+e$

A+thou h any !a"ticu+a" !"oduction #unction can e0hibit inc"easin & constant o" diminishin "etu"ns to sca+e th"ou hout& it used to be a common !"o!osition that a single !"oduction #unction *ou+d ha)e di##e"ent "etu"ns to sca+e at di##e"ent +e)e+s o# out!ut$ S!eci#ica++y& it *as natu"a+ to assume that *hen a #i"m is !"oducin at a )e"y sma++ sca+e& it o#ten #aces inc"easin "etu"ns because by inc"easin its si3e& it can make mo"e e##icient use o# "esou"ces by di)ision o# +abo" and s!ecia+i3ation o# ski++s$ 7o*e)e"& i# a #i"m is a+"eady !"oducin at a )e"y +a" e sca+e& it *i++ #ace dec"easin "etu"ns because it is a+"eady :uite un*ie+dy #o" the ent"e!"eneu" to mana e !"o!e"+y& thus any inc"ease in si3e *i++ !"obab+y make his 4ob e)en mo"e com!+icated$ %he mo)ement #"om inc"easin "etu"ns to sca+e to dec"easin "etu"ns to sca+e as out!ut inc"eases is "e#e""ed to as the ultra*passum law o# !"oduction$

".# :east -ost -om3ination of Inputs)

%he"e may be +a" e numbe" o# "esou"ce combinations *hich *i++ !"oduces same +e)e+ o# out!ut$ ;ut cost o# !"oducin that !a"ticu+a" +e)e+ o# out!ut by di##e"ent combinations may not same$ 8"oduce" has to incu" di##e"ent +e)e+ o# cost #o" di##e"ent combinations$ In this to!ic *e sha++ t"y to unde"stand ho* to asce"tain +east cost

@B

combination o# in!uts in !"oducin a !a"ticu+a" +e)e+ o# out!ut$ And a+so *e sha++ t"y to unde"stand conce!ts "e+ated to +east cost combinations$ %he ana+ysis o# the mu+ti-#acto" case "e:ui"es mathematica+ too+s& *hich is beyond the sco!e o# this cou"se$ /o" sim!+icity& *e *i++ assume that a #i"m !"oduces out!ut usin t*o ty!es o# in!uts: +abo" and ca!ita+$ /o" no*& *e can think o# +abo" as "e!"esentin a++ o# the in!uts that a"e )a"iab+e in the sho"t "un and ca!ita+ as "e!"esentin a++ o# the in!uts that a"e #i0ed in the sho"t-"un$ Unde" this assum!tion& *e can de#ine as #i"mZs sho"t-"un !"oduction #unction as: >F#DL&5Lhe"e: > F :uantity o# out!ut !"oduced L F amount o# +abo" in!ut 5 F amount o# ca!ita+ in!ut %he !"oduction #unction& #& is a mathematica+ #unction that !"o)ides the ma0imum :uantity o# out!ut that can be !"oduced #o" each !ossib+e combination o# in!uts used by the #i"m$ A con)enient *ay o# "e!"esentin this !"oduction #unction is th"ou h the use o# a "a!h containin iso:uant cu")es$ ".#.1)Iso0uants) An iso0uant cur e is a "a!h o# a++ o# the combinations o# in!uts that "esu+t in the !"oduction o# a i)en +e)e+ o# out!ut /i u"e 9$, sho*s a hy!othetica+ iso:uant$ In this dia "am +abou" measu"ed in ho"i3onta+ a0is and ca!ita+ measu"ed in )e"tica+ a0is$ %his iso:uant su ests that the #i"m cou+d !"oduce =G units o# out!ut !e" day usin eithe" .G units o# +abo" and = units o# ca!ita+ at !oint C o" 9 units o# +abo" and ,= units o# ca!ita+ at !oint A$ In #act& any combination o# +abo" and ca!ita+ a+on this cu")e a++o*s the #i"m to !"oduce =G units o# out!ut !e" day D#o" e0am!+e !oint ;-$ Note that this cu")e is do*n*a"d s+o!in because the #i"m can "e!+ace *o"ke"s *ith machines o" "e!+ace machines *ith *o"ke"s and sti++ mana e to !"oduce the same +e)e+ o# out!ut$

@H

,igure ".1) Iso0uant -ur e

In this dia "am& the #i"m can !"oduce =G units o# out!ut usin any o# the in!ut combinations i)en by !oints: A& ;& o" C$ Lhat ha!!ens i# *e com!a"e !oints ; and D6 At !oint D& the #i"m is usin mo"e +abo" and mo"e ca!ita+ than it is usin at !oint ;$ I# it uses mo"e o# each in!ut it cou+d !"oduce mo"e tota+ out!ut$ %hus& *e kno* that this #i"m can !"oduce mo"e out!ut at !oint D than at !oint ;$ Since the #i"m !"oduces =G units o# out!ut at !oints A& ;& and C& the out!ut +e)e+ co""es!ondin to !oint ; is hi he" than at any o# the !oints on the iso:uant$ Mo"e ene"a++y& *e can state that any !oint that +ies abo)e and to the "i ht o# an iso:uant cu")e co""es!onds to a hi he" +e)e+ o# out!ut$ Usin simi+a" +o ic& the +e)e+ o# out!ut *i++ be +o*e" i# the #i"m se+ects a combination o# in!uts that +ies be+o* and to the +e#t o# an iso:uant$ %he s+o!e o" the natu"e o# iso:uant de!ends on the Ma" ina+ Rate o# %echnica+ Substitution DMR%S- o" sim!+y MRS$ MRS sho*s the "ate at *hich t*o "esou"ces can be substituted i$e$ ho* much the use o# one "esou"ce can be i)en u! in o"de" to use an additiona+ unit o# othe" in!ut& in such a *ay as to maintain the same +e)e+ o# out!ut$ r in the use o# "e!+aced "esou"ce MRS0,0. F r in the use o# added "esou"ce F rE. rE,

@I

MRS o# one in!ut #o" the othe" in othe" *o"ds s+o!e o# an iso:uant *ou+d de!end on the e0tent o# substitutabi+ity o# the t*o in!uts$ On the basis o# the e0tent o# the substitutabi+ity *e can cate o"ies in!ut-in!ut "e+ation into th"ee main cate o"ies$ ?i3$ !e"#ect non-substitutab+e& !e"#ect substitutab+e and +imited substitutab+e Dsubstitutes but not !e"#ect substitutes-$ Perfect 1on*Substitutable: I# in!uts a"e !e"#ect+y non-substitute then such t*o in!uts a"e to be used in #i0ed !"o!o"tion$ Ce"tain !"oducts can be !"oduced on+y i# in!uts a"e used in #i0ed !"o!o"tion at a++ +e)e+s o# !"oduction$ In!uts a"e !e"#ect+y non-substitute unde" such in!ut-in!ut "e+ation$ I# in!ut-in!ut "e+ation is such then iso:uant *i++ be o# "ectan u+a" ty!e$ 8e"#ect Substitutes: 8e"#ect+y substitutab+e can be "e!+aced each othe" at a constant "ate in o"de" to maintain the same +e)e+ o# out!ut$ I# t*o in!uts a"e !e"#ect+y substitutab+e then iso:uant in such in!ut-in!ut "e+ation *i++ be a st"ai ht +ine *hich s+o!es do*n*a"d #"om +e#t to "i ht$ Limited substitutab+e: In the !"oduction o# some commodities the"e a"e some in!uts& *hich a"e substitutab+e but not !e"#ect substitutab+e$ In the !"oduction o# most o# the commodities +abou" and ca!ita+ a"e c+ose but not !e"#ect substitutab+e thei" substitutabi+ity become mo"e and mo"e di##e"ent as one #acto" is substituted #o" anothe"$ Lhen in!ut-in!ut "e+ationshi! is such that iso:uant *i++ be con)e0 to the o"i in$ %he iso:uant that is con)e0 to the o"i in sho*s the dec+inin MRSE,E.$

Substitutabi+ity become mo"e di##icu+t as E, in!ut is substituted #o" E. in!ut$ 7e"e t*o in!uts a"e substitutab+e but not !e"#ect substitutab+e because MRS 0, #o" E. oes on diminishin as the !"oduce" oes on substitutin E, #o" E.$ 8"actica++y& in the !"oduction o# most o# the commodities many in!uts a"e substitutab+e *ithin a ce"tain +imits$ 7ence& this #o"m o# iso:uants is *ide+y a!!+icab+e in the +east cost combination ana+ysis *he"eas !e"#ect substitutabi+ity and !e"#ect non-substitutabi+ity is a )e"y "a"e e)ent$ 7ence& st"ai ht-+ine iso:uant and "ectan u+a" iso:uants a"e not much use#u+ in this ana+ysis$

BG

%he law of diminishing MRS states that the MRS dec+ines as the +e)e+ o# +abo" use "ises a+on an iso:uant$ An e:ui)a+ent *ay o# statin this +a* is to state that iso:uant cu")es a"e con)e0$ LetZs conside" the intuition unde"+yin this +a*$ %his +a* su ests that it takes a +a" e amount o# ca!ita+ to "e!+ace a unit o# +abo" *hen ca!ita+ use is hi h but +itt+e +abo" is used$ As +abo" becomes mo"e !+enti#u+ and ca!ita+ becomes sca"ce"& ho*e)e"& +ess ca!ita+ is "e:ui"ed to "e!+ace an additiona+ unit o# +abo"$ %hus& the +a* o# diminishin MRS indicates that it is "e+ati)e+y di##icu+t to "e!+ace additiona+ :uantities o# an in!ut *hen the +e)e+ o# that in!ut becomes "e+ati)e+y +o*$ %his seems to be cha"acte"istic o# most !"oduction !"ocesses$ Conside"& #o" e0am!+e& the situation on a #a"m$ Lhen a #a"m is hi h+y mechani3ed and has on+y a sma++ numbe" o# *o"ke"s o!e"atin the #a"m e:ui!ment& a )e"y +a" e amount o# ca!ita+ *ou+d be "e:ui"ed to "e!+ace a *o"ke"$ I# a #i"m& thou h& has many *o"ke"s but #e* too+s& the int"oduction o# a sma++ amount o# ca!ita+ Dsuch as a t"acto"- can "e!+ace a "e+ati)e+y +a" e numbe" o# *o"ke"s$ ".#.2) Iso1-ost -ur e) %he iso:uant cu")e e0!+ains about the !hysica+ *ays in *hich in!uts can be combined to !"oduce out!ut$ Notice that it does not te++ us anythin about the costs associated *ith a+te"nati)e +e)e+s o# in!ut use$ %he ne0t ste! to*a"ds the dete"mination o# o!timumA+east cost combination o# in!uts is to add in#o"mation on cost o# those in!uts$ %his cost in#o"mation int"oduced in the #o"m o# iso-cost +ine$ Iso*cost line indicate all possible combination of two inputs which can be purchased at a given outlay of investment and the market price level of inputs. /o" e0am!+e& i)en the !e" unit !"ice o# ca!ita+D"- and +abou" D*-& the tota+ e0!enditu"e DC- on ca!ita+ and +abou" is C F "5 O *L Re*"itin this e:uation by so+)in #o" 5 as a #unction o# L 5 F CA" J *A"L %his is an e:uation #o" st"ai ht +ine *he"e CA" is the )e"tica+ inte"ce!t and J*A" is the "ate at *hich +abou" can be e0chan ed #o" ca!ita+ in the ma"ket$ /o" e0am!+e& i# *F. and "F9&

B,

, unit o# ca!ita+ can be t"aded #o" ,$= unit o# +abou" o" , unit o# +abou" can be t"aded #o" .A9 unit o# ca!ita+$ %he Iso-cost +ine #o" the i)en *F.& "F9 and CDout+ay- F<G isC 5 <GA9 J .A9L O" 5 F ,9$99 J .A9L I# a++ the <G "u!ees Dout+ay- is s!ent on the ca!ita+ DLFG- ,9$99 units o# ca!ita+ can be !u"chased$ Con)e"se+y i# a++ the <G "u!ees s!ent on +abou" Dca!ita+FG- .G units o# it cou+d be !u"chased$ ,9$99 units o# ca!ita+ and .Gunits o# +abou" a"e the inte"ce!t on ca!ita+ and +abou" a0is "es!ecti)e+y& in bet*een the t*o e0t"eme )a+ues the"e *i++ be +a" e numbe" o# combination o# these t*o in!uts$ /i u"e 9$. sho*s the iso-cost cost +ines #o" the out+ay o# "u!ees 9G& <G and =G "es!ecti)e+y$ /i u"e 9$.: Iso-Cost Line #o" Out+ay o# Ru!ees 9G& <G and =G

It is c+ea" #"om the #i u"e that as the out+ay o# in)estment on these t*o in!uts oes on inc"easin the iso-cost +ine shi#t out*a"d but they "emain !a"a++e+ to each othe"$ It is because the in!ut !"ice "atios o" the in!ut !"ices "emain constant$ ".#.") :east -ost -om3ination of Inputs. Lhen both ca!ita+ and +abou" a"e )a"iab+e& dete"mination o# o!timumA+east cost combination o# these in!uts "e:ui"es that technica+ in#o"mation #"om the !"oduction #unction Di$e$ the iso:uant- be combined *ith the ma"ket data on the in!uts !"ice Di$e$ the

B.

iso-cost cu")e-$ Conside" the !"ob+em o# minimi3in the cost #o" a i)en +e)e+ o# out !ut$ Let us unde"stand this !"ob+em *ith the he+! o# #i u"e 9$9$ /i u"e 9$9: Least Cost Combination o# In!uts$

%his #i u"e consists o# t*o iso:uants$ S!eci#ica++y su!!ose that the #i"m(s ob4ecti)e is to !"oduce ten units o# out!ut at minimum cost$ %he in#inite numbe" o# ca!ita+ and +abou" combinations cou+d !"oduce ,G units o# out!ut as sho*n by the iso:uant cu")e$ %h"ee o# these combinations a"e indicated by a& b and c$ !oint a and c a"e on the iso-cost +ine "e!"esentin the e0!enditu"e o# "u!ees ,=G and b is on the iso-cost +ine "e!"esentin the e0!enditu"e o# "u!ees ,GG$ O# these& c+ea"+y b is the best in the sense o# bein the +o*est cost$ At !oint b ,G units iso:uant is tan ent to the iso-cost +ine "e!"esentin the out+ay o# "u!ees ,GG$ A++ othe" in!ut combinations sho*n on the ,G-unit iso:uant *ou+d co""es!ond to hi he" iso-cost cu")e and *ou+d cost mo"e than ,GG "u!ees$ It is im!o"tant to note that the tan ency bet*een iso:uant and iso-cost cu"e at !oint b indicate that the MRS0,0. is e:ua+ to the #acto" !"ice "atio *hich is an im!o"tant c"ite"ion to decide the attainment o# +east cost$

B9

".'. Economies and diseconomies of Scale

%he sca+e o# ente"!"ise o" si3e o# !+ant "e#+ects the amount o# in)estment made in the "e+ati)e+y #i0ed #acto" o# !"oduction& i$e$& !+ant and #i0ed e:ui!ment$ %he conce!ts o# economies and diseconomies o# sca+e a"e "e+ated to economic ad)anta es o" disad)anta es associated *ith the sca+e o" si3e o# the !+ant$ %he unde"standin o# these conce!ts enab+es the mana ement to decide about the o!timum sca+e o" si3e o# the !+ant$ Sca+e o# !"oduction )a"ies on+y in the +on "un and hence economies and diseconomies o# sca+e a"e associated *ith the +on -"un decisions$ Lhen mo"e units o# a ood o" a se")ice can be !"oduced on a +a" e" sca+e& yet *ith +ess a)e"a e in!ut costs& economies o# sca+e a"e said to be achie)ed$ A+te"nati)e+y& this means that as a com!any "o*s and !"oduction units inc"ease& a com!any *i++ ha)e a bette" chance to dec"ease its costs$ Acco"din to theo"y& economic "o*th may be achie)ed *hen economies o# sca+e a"e "ea+i3ed$ Adam Smith identi#ied the di)ision o# +abo" and s!ecia+i3ation as the t*o key means to achie)e a +a" e" "etu"n on !"oduction$ %h"ou h these t*o techni:ues& em!+oyees *ou+d not on+y be ab+e to concent"ate on a s!eci#ic task& but *ith time& im!"o)e the ski++s necessa"y to !e"#o"m thei" 4obs$ %he tasks cou+d then be !e"#o"med bette" and #aste"$ 7ence& th"ou h such e##iciency& time and money cou+d be sa)ed *hi+e !"oduction +e)e+s inc"eased$ Kust +ike the"e a"e economies o# sca+e& diseconomies o# sca+e a+so e0ist$ %he"e a"e ine##iciencies *ithin the #i"m o" indust"y "esu+tin in "isin a)e"a e costs as the com!any o" !"oduction units "o* beyond a ce"tain +imit$ In a nutshe++ economies o# sca+e is said to be e0istin i# a)e"a e cost #a++s as !+ant si3e inc"eases and the diseconomies o# sca+e !"e)ai+ i# the o!!osite is the case$ /i u"e 9$< de!icts the economies and diseconomies o# sca+e$ In this #i u"e economies o# sca+e is !"e)ai+in u! to OM +e)e+ o# out!ut$ U! to OM +e)e+ o# out!ut a)e"a e cost oes on dec+inin and it "eaches its minimum !oint at E and the"e a#te"*a"ds diseconomies o# sca+e set into the !"oduction system hence a)e"a e cost be ins to inc"ease$ Economies o# sca+e is e0istin in the "an e o# dec+inin a)e"a e cost cu")e and simi+a"+y diseconomies o# sca+e is o!e"atin in the "an e o# inc"easin a)e"a e cost cu")e$

B<

/i u"e 9$<: Economies and Diseconomies o# Sca+e

".'.1 Internal and EHternal Economies of Scale A+#"ed Ma"sha++ made a distinction bet*een inte"na+ and e0te"na+ economies o# sca+e$ Lhen a com!any "educes costs and inc"eases !"oduction& inte"na+ economies o# sca+e ha)e been achie)ed$ E0te"na+ economies o# sca+e occu" outside o# a #i"m& *ithin an indust"y$ %hus& *hen an indust"yZs sco!e o# o!e"ations e0!ands due to& #o" e0am!+e& the c"eation o# a bette" t"ans!o"tation net*o"k& "esu+tin in a subse:uent dec"ease in cost #o" a com!any *o"kin *ithin that indust"y& e0te"na+ economies o# sca+e a"e said to ha)e been achie)ed$ %hus inte"na+ economies and diseconomies a"ise due to the #i"m(s o*n e0!ansion$ %hese inc+ude +abou"& technica+& mana e"ia+& #inancia+ and ma"kin economies and diseconomies$ E0te"na+ economies and diseconomies may a"ise due to the e0!ansion o# the indust"y as a *ho+e$ Lith e0te"na+ economies o# sca+e a++ #i"ms *ithin the indust"y *i++ bene#it$ /"om the mana e"ia+ !oint o# )ie*& inte"na+ economies a"e mo"e im!o"tant than e0te"na+ ones& #o" a *hi+e the #o"me" can be a##ected by mana e"ia+ decisions o# an indi)idua+ #i"m chan in its si3e o" sca+e& the +atte" a"e not sub4ect to such in#+uences

B=

".'.2 Reasons for Internal Economies of Scale %hese a"e economies made *ithin a #i"m as a "esu+t o# mass !"oduction$ As the #i"m !"oduces mo"e and mo"e oods& a)e"a e cost be ins to #a++$ It is due to: +abour economies a"ise in the be innin because e0!ansion o# out!ut !e"mits s!ecia+i3ation& *hich "educes !e" unit cost$ Technical economies made in the actua+ !"oduction o# the ood$ %echnica+ economies a"ise because +a" e out!ut !e"mits int"oduction o# ne* methods o# !"oduction$ La" e #i"ms can use e0!ensi)e machine"y& intensi)e+y$ etc$ ,inancial economies made by bo""o*in money at +o*e" "ates o# inte"est )arketing economies made by s!"eadin the hi h cost o# ad)e"tisin on 'ommercial economies made *hen buyin su!!+ies in bu+k and the"e#o"e ainin a +a" e" discount$ /esearch and development economies made *hen de)e+o!in ne* and bette" !"oducts$ ".'." EHternal Economies of Scale %hese a"e economies made outside the #i"m as a "esu+t o# the e0!ansion o# the indust"y as a *ho+e: A +oca+ ski++ed +abou" #o"ce is a)ai+ab+e$ S!ecia+ist +oca+ back-u! #i"ms can su!!+y !a"ts o" se")ices$ An a"ea has a ood t"ans!o"t net*o"k$ Indust"y e0!ansion may +ead to the than sma++e" #i"ms$ te+e)ision and in nationa+ ne*s!a!e"s& ac"oss a +a" e +e)e+ o# out!ut$ )anagerial economies made in the administ"ation o# a +a" e #i"m by s!+ittin u! mana ement 4obs and em!+oyin s!ecia+ist accountants& sa+esmen&

const"uction o# a "ai+*ay +ine in a ce"tain "e ion "esu+tin in a "eduction in t"ans!o"t cost #o" a++ the #i"ms An a"ea has an e0ce++ent "e!utation #o" !"oducin a !a"ticu+a" ood$ /o" e0am!+e& She##ie+d is associated *ith stee+$

B@

".'.# Internal Diseconomies of Scale %hese occu" *hen the #i"m has become too +a" e and ine##icient$ As the #i"m inc"eases !"oduction& e)entua++y a)e"a e costs be in to "ise because: +abour diseconomies o# sca+e :Once the out!ut has e0!anded to a "easonab+e +e)e+& #u"the" e0!ansion +eads to !"ob+em o# o)e"-c"o*din & *hich "ende"s cont"o+ and coo"dination o# the +abou" #o"ce di##icu+t& and +ack a sense o# "es!onsibi+ity& *hich endan e"s e##iciency$ %hus& beyond a !oint& the"e a"e diseconomies o# +abou"$ Mana ement becomes out o# touch *ith the sho! #+oo" and some Decisions a"e not taken :uick+y and the"e is too much #o"m #i++in $ Lack o# communication in a +a" e #i"m means that mana ement tasks 8oo" +abou" "e+ations may de)e+o! in +a" e com!anies$ machine"y becomes o)e"-manned$

sometimes et done t*ice$

".'.' EHternal Diseconomies of Scale %hese occu" *hen too many #i"ms ha)e +ocated in one a"ea$ Unit costs be in to "ise because: Loca+ +abou" becomes sca"ce and #i"ms no* ha)e to o##e" hi he" *a es to att"act ne* *o"ke"s$ Land and #acto"ies become sca"ce and "ents be in to "ise$ Loca+ "oads become con ested and so t"ans!o"t costs be in to "ise$

%he key to unde"standin economies and diseconomies o# sca+e is that the sou"ces )a"y$ A com!any needs to dete"mine the net e##ect o# its decisions a##ectin its e##iciency& and not 4ust #ocus on one !a"ticu+a" sou"ce$ %hus& *hi+e a decision to inc"ease its sca+e o# o!e"ations may "esu+t in dec"easin the a)e"a e cost o# out!uts& it cou+d a+so i)e "ise to diseconomies o# sca+e i# its subse:uent+y *idened dist"ibution net*o"k is ine##icient$ %hus& *hen makin a st"ate ic decision to e0!and& com!anies need to ba+ance the e##ects o# di##e"ent sou"ces o# ES and DS so that the a)e"a e cost o# a++ decisions made is +o*e"& "esu+tin in "eate" e##iciency a++ a"ound$

BB

".+ -ost -oncepts

8"oduction ana+ysis& discussed so #a"& "e+ate !hysica+ out!ut to !hysica+ in!uts$ Cost ana+ysis& to be discussed in this section& dea+s *ith )a"ious ty!es o# costs and thei" "o+e in decision-makin & and the cost and out!ut "e+ationshi!s$ %his ana+ysis e:ui!s the #utu"e man e"s o# business houses *ith )a"ious cost conce!ts suitab+e #o" )a"ious business decisions$ %he kind o# cost conce!t to be used in a !a"ticu+a" situation de!ends u!on the business decisions to be made$ Cost conside"ations ente" in to a+most e)e"y business decision& and it is im!o"tant& thou h sometimes di##icu+t& to use the "i ht kind o# cost$ 7ence an unde"standin o# the meanin o# )a"ious conce!ts is essentia+ #o" c+ea" business thinkin $ ".+.1. *ctual -ost and (pportunit. -ost Actua+ costs mean the actua+ e0!enditu"e incu""ed #o" ac:ui"in o" !"oducin a ood o" se")ice$ %hese costs a"e the costs that a"e ene"a++y "eco"ded in the books o# accounts& #o" e0am!+e& actua+ *a es !aid& cost o# mate"ia+s !u"chased& inte"est !aid& etc$ %hese costs a"e a+so common+y kno*n as Abso+ute costs o" Out+ay costs$ O!!o"tunity cost o# a in!ut o" se")ice is measu"ed in te"ms o# "e)enue *hich cou+d ha)e been ea"ned by em!+oyin that in!ut o" se")ice in some othe" a+te"nati)e uses$ O!!o"tunity cost can be de#ined as the "e)enue #o" one by not makin the best a+te"nati)e use$ %he o!!o"tunity cost conce!t a!!+ies to a++ situation *he"e a thin can ha)e a+te"nati)e use$ ?e"y o#ten& the"e a"e cases *he"e a !a"ticu+a" "esou"ce o" #acto"s o# !"oduction has no a+te"nati)e use$ Its o!!o"tunity cost *i++ be ni+ i""es!ecti)e o# its uti+ity in the e0istin use$ ".+.2 Economic -osts and *ccounting -osts EconomistsZ idea o# cost o# !"oduction di##e"s #"om that o# an accountant$ In economics& the cost o# !"oduction consists o# "emune"ation to a++ #acto"s o# !"oduction and the im!uted )a+ue o# the o*ne"Zs o*ned "esou"ces used #o" the !"oduction o# oods andA o" se")ices$ An accountant on the othe" hand *ou+d inc+ude on+y the cash !ayments to the #acto"s o# !"oduction& made by the ent"e!"eneu"& #o" the se")ices "ende"ed by these #acto"s in the !"oduction !"ocess$ Such cash !ayments a"e ca++ed the e0!+icit costs$ AccountantsZ c+assi#ications o# costs a"e usua++y set u! #o" +e a+& #inancia+ cont"o+ and auditin !u"!ose *hi+e economists( c+assi#ication desi ned to !"o)ide decision-makin BH

uide+ine #o" mana ement to achie)e the economic oa+s o# the #i"m$ %he"e#o"e& an accountant *i++ inc+ude on+y e0!+icit costs in his cost ca+cu+ation *he"e as economists inc+ude not on+y e0!+icit cost but a+so im!+icit cost$ %he di##e"ence bet*een accountin cost and economics cost cou+d be bette" unde"stood by the #o++o*in "e+ationshi!$ Economic Cost F Accountin Cost De0!+icit cost- O im!+icit cost ".+." Short1Run and :ong1Run -osts In economics& sho"t-"un is de#ined as a !e"iod du"in *hich at +east one in!ut is in #i0ed su!!+yC the #i0ed #acto" in!ut is !+ant and e:ui!ment$ In the +on "un a++ #acto" in!uts a"e )a"iab+es$ %he sho"t and +on "un do not "e#e" to any #i0ed units o# ca+enda" time$ Co""es!ondin to this !e"iod c+assi#ication& the"e a"e sho"t "un and +on "un costs$ A sho"t "un cost is that cost *hich )a"ies *ith out!ut *hen #i0ed !+ant and ca!ita+ e:ui!ment "emain the same *hi+e a +on "un cost is that *hich )a"ies *ith out!ut *hen a++ #acto" in!uts& inc+udin !+ant and e:ui!ment& )a"y$ In the +on "un& a++ costs a"e )a"iab+e$ %he !+ant may be #i0ed today& but in #utu"e com!any may decide to inc"ease its si3e to any +e)e+ desi"ed *ithin the "an e o# !ossib+e a+te"nati)es$ Sho"t "un cost is "e+e)ant *hen a #i"m as to decide *hethe" o" not to !"oduce mo"e o" +ess *ith a i)en !+ant$ Lon "un cost ana+ysis use#u+ in in)estment decision$ ".+.# ,iHed and Faria3le -osts Costs a"e !+aced in to t*o b"oad cate o"ies& #i0ed and )a"iab+e cost$ /i0ed costs a"e de#ined as those& *hich "emain the same at a i)en ca!acity and do not )a"y *ith out!ut$ %hese costs *i++ e0ist e)en i# no out!ut is !"oduced in the sho"t "un$ ?a"iab+e costs& on the othe" hand& )a"y di"ect+y as out!ut chan es$ Rent on #acto"y and o##ice bui+din s& inte"est !ayments on bonds& and de!"eciation o# bui+din a"e e0am!+es o# #i0ed costs$ E0am!+es o# )a"iab+e costs a"e *a es and e0!enditu"e on "a* mate"ia+s$ %he"e a"e some costs& *hich #a++ bet*een these t*o e0t"emes$ %hey a"e ca++ed semi )a"iab+e costs$ %hey a"e neithe" !e"#ect+y )a"iab+e no" abso+ute+y #i0ed in "e+ation to chan es in out!ut$ /o" e0am!+e& e+ect"icity bi++s o#ten inc+ude a minimum cha" e& *hich the #i"m is bound to !ay i""es!ecti)e o# its consum!tion and the actua+ bi++ inc"eases i# mo"e than minimum e+ect"icity is consumed$

BI

".+.' Separa3le and -ommon -osts Costs a"e a+so c+assi#ied on the basis o# thei" t"aceabi+ity$ Se!a"ab+e costs a"e those& *hich can be att"ibuted to a !"oduct& a de!a"tment& o" a !"ocess$ On the othe" hand& common costs a"e those& *hich cannot be t"aced to any one unit o# o!e"ation$ /o" e0am!+e& e+ect"icity cha" es may not be se!a"ab+e de!a"tment *ise in a sin +e !"oduct #i"m o" e)en !"oduct *ise in a mu+ti!+e !"oduct #i"m$ %he se!a"ab+e and common costs a"e a+so kno*n as di"ect and indi"ect costs& "es!ecti)e+y$ %his is because di"ect costs can be identi#ied *hi+e indi"ect costs cannot be att"ibuted di"ect+y to any unit o# o!e"ation$ Common costs may c"eate !"ob+ems in the case o# 4oint !"oducts$ %he ent"e!"eneu" mi ht +ikes to kno* the tota+ cost o# each !"oduct +ine$ %his he may need #o" !"icin !u"!oses& #o" decidin *hethe" o" not it is a !"o#itab+e +ine o# !"oduction& and *hethe" to discontinue o" modi#y its !"oduction and so on$ %hus& mana ement may desi"e to dist"ibute the common costs into )a"ious !"oduct +ines$ ".+.+ Past -osts and ,uture -osts 8ast costs a"e actua+ costs incu""ed in the !ast and a"e ene"a++y contained in the #inancia+ accounts$ %he measu"ement o# !ast cost is essentia++y a "eco"d kee!in acti)ity and is essentia++y !assi)e #unction inso#a" as the mana ement is conce"ned$ %hese costs can me"e+y be obse")ed and e)a+uated in "et"os!ect$ Kust to #ind out the #acto"s "es!onsib+e #o" the e0cessi)e costs i# any& *ithout bein ab+e to do anythin #o" "educin them$ /utu"e costs a"e costs that a"e "easonab+y e0!ected to be incu""ed in some #utu"e !e"iod o" !e"iods$ %hen #utu"e costs a"e the on+y costs that matte" #o" ma" ina+ decisions because they a"e the on+y cost sub4ect to mana ement cont"o+$ Un+ike !ast costs& they can be !+anned #o" and !+anned to be a)oided$ I# the #utu"e costs a"e conside"ed too hi h the mana ement can eithe" !+an to "educe them o" #ind out *ays and means to meet them$ ".+.2 Sun=< Shutdown *nd *3andonment -osts A !ast cost "esu+tin #"om decisions& *hich can no mo"e be "e)ised& is ca++ed a sunk cost$ In othe" *o"ds a sunk cost is a cost once incu""ed cannot be "et"ie)ed$ It is usua++y associated *ith the commitment o# #unds to s!ecia+i3ed e:ui!ment o" othe" s!ecia+ties not "eadi+y ada!tab+e to !"esent o" #utu"e use e$ $ b"e*e"y !+ant in times o# !"ohibition$ Shutdo*n costs may de#ined as those costs *hich *ou+d be incu""ed in the HG

e)ent o# sus!ension o# the !+ant o!e"ation and *hich *ou+d be sa)ed i# the o!e"ations a"e continued$ E0am!+es o# such costs a"e the cost o# she+te"in the !+ant and e:ui!ment and const"uction o# sheds #o" sto"in e0!osed !"o!e"ty$ Abandonment costs a"e the costs o# "eti"in a+to ethe" a !+ant #"om se")ice$ Abandonment a"ises *hen the"e is a com!+ete cessation o# acti)ities and c"eates a !"ob+em as to the dis!osa+ o# assets$ %hese costs become im!o"tant *hen mana ement #aced *ith a+te"nati)es o# eithe" continuin e0istin !+ant sus!endin its o!e"ations o" abandonin a+to ethe"$ ".+.6 /otal -ost< * erage -ost and Marginal -ost %ota+ cost inc+udes a++ cash !ayments made to hi"ed #acto"s o# !"oduction and a++ cash cha" es im!uted #o" the use o# the o*ne"(s #acto"s o# !"oduction in ac:ui"in o" !"oducin oods o" se")ices$ In the !"oduction decisions a)e"a e and ma" ina+ cost conce!ts a"e !+ayin im!o"tant "o+e$ A)e"a e cost is the cost !e" unit o# out!ut$ It cou+d be obtained by di)idin the tota+ cost by tota+ :uantity !"oduced DAC F %CA>-$ I# %C F ,=G& and > F 9G units& then AC F ,=GA9G F=$ Ma" ina+ cost is the addition made to tota+ cost by !"oducin an additiona+ unit o# out!ut$ It can be obtained by MCn F %Cn J %Cn-,$ I# tota+ cost #o" !"oducin ,GG units o# out!ut is say "u!ees ,GGGG and tota+ cost o# !"oducin ,G, unit o# out!ut is "u!ees ,G,,G then Ma" ina+ Cost o# !"oducin ,G,th unit o# out!ut is DMC,G, F %C,G, J %C,GG F ,G,,G J,GGGG F ,,G- ,,G$ %he a)e"a e cost conce!t is im!o"tant #o" ca+cu+atin !e" unit !"o#it o# a business conce"n$ Ma" ina+ cost conce!t is essentia+ in decidin *hethe" a #i"m needs to e0!and its !"oduction o" not$ %he "e+e)ant costs to be conside"ed *i++ di##e" #"om one situation to othe" de!endin on the natu"e o# !"ob+em #aced by the o" ani3ation$

".2. -ost (utput Relationship

%he beha)io" o# cost is o# )ita+ im!o"tance in the mana ement decision-makin !"ocess$ %he cost o# !"oduction de!ends on many #acto"s and they )a"y #"om one #i"m to anothe" in the same indust"y and #"om one ty!e o# indust"y to anothe"$ %he ene"a+ dete"minants o# costs a"eC a- out!ut +e)e+& b- !"ices o# #acto"s o# !"oduction& c!"oducti)ity o# #acto"s o# !"oduction and d- techno+o y$ O# a++& the "e+ationshi!s bet*een cost and its indi)idua+ dete"minants& the cost-out!ut "e+ationshi! is the most im!o"tant one$ Its si ni#icance is so "eat that in economic ana+ysis the cost #unction usua++y "e#e"s H,

to the "e+ationshi! bet*een cost and "ate o# out!ut a+one& and thus assumes that a++ o# the othe" inde!endent )a"iab+es a"e ke!t constant$ %he cost and out!ut "e+ationshi! is main+y o# t*o ty!es$ One is sho"t "un cost and out!ut "e+ationshi! and anothe" is +on "un cost and out!ut "e+ationshi!$ %he Sho"t-"un costs a"e those costs& *hich a"e incu""ed by the #i"m du"in a !e"iod in *hich some #acto"s& es!ecia++y& ca!ita+ e:ui!ment& +and and mana ement a"e he+d constant$ %he sho"t"un costs a"e incu""ed on the !u"chases o# "a* mate"ia+s& chemica+s& #ue+& casua+ +abou" etc$ Lhich )a"y *ith the chan es in the +e)e+ o# out!ut$ On the othe" hand& the +on -"un costs a"e the costs incu""ed du"in a !e"iod& *hich is su##icient+y +a" e to a++o* the )a"iation in a++ #acto"s o# !"oduction inc+udin ca!ita+ e:ui!ment& +and and mana e"ia+ sta## to !"oduce a +e)e+ o# out!ut$ In the be innin sho"t "un cost out!ut "e+ationshi! is desc"ibed #o++o*ed by the +on "un cost out!ut "e+ationshi!$ ".2.1 -ost (utput Relationship in the Short Run %he sho"t-"un cost-out!ut "e+ationshi! "e#e"s to a !a"ticu+a" sca+e o# o!e"ation o" to a #i0ed !+ant$ %hat is& it indicates )a"iations in cost o)e" out!ut #o" the !+ant o# a i)en ca!acity and this "e+ationshi! *i++ )a"y *ith !+ants o# )a"yin ca!acity$ %hus& the sho"t"un #unction "e+atin cost to out!ut )a"iations is o# the #o++o*in ty!e: %C F #D0- O A Lhe"e: %C F tota+ cost E F out!ut and A F tota+ #i0ed cost %he #i0ed cost is #o" a i)en !+ant si3eC #o" di##e"ent !+ant si3es& its )a+ue *i++ di##e"$ #D0ob)ious+y denotes tota+ )a"iab+e cost$ /o" decision-makin & one needs to kno* not on+y the "e+ationshi! bet*een tota+ cost and out!ut but a+so se!a"ate+y bet*een )a"ious ty!es o# costs and out!ut$ %hus& the sho"t-"un cost-out!ut "e+ationshi! needs to be discussed in te"ms o#C a- #i0ed cost and out!ut& b- )a"iab+e cost and out!ut& c- tota+ cost and out!ut$ ".2.1.1 /otal ,iHed and Faria3le -osts in the Short Run %he"e a"e some in!uts o" #acto"s& *hich can be "eadi+y ad4usted *ith the chan es in the out!ut +e)e+$ %hus& a #i"m can "eadi+y em!+oy mo"e *o"ke"s& i# it has to inc"ease

H.

out!ut$ Like*ise& it can secu"e and use mo"e "a* mate"ia+& mo"e chemica+s *ithout much de+ay i# it has to e0!and !"oduction$ Such #acto"s a"e ca++ed )a"iab+e #acto"s$ On the othe" hand& the"e a"e #acto"s such as ca!ita+ e:ui!ment& #acto"y bui+din & to! mana ement !e"sonne+ that cannot be so "eadi+y )a"ied$ It "e:ui"es a com!a"ati)e+y +on time to make )a"iations in them$ Such #acto"s a"e ca++ed #i0ed #acto"s$ Co""es!ondin to this distinction bet*een )a"iab+e #acto"s and #i0ed #acto"s&

economists distin uish bet*een the sho"t "un and the +on "un$ %he sho"t "un is a !e"iod o# time in *hich out!ut can be inc"eased o" dec"eased by chan in on+y the amount o# )a"iab+e #acto"s such as +abou"& "a* mate"ia+s& chemica+s& etc$ In the sho"t "un& :uantities o# the #i0ed #acto"s such as ca!ita+ e:ui!ment& #acto"y-bui+din etc$& cannot be )a"ied #o" makin chan es in out!ut$ I# the #i"m *ants to inc"ease out!ut in the sho"t "un& it can on+y do so by usin mo"e +abou" and mo"e "a* mate"ia+s& it cannot inc"ease out!ut in the sho"t "un by e0!andin the ca!acity o# its e0istin !+ant bui+din a ne* !+ant *ith a +a" e" ca!acity$ On the othe" hand& the +on "un is de#ined as the !e"iod o# time in *hich the :uantities o# a++ #acto"s may be )a"ied$ In the +on "un& the out!ut can be inc"eased not on+y by usin mo"e :uantities o# +abou" and "a* mate"ia+s but a+so by e0!andin the si3e o# the e0istin !+ant o" by bui+din a ne* !+ant *ith a +a" e" !"oducti)e ca!acity$ It may be noted that the *o"d Z!+antZ in economics stands #o" a co++ection o# #i0ed #acto"s& such as #acto"y bui+din & machine"y insta++ed& the o" anisation "e!"esented by the mana ement and othe" essentia+ ski++ed !e"sonne+$ /i0ed costs a"e a+so kno*n as o)e"head costs and inc+ude cha" es such as cont"actua+ "ent& insu"ance #ee& maintenance costs& !"o!e"ty ta0es& inte"est on the bo""o*ed #unds& minimum administ"ati)e e0!enses such as mana e"Zs sa+a"y& *atchmanZs *a es etc$ %hus #i0ed cost is the cost incu""ed to*a"ds the #i0ed #acto"s o# !"oduction$ ?a"iab+e costs inc+ude !ayments to +abou" em!+oyed& the !"ices o# the "a* mate"ia+& #ue+ and !o*e" used& the e0!ense incu""ed on t"ans!o"tation and the +ike$ I# a #i"m shuts do*n its o!e"ation #o" some time in the sho"t "un& it *i++ not use the )a"iab+e #acto"s o# !"oduction and *i++ not the"e#o"e incu" any )a"iab+e costs$ ?a"iab+e costs a"e a+so ca++ed

H9

!"ime costs o" di"ect costs$ %hus )a"iab+e cost is the cost incu""ed on the )a"iab+e #acto"s o# !"oduction$ %ota+ cost is the sum o# these t*o costs$ %C F %/C O %?C %he sho"t-"un tota+ #i0ed& )a"iab+e and tota+ costs cu")es a"e !o"t"ayed in /i u"e 9$= *he"e out!ut is measu"ed on E-a0is and cost on M-a0is$ Since the tota+ #i0ed cost "emains constant *hate)e" the +e)e+ o# out!ut& the tota+ #i0ed cost cu")e D%/C- is !a"a++e+ to the E-a0is$ It *i++ be seen in the #i u"e that the tota+ #i0ed cost cu")e D%/C- sta"ts #"om a !oint on the y-a0is meanin the"eby that the tota+ #i0ed cost *i++ be incu""ed e)en i# the out!ut is 3e"o$ On the othe" hand& the tota+ )a"iab+e cost cu")e D%?C- "ises u!*a"d sho*in the"eby that as the out!ut inc"eased& the tota+ )a"iab+e cost a+so inc"eases$ %he tota+ )a"iab+e cost cu")e %?C sta"ts #"om the o"i in *hich sho*s that *hen out!ut is 3e"o the )a"iab+e costs a"e a+so ni+$ /i u"e 9$= Sho"t-Run %ota+ /i0ed& ?a"iab+e and %ota+ Costs$

It shou+d be noted that tota+ cost D%C- is #unction o# the tota+ out!ut D:-C the "eate" the out!ut& the "eate" *i++ be the tota+ cost$ In symbo+ *e *"ite %C F # D:-

H<

*e can !"o)e this as #o++o*s: %C F %/C O %?C Su!!ose %/C is e:ua+ to 5& *hich is a constant amount *hate)e" the +e)e+ o# out!ut$ %?C is e:ua+ to the amount used o# the )a"iab+e #acto" say& L& mu+ti!+ied by the i)en !"ice o# the )a"iab+e& say& L& %?C F L$* %C F 5 O L$*$ No*& L$*$& that is& %?C must "ise *ith the inc"ease in out!ut& because on+y by inc"ease in the amount o# )a"iab+e #acto"& that is& by inc"ease in L& that the out!ut can be inc"eased$ /"om the abo)e e:uation it is c+ea" that *ith the inc"ease in L$*$ as out!ut "ises& %C must a+so "ise$ In othe" *o"ds& tota+ cost D%C- is #unction o# tota+ out!ut D:- and )a"ies di"ect+y *ith it$ It *i++ be seen #"om the tab+e that the )e"tica+ distance bet*een the %?C and %C cu")es is constant th"ou hout$ %his is because the )e"tica+ distance bet*een the %?C and %C cu")e "e!"esents the amount o# tota+ #i0ed cost& *hich "emains and chan ed as out!ut is inc"eased in the sho"t "un$ As !e" economic theo"y& its natu"e is such that in the be innin e)entua++y at an inc"easin "ate$ %hus& the inc"ease in tota+ )a"iab+e cost as out!ut oes on

inc"eases& tota+ )a"iab+e cost inc"eases at a dec"easin "ate& then at a constant "ate and inc"easin at the diminishin "ate u! to a ce"tain +e)e+ o# out!ut& then "emains constant #o" some "an e o# out!ut& and then it sta"ts "isin at an inc"easin "ate$ %his is so because the need #o" )a"iab+e #acto" in!uts #o" inc"eased out!ut beha)es in a simi+a" #ashion& and the"e is the o!e"ation o# the +a* o# diminishin "etu"ns$ ;ecause& the "e:ui"ement o# +abou" does not chan e +inea"+y *ith :uantity !"oduced$ Once the out!ut has "eached a "easonab+e +e)e+& the inc"ease in out!ut may become inc"easin +y cost+y because the )a"iab+e #acto" in!uts may not be easi+y a)ai+ab+e o" they may ha)e to be !aid hi he" !"ice than be#o"e$ Met anothe" "eason #o" a non-+inea" tota+ )a"iab+e cost and out!ut "e+ationshi! is the o!e"ation o# the +a* o# diminishin "etu"ns$ Acco"din to this +a* as mo"e and mo"e units o# a )a"iab+e #acto" o# !"oduction a"e used a+on *ith a #i0ed #acto" o# !"oduction& the ma" ina+ !"oduct o# that )a"iab+e #acto" #i"st inc"eased& then "emains constant and #ina++y sta"ts diminishin $

H=

".2.1.2 * erage and Marginal -ost -ur es in the Short Run %he abo)e section desc"ibes the tota+ cost conce!ts and out!ut "e+ationshi!$ In !"actice businessmen and economists& )e"y o#ten& use the costs in the #o"m o# cost !e" unit& o" a)e"a e costs "athe" than tota+s$ ;esides ma" ina+ cost is anothe" im!o"tant conce!t& *hich is bein & )e"y *ide+y used in !"actice$ Im!o"tant a)e"a e cost conce!ts used in the decision-makin a"e A)e"a e /i0ed Cost& A)e"a e ?a"iab+e Cost and A)e"a e %ota+ Coast$ *FER*&E ,I$ED -(S/ ?*,-@: A)e"a e #i0ed cost is the tota+ #i0ed costs di)ided by the numbe" o# units o# out!ut !"oduced$ %he"e#o"eC A/C F %/C A> Lhe"e > "e!"esents numbe" o# units o# out!ut !"oduced$ %hus& the a)e"a e #i0ed cost can be obtained by the di)idin the tota+ #i0ed cost by the +e)e+ o# out!ut$ In the tab+e 9$,& the co+umn @ i)es the a)e"a e #i0ed cost$ Since tota+ #i0ed cost is a constant :uantity DRs$9GGG- a)e"a e #i0ed cost steadi+y #a++s as out!ut inc"eases$ %he"e#o"e& a)e"a e #i0ed cost cu")e& as sho*n in the #i u"e 9$@& s+o!s do*n*a"d th"ou hout its +en th$ As out!ut inc"eases& the tota+ #i0ed cost s!"eads o)e" mo"e and mo"e units and the"e#o"e a)e"a e #i0ed cost become +ess and +ess$ Lhen out!ut becomes )e"y +a" e a)e"a e #i0ed cost a!!"oaches 3e"o$ %he A/C cu")e ets )e"y nea"e" to but ne)e" touches eithe" a0is$ %ab+e 9$,: Di##e"ent Cost Conce!ts >uantity Numbe" o# %ota+ %ota+ %ota+ Cost A / C A?C A%C MC o# Lo"ke"s /i0ed ?a"iab+e Out!ut DLCost Cost D,D.D9D<D=D@-F 9A, DB- F <A, DH- F =A, DI- F [=A[, ,GG ,G 9GGG ,GGG <GGG 9G ,G <G <G .GG ,= 9GGG ,=GG <=GG ,= B$= ..$= = 9GG .9 9GGG .9GG =9GG ,G B$B ,B$B H <GG <G 9GGG <GGG BGGG B$= ,G ,B$= ,B =GG B9 9GGG B9GG ,G9GG @ ,<$@ .G$@ 99

H@

/i u"e 9$@: Re+ationshi! bet*een Out!ut and Di##e"ent Cost Cu")es

*FER*&E F*RI*A:E -(S/ ?*F-@) A)e"a e )a"iab+e cost is the tota+ )a"iab+e cost di)ided by the numbe" o# units out!ut !"oduced$ %he"e#o"eC A?C F %?C A> Lhe"e > "e!"esents the tota+ out!ut !"oduced$ %hus& a)e"a e )a"iab+e cost is )a"iab+e cost !e" unit o# out!ut$ It *i++ be seen that a)e"a e )a"iab+e cost #a++s unti+ .GG units o# out!ut and the"e a#te" it inc"eases$ %he a)e"a e )a"iab+e cost *i++ ene"a++y #a++ as the out!ut inc"eases #"om 3e"o to the no"ma+ ca!acity o# out!ut$ %hen a#te"*a"ds a)e"a e )a"iab+e cost *i++ "ise stee!+y because o# the o!e"ation o# diminishin "etu"ns$ %he a)e"a e )a"iab+e cost cu")e is sho*n in #i u"e 9$@ by the cu")e A?C *hich #i"st #a++s& "eaches minimum and "ises$ *FER*&E /(/*: -(S/ ?*/-@) %he a)e"a e tota+ cost o" *hat is ca++ed sim!+y A)e"a e cost is the tota+ cost di)ided by the numbe" o# units o# out!ut !"oduced$ A%C F %C A> Since the tota+ cost is the sum o# tota+ )a"iab+e cost and tota+ #i0ed cost& the a)e"a e tota+ cost is a+so the sum o# a)e"a e )a"iab+e cost and a)e"a e #i0ed cost$ %his can be !"o)ed as #o++o*s: A%C F %C A > Since %C F %?C O %/C HB

%he"e#o"e& A%C F D%?C O%/C-A> o" A?C O A/C It *i++ be seen #"om tab+e 9$, that as out!ut inc"eases& in the initia+ sta es& that is& unti+ <GG units o# out!ut !"oduced a)e"a e tota+ cost #a++s and the"ea#te" it is "isin $ %his im!e+s that sho"t "un A%C *i++ ha)e a U - sha!e& *hich is sho*n in #i u"e 9$@$ %he beha)io" o# the a)e"a e tota+ cost cu")e *i++ de!end u!on the beha)io" o# the a)e"a e )a"iab+e cost cu")e and a)e"a e #i0ed cost cu")e$ In the be innin & both A?C and A/C cu")es #a++& the A%C cu")e the"e#o"e #a++s sha"!+y in the be innin $ Lhen A?C cu")e be ins "isin & but A/C cu")e is #a++in stee!+y& the A%C continues to #a++$ %his is because du"in this sta e the #a++s in A/C cu")e *ei hs mo"e than the "ise in the A?C cu")e$ ;ut as out!ut inc"eases #u"the"& the"e is a sha"! "ise in A?C& *hich mo"e than o##sets the #a++ in A/C$ %he"e#o"e& the A%C cu")e "ises a#te" a !oint$ %he"e#o"e& A%C +ike the A?C cu")e #i"st #a++s& "eaches its minimum )a+ue and then "ises$ %he A%C is& the"e#o"e& a+most o# a ZUZ sha!ed$ M*R&IN*: -(S/ ?M-@) %he conce!t o# ma" ina+ cost occu!ies an im!o"tant !+ace in the economic theo"y$ Ma" ina+ cost is an addition made to the tota+ cost by !"oducin an additiona+ unit o# out!ut$ In othe" *o"ds& ma" ina+ cost is the addition to the tota+ cost o# !"oducin ZnZ units instead o# n-, units Di$e$& one +ess-$ Lhe"e n is any i)en numbe"$ It can be *"itten asC MCn F %Cn - %Cn-, %his #o"mu+a is suitab+e *hen the out!ut data a)ai+ab+e in indi)idua+ units$ Lhen the out!ut data is in the a "e ate #o"m MC cou+d be obtained #o"m the a+te"nati)e #o"mu+a$ Since ma" ina+ cost is a chan e in tota+ cost as a "esu+t o# a unit chan e in out!ut& it can a+so be *"itten as: MCF [%CA[> Lhe"e [%C "e!"esents a chan e in tota+ cost and [> "e!"esents chan e in the out!ut$ In the tab+e 9$, *hen out!ut inc"ease #o"m ,GG units to .GG units the tota+ cost inc"eased #o"m "u!ees <GGG to <=GG$ 7e"e chan e in :uantity o# out!ut D[>- is ,GG units and simi+a"+y chan e in tota+ cost is "u!ees =GG$ %he"e#o"eC MC F =GGA,GG F =

HH

Like othe" a)e"a e cost cu")e& Ma" ina+ Cost cu")e a+so #a++s in the be innin and then inc"ease continuous+y$ Le can #ind some inte"estin "e+ationshi! bet*een a)e"a e cost and ma" ina+ cost$ Lhen ma" ina+ cost is be+o* the a)e"a e cost a)e"a e cost is #a++in $ Lhen MC is abo)e the AC a)e"a e cost is inc"easin $ Simi+a"+y *hen MC F AC +atte" is at its minimum !oint$ It is *o"th to "eca++ the #act #"om +a*s o# "etu"ns$ Ma" ina+ !"oducti)ity cu")e inte"sect the a)e"a e !"oducti)ity cu")e #"om the abo)e$ Lhen a)e"a e !"oducti)ity is e:ua+ to ma" ina+ !"oducti)ity& a)e"a e !"oducti)ity is at its ma0imum !oint$ 8"oducti)ity and cost mo)es in the o!!osite di"ection$ %he"e#o"e *e can #ind such a "e+ationshi! bet*een AC and MC$ ".2.2 -ost (utput Relationship in the :ong Run %he +on "un& as a+"eady e0!+ained abo)e& "e#e"s to time !e"iod du"in *hich #u++ ad4ustment cou+d be made th"ou h )a"yin a++ in!uts inc+udin ca!ita+ e:ui!ment and #acto"y bui+din $ In the +on "un& the"e#o"e& the"e is no #i0ed #acto" o# !"oduction and hence the"e is no #i0ed cost$ %he +on "un tota+ cost #unction *i++ be o# the #o++o*in #o"m: %C F # D0& kLhe"e k stands #o" the !+ant si3e and 0 stand #o" the out!ut +e)e+$ As k chan es& %C a+so chan es$ %hus& the abo)e-mentioned +on -"un cost #unction contains a #ami+y o# sho"t-"un cost #unctions& one #o" each )a+ue o# k$ It is im!o"tant to note that a++ !"oduction is done in the sho"t "un du"in *hich the !+ant si3e is i)en$ %hus& +on "un consists o# a++ !ossib+e sho"t "un situations amon *hich the #i"m has to choose to !"oduce a ta" et +e)e+ o# out!ut$ In the sho"t "un the #i"m tied *ith a i)en !+ant *he"eas in the +on "un the #i"m mo)es #o"m one !+ant si3e to anothe"C the #i"m can make a +a" e !+ant i# it has to inc"ease its out!ut +e)e+ and a sma++ !+ant i# it has to "educe its out!ut$ %he"e#o"e& the +on "un a)e"a e cost cu")e de!icts the +east !ossib+e a)e"a e cost #o" !"oducin )a"ious +e)e+s o# out!ut$ In o"de" to unde"stand ho* the +on "un a)e"a e cost is de"i)ed& conside" the th"ee sho"t "un a)e"a e cost cu")e as sho*n in the #i u"e 9$B %he sho"t "un a)e"a e cost cu")es a"e a+so ca++ed !+ant cu")es because in the sho"t "un !+ant si3e is #i0ed and each o# the sho"t "un a)e"a e cost cu")e co""es!ond to a !a"ticu+a" !+ant$ SAC,& SAC. and SAC9 sho*s the di##e"ent !+ant si3e and the !"oduce"& in HI

the +on "un& cou+d choose any o# these !+ant si3e acco"din to his "e:ui"ement$ It is c+ea" #o"m the #i u"e that u! to O; amount o# out!ut& the #i"m *i++ o!e"ate on the SAC, thou h it cou+d a+so !"oduce *ith SAC. because u! to O; amount o# out!ut& !"oduction on SAC, cu")e entit+es +o*e" cost than on the SAC.$ /o" instance& i# the +e)e+ o# out!ut OA is !"oduced *ith SAC, it *i++ cost AL !e" unit and i# it is !"oduced *ith SAC. it *i++ cost A7 !e" unit$ Ob)ious+y AL is sma++e" than A7$ Simi+a"+y a++ othe" out!ut +e)e+s u! to O; can be !"oduced mo"e economica++y *ith sma++e" !+ant SAC, than *ith +a" e" !+ant SAC.$ %o !"oduce e0act+y O; +e)e+ o# out!ut a)e"a e cost is same on both the !+ant si3e unde" such ci"cumstances it is "ationa+ to choose SAC. because it contains "ese")ed ca!acity at that +e)e+$ I# the #i"m *ants to !"oduce an out!ut& *hich is e:ua+ to o" +a" e" than O;& then it *i++ be economica+ to !"oduce on SAC.$ 8+ant si3e SAC, is suitab+e si3e to !"oduce the O; +e)e+ o# out!ut to OD +e)e+ o# out!ut$ I# the #i"m #u"the" *ants to !"oduce the out!ut beyond the OD +e)e+ then the #i"m needs to #u"the" e0!and its si3e$ /i u"e 9$B: Sho"t Run A)e"a e Cost Cu")e #o" Di##e"ent 8+ant Si3e$

%hus& In the +on "un the #i"m has a choice in the em!+oyment o# a !+ant& and it *i++ em!+oy that !+ant *hich yie+d minimum !ossib+e unit cost #o" !"oducin a i)en out!ut$ %he +on "un a)e"a e cost cu")e de!icts the +east !ossib+e a)e"a e cost #o" !"oducin )a"ious +e)e+s o# out !ut *hen a++ the in!uts inc+udin the !+ant si3e is )a"iab+e$ IG

I# the out!ut is sma++& the tota+ cost is +ess #o" a sma++ !+ant si3e than #o" a +a" e !+ant si3e and :uite the "e)e"se ho+ds ood #o" +a" e out!uts$ %his is so because i# a +a" e !+ant is insta++ed it *i++ "emain unde"-uti+i3ed *hen out!ut is sma++ *hi+e a sma++ !+ant *i++ be inade:uate o" insu##icient #o" +a" e out!uts$ %hus& the #ami+y o# sho"t-"un tota+ cost cu")es& one #o" each !+ant si3e& *i++ be o# the ty!e sho*n in /i u"e 9$H$ /i u"e 9$H: Lon Run A)e"a e Cost Cu")e

In any case& the"e my be in#inite numbe" o# shot "un a)e"a e cost cu")es$ %he Lon Run A)e"a e Cost DLAC- cu")e is to d"a* in such a *ay as to tan ent to each o# the sho"t "un a)e"a e cost cu")es$ %he"e#o"e& the +on "un a)e"a e cost cu")e is a+so ca++ed envelope because it su!!o"ts a #ami+y o# sho"t "un a)e"a e cost cu")es$ Since an in#inite numbe" o# sho"t "un a)e"a e cost cu")es a"e assumed& e)e"y !oint on the +on "un a)e"a e cost cu")e *i++ be tan ency !oint *ith some sho"t "un a)e"a e cost cu")e$ In #act& +on "un a)e"a e cost cu")e is nothin e+se but the +ouses o# a++ these tan ency !oints$ I# a #i"m desi"es to !"oduce a !a"ticu+a" out!ut in the +on "un& it *i++ !ick a !oint on the +on "un a)e"a e cost cu")e co""es!ondin to that out!ut and it *i++ then bui+d a "e+e)ant !+ant

I,

and o!e"ate on the co""es!ondin shot "un a)e"a e cost cu")e$ In this e0am!+e !+ant si3e indicated by SAC< is an o!timum !+ant si3e because the minimum !oint o# this cu"e tan ent the minimum !oint o# the LAC cu")e$ ".2." Modern Fiews on -ost (utput Relationship %he U sha!ed cost cu")es o# the t"aditiona+ theo"y ha)e been :uestioned by )a"ious *"ite"s both on theo"etica+ a priori and on em!i"ica+ "ounds$ As ea"+y as ,I9I Geo" e Sti +e" su ested that the sho"t "un a)e"a e )a"iab+e cost has a #+at st"etch o)e" a "an e o# out!ut& *hich "e#+ects the #act that #i"ms bui+d !+ant *ith some #+e0ibi+ity in thei" !"oducti)e ca!acity$ In the mode"n days !+ants& ene"a++y& *i++ ha)e a ca!acity +a" e" than the e0!ected a)e"a e +e)e+ o# sa+es& as o" ani3ations desi"e to ha)e some "ese")ed ca!acity$ %hus& the sho"t "un a)e"a e )a"iab+e cost in the mode"n )e"sion has a sauce" ty!e sha!e$ %hat is it is b"oad+y U sha!ed but has a #+at st"etch o)e" a "an e o# out!ut$ %he sha!e o# the +on "un cost cu")e has att"acted "eate" attention in economic +ite"atu"e& due to the se"ious !o+icy im!+ications o# the economies o# +a" e-sca+e !"oduction$ Acco"din to the mode"n theo"y +on "un a)e"a e cost cu")e is L sha!ed$ Se)e"a+ "easons ha)e been !ut #o"*a"d to e0!+ain the *hy +on "un cost cu")e is L sha!ed "athe" than U sha!ed$ It has been a" ued that mana e"ia+ diseconomies can be a)oided by the im!"o)ed method o# mode"n mana ement sciences$

".6. Self Re iew 8uestions

,$ .$ 9$ <$ =$ @$ B$ H De#ine !"oduction #unction Lhat is Iso:uant6 De#ine iso-cost +ine *ith suitab+e e0am!+e Distin uish bet*een +a*s o# "etu"ns and +a*s o# "etu"ns to sca+e Distin uish bet*een #i0ed cost and )a"iab+e cost Mention dete"minants o# cost$ Mention the !"oduction decision !"ob+ems$ E0!+ain the a!!+ication o# C"itica++y e0amine the im!o"tance o# iso:uant and iso-cost cu")e in the

!"oduction #unction ana+ysis in so+)in these !"ob+ems$ mana e"ia+ decision makin !"ocess$

I.

I$ E0!+ain the mana e"ia+ uses o# cost out!ut "e+ationshi!$ ,G$ E0!+ain /i0ed Cost D/C-& %ota+ ?a"iab+e Cost D%?C-& %ota+ Cost D%C-& A)e"a e /i0ed Cost DA/C-& A)e"a e Cost DAC- and Ma" ina+ Cost DMC- and com!+ete the #o++o*in tab+e Units o# /C Out!ut G ,G .G 9G <G =G @G BG %?C .GGG .GGG G ,<GG 9H@G .GGG .GGG ..GG .HGG =GGG =HGG BGGG ,G= @G ,GG %C A/C .GGG $$$ .HGG ,GG <@ A?C $$$ AC $$$ MC $$$ HG

9$I$

Re#e"encesA Su

ested Readin s

,$ 5outsoyiannis& A$: 1Mode"n Mic"o Economics2& EL;S Lith Macmi++an& 7on 5on $ .$ Mote& ?$ L$& Samue+ 8au+& Gu!ta&G$ S: 1 Mana e"ia+ Economics: Conce!ts and Cases2& %ata McG"a*-7i++ 8ub+ishin Com!any Limited& Ne* De+hi 9$ D$M$Mithani : 1Mana e"ia+ Economics: %heo"y and A!!+ications2& 7ima+aya 8ub+ishin 7ouse& Mumbai-<GG GG< <$ C"ai 8ete"sen$ 7& and C"is Le*is$L: 1 Mana e"ia+ Economics2& Ma0*e++ Macmi++an Inte"nationa+ editions& Ne* Mo"k =$ Dominick Sa+)ato"e: 1Mana e"ia+ Economics2& McG"a*-7i++ Inte"nationa+ Editions& Sin a!o"e @$ Ahu4a& 7$ L$: 1Ad)anced Economic %heo"y2& S$Chand N Com!any Ltd$ Ne* De+hi,,G G== B$ Khin an& M$L$: 1Ad)anced Economic %heo"y2& ?"inda 8ub+ications D8- L%D&De+hi-,,G GI, H$ ?a"shney RL& and Mahesh*a"i 5$L: 1Mana e"ia+ Economics2& Su+tan Chand N Sons& Ne* De+hi-,,GGG.

I9

MODULE-I?:

MAR5E% S%RUC%URE AND 8RICE DE%ERMINA%ION

Dete"mination o# !"ice is an im!o"tant mana e"ia+ #unction in a++ kinds o# business o" ani3ations$ 8"ecedin cha!te"s desc"ibed the demand and su!!+y o# oods and se")ices$ %his cha!te" b"in s these issues to ethe" in o"de" to desc"ibe the dete"mination o# the !"ice o# oods and se")ices$ It dea+s *ith the meanin and ty!es o# ma"ket and theo"etica+ ma"ket mode+s o# !"ice and out!ut dete"mination$ %he +ast section o# this cha!te" desc"ibes the !"icin method in !"actice$

#.1 Meaning of Mar=et

# )arket is an institutional arrangement under which buyers and sellers can e"change some 2uantity of goods and services at mutually agreeable prices $ A ma"ket can& but need not& be a s!eci#ied !+ace o" +ocation *he"e buye"s and se++e"s actua++y come #ace to #ace #o" the !u"!ose o# t"ansactin thei" business$ /o" e0am!+e 5$ R$ Ma"ket in ;an a+o"e is +ocated in !a"ticu+a" +ocation$ On the othe" hand& the ma"ket #o" mana ement #acu+ty has no s!eci#ic +ocationC "athe" it "e#e"s to the enti"e #o"ma+ and in#o"ma+ net*o"k on teachin o!!o"tunity th"ou hout the nation. In other words market can be described as an arrangement whereby buyers and sellers come in close contact with each other directly or indirectly to sell and buy goods or service at mutually agreeable prices. %he"e#o"e& ma"ket may be !hysica++y identi#iab+e e$ $ 5$ R$ Ma"ket in ;an a+o"e$ ;ut conce!t o# ma"ket does not "e#e" on+y to a #i0ed +ocation$ Lhat is needed #o" a ma"ket is a "ou! o# !otentia+ se++e"s and buye"s a"e in c+ose contact *ith each othe" th"ou h any means so that t"ansaction !"ocesses take !+ace$ Ma"ket& thus& "e#e"s to the conditions and comme"cia+ "e+ationshi!s #aci+itatin the t"ansaction bet*een buye"s and se++e"s$

#.2 /.pes of Mar=ets

Ma"kets may be c+assi#ied on the basis o# eo "a!hica+ a"ea& time e+ement and com!etition$ O# a++ the c"ite"ia used #o" the c+assi#ication o# the ma"ket com!etition is most im!o"tant #"om the mana ement decision !oint o# )ie*$ On+y a !assin "e#e"ence is i)en about the ma"ket c+assi#ication based on the othe" t*o c"ite"ia$ Ma"ket c+assi#ication based on the com!etition is e0!+ained unde" the headin ma"ket st"uctu"e$

I<

;ased on the

eo "a!hica+ a"ea ma"kets cou+d be c+assi#ied into Loca+

ma"kets& Re iona+ ma"kets& nationa+ ma"ket and *o"+d ma"ket$ Loca+ ma"ket has a na""o* eo "a!hica+ co)e"a e$ It is con#ined to a !a"ticu+a" )i++a e& to*n o" city on+y$ 8e"ishab+e oods +ike mi+k& )e etab+e& #"uits& etc$ a"e ene"a++y t"aded in +oca+ ma"kets$ Goods o" se")ices& *hich ha)e the "e iona+ im!o"tance& *i++ be t"aded in "e iona+ ma"kets$ 5annada #i+ms ha)e *ide ma"ket in 5a"nataka because it is the +an ua e o# this "e ion$ Lhen oods a"e demanded and so+d on a nation *ide sca+e& such oods said to ac:ui"e the nationa+ ma"ket$ Same is the case *ith the *o"+d ma"ket$ ;ased on the time e+ement ma"ket cou+d be c+assi#ied into ma"ket !e"iod& sho"t !e"iod and +on !e"iod$ %he ma"ket !e"iod is "e a"ded as a )e"y sho"t !e"iod du"in *hich it !hysica++y im!ossib+e to chan e the stock o# the commodity$ In this !e"iod it is not !ossib+e to make any ad4ustment in the su!!+y to the chan in demand condition$ Simi+a"+y the sho"t !e"iod is a time !e"iod du"in *hich it is !ossib+e #o" a #i"m to e0!and out!ut by usin mo"e o# )a"iab+e in!uts but not the #i0ed #acto"s o# !"oduction$ In this time !e"iod #i"ms cou+d make some ad4ustment in the su!!+y acco"din to the chan in demand condition$ %he +on !e"iod "e#e"s to a time !e"iod du"in *hich #i"m cou+d ad4ust its sca+e o# !"oduction in o"de" to meet the chan in demand condition$ In the +on "un #i"ms cou+d ad4ust thei" su!!+y in the chan in demand condition$ #.2.1 Mar=et Structures) %he natu"e o# com!etition in ma"ket de!ends on the numbe" o# !a"tici!ants in the ma"ket and natu"e o# commodity& *hich to ethe" dete"mine the e0tent o# ma"ket cont"o+ o# each !a"tici!ant$ 8e"#ect com!etition "e!"esents the benchma"k ma"ket st"uctu"e that contains a +a" e numbe" o# !a"tici!ants on both sides o# the ma"ket& and no ma"ket cont"o+ by any #i"m$ %h"ee ma"ket st"uctu"e mode+s *ith )a"yin de "ees o# ma"ket cont"o+ on the su!!+y side o# the ma"ket a"e: mono!o+y& mono!o+istic com!etition& and o+i o!o+y Dtab+e <$,-$ %h"ee +esse"-kno*n ma"ket st"uctu"es *ith

I=

)a"yin de "ees o# ma"ket cont"o+ on the demand side o# the ma"ket a"e: mono!sony& o+i o!sony& and mono!sonistic com!etition$ %ab+e <$,$ C+assi#ication o# Ma"kets D;ased on Com!etition-$
5ind o# Com!etition Numbe" o# #i"ms Natu"e o# 8"oducts De "ee o# cont"o+ o)e" !"ice 8a"t o# economy *he"e !"e)a+ent

Perfect -ompetition
8e"#ect Com!etition La" e numbe" 7omo eneous None A #e* a "icu+tu"a+ !"oducts

Imperfect competition
Mono!o+istic Com!etition O+i o!o+y 8u"e La" e numbe" /e* Di##e"entiated but c+ose substitutes 7omo eneous Di##e"entiated Uni:ue Some Some Some
Conside"ab+e

%ooth !aste& soa! etc$ Stee+& A+uminum Automobi+es A #e* uti+ities !ub+ic

Di##e"entiated/e* Mono!o+y One

#.2.2. Suppl.1Side Mar=et Structures %he st"uctu"e o# a Ma"ket !"ima"i+y de!ends on the numbe" o# #i"ms o!e"atin in the ma"ket$ 8e"#ect Com!etition is the theo"etica+ benchma"k o# e##iciency achie)ed because +a" e numbe" o# !a"tici!ants in the ma"ket i)es neithe" buye"s no" se++e"s ma"ket cont"o+$ Othe" ma"ket st"uctu"es ha)e di##e"ent amounts o# ma"ket cont"o+ due to di##e"ent numbe"s o# com!etito"s$ In ?a"yin ene"a+& mo"e com!etition means +ess ma"ket cont"o+$ se++e"s ene"ate th"ee a+te"nati)e ma"ket de "ees o# ma"ket cont"o+ amon

st"uctu"es )i3$ Mono!o+y& Mono!o+istic com!etition and O+i o!o+y$ Perfect 'ompetition: 8e"#ect com!etition is an idea+ ma"ket st"uctu"e cha"acte"i3ed by a +a" e numbe" o# !a"tici!ants on both sides o# the ma"ket$ %he !"oduct so+d by each #i"m in the ma"ket is identica+ to that so+d by e)e"y othe" #i"m$ ;uye"s and se++e"s ha)e com!+ete #"eedom o# ent"y into and e0it out o# the indust"y& and !e"#ect kno*+ed e o# !"ices and techno+o y$ 8e"#ect com!etition is an idea+i3ed ma"ket st"uctu"e that is not obse")ed in its !u"est #o"m in the "ea+

I@

*o"+d$ 7o*e)e"& some o# the a "icu+tu"a+ !"oducts !ossess main #eatu"e o# !e"#ect com!etition ma"ket$ Lhi+e un"ea+istic& its !"ima"y #unction is to !"o)ide a benchma"k that can be used to ana+y3e "ea+ *o"+d ma"ket st"uctu"es$ In !a"ticu+a"& !e"#ect com!etition e##icient+y a++ocates "esou"ces$ It does this by e0chan in the :uantity o# oods that e:uate !"ice and ma" ina+ cost$ Lith a +a" e numbe" o# !a"tici!ants& both buye"s and se++e"s a"e !"ice take"s$ Indi)idua+ !a"tici!ants must e0chan e oods at the ma"ket !"ice and none can in#+uence the ma"ket in any *ay$ /o" this "eason& the demand !"ice buye"s a"e *i++in to !ay& based on the satis#action "ecei)ed& is e:ua+ to the su!!+y that se++e"s a"e *i++in to acce!t& based on the o!!o"tunity cost o# !"oduction$ )onopoly: Mono!o+y& cha"acte"i3ed by a sin +e com!etito" and com!+ete

cont"o+ o# the su!!+y side o# the ma"ket$ Mono!o+y contains a sin +e se++e" o# a uni:ue !"oduct *ith no c+ose substitutes$ %he demand #o" mono!o+y out!ut is the ma"ket demand$ Mono!o+y is the *o"st-case scena"io o# ine##iciency on the se++in side o# the ma"ket and thus is o#ten sub4ect to o)e"nment "e u+ation$ )onopolistic 'ompetition: Mono!o+istic com!etition "esidin c+ose" to

!e"#ect com!etition$ It cha"acte"i3ed by a +a" e numbe" o# "e+ati)e+y sma++ com!etito"s& each *ith a modest de "ee o# ma"ket cont"o+ on the su!!+y side$ A key #eatu"e o# mono!o+istic com!etition is !"oduct di##e"entiation$ %he out!ut o# each !"oduce" is a c+ose but not !e"#ect substitute to that o# e)e"y othe" #i"m& *hich he+!s satis#y di)e"se consume" *ants and needs$ Lhi+e ma"ket cont"o+ a+*ays means ine##iciency& mono!o+istic com!etition is not a se"ious o##ende"$ .ligopoly& O+i o!o+y is c+ose" to mono!o+y$ It cha"acte"i3ed by a sma++

numbe" o# "e+ati)e+y +a" e com!etito"s& each *ith substantia+ ma"ket cont"o+$ O+i o!o+y se++e"s e0hibit inte"de!endent decision-makin & *hich can +ead to intense com!etition and the moti)ation to coo!e"ate th"ou h me" e"s and co++usion$ O+i o!o+y tends to ha)e se"ious ine##iciency !"ob+ems& but a+so !"o)ides the bene#its o# inno)ation and +a" e-sca+e !"oduction$ /u"the"& It cou+d

IB

be c+assi#ied into t*o kinds& based on the natu"e o# commodity )i3$ 8u"e O+i o!o+y and Di##e"entiated O+i o!o+y$ ;esides these #ou" ma"kets& t*o othe" ma"ket st"uctu"es that tend to a!!ea" in the ana+ysis o# !"oduct and #acto" ma"kets a"e duo!o+y and bi+ate"a+ mono!o+y$ $uopoly: %his is a s!ecia+ ty!e o# o+i o!o+y that contains t*o #i"ms$ Lhi+e the duo!o+y ma"ket st"uctu"e can and does e0ist in the "ea+ *o"+d& it is !e"ha!s most im!o"tant as a too+ used to ana+y3e o+i o!o+y$ (ilateral )onopoly: %his is a ma"ket containin one se++e" and one buye"$ side$ %his ma"ket st"uctu"e !"o)ides a "eat dea+ o# insi ht into

In e##ect& it is the me" e" o# mono!o+y #"om the se++in side *ith mono!sony #"om the buyin unioni3ed +abo" ma"kets& *he"e the em!+oye" is the sin +e mono!sony buye" and the +abo" union "e!"esents the mono!o+y se++e"$ #.2.". Demand1Side Mar=et Structures Lhi+e the #ocus o# ma"ket st"uctu"es usua++y #a++s on the su!!+y-side o# ma"kets& )a"yin de "ees o# ma"ket cont"o+ on the demand side ene"ate th"ee additiona+ ma"ket st"uctu"es )i3$ Mono!sony& Mono!sonistic Com!etition and O+i o!sony$ )onopsony& Mono!sony cha"acte"i3ed by a sin +e com!etito" and com!+ete cont"o+ o# the demand side o# the ma"ket$ Mono!sony contains a sin +e buye" in the ma"ket and "e!"esents the demand-side counte"!a"t to mono!o+y on the su!!+y side$ %he su!!+y #acin a mono!sony is the ma"ket su!!+y$ Mono!sony is the *o"st-case scena"io o# ine##iciency on the buyin side o# the ma"ket$ )onopsonistic 'ompetition: Mono!sonistic com!etition cha"acte"i3ed by

a +a" e numbe" o# "e+ati)e+y sma++ com!etito"s& each *ith a modest de "ee o# ma"ket cont"o+ on the demand side$ Mono!sonistic com!etition "e!"esents the demand-side counte"!a"t to mono!o+istic com!etition on the su!!+y side$ A key #eatu"e o# mono!sonistic com!etition is !"oduct di##e"entiation as each buye" seeks to !u"chase a s+i ht+y di##e"ent !"oduct$ Lhi+e ma"ket cont"o+ IH

a+*ays means ine##iciency& mono!sonistic com!etition is not a se"ious o##ende"$ Mono!sonistica++y com!etiti)e buye"s a"e o#ten on the othe" side o# a ma"ket containin mono!o+istica++y com!etiti)e se++e"s$ .ligopsony: O+i o!sony cha"acte"i3ed by a sma++ numbe" o# "e+ati)e+y

+a" e com!etito"s& each *ith substantia+ ma"ket cont"o+$ O+i o!sony "e!"esents the demand-side counte"!a"t to O+i o!o+y on the su!!+y side$ O+i o!sony buye"s& +ike thei" o+i o!o+y counte"!a"ts& e0hibit inte"de!endent decisionmakin & *hich can +ead to intense com!etition and the moti)ation to coo!e"ate$ O+i o!sony tends to ha)e se"ious ine##iciency !"ob+ems$ It is a+so c+ea" #"om the abo)e demand side ma"ket st"uctu"es that& as the numbe" o# !a"tici!ants on the demand side o# the ma"ket inc"eases ma"ket cont"o+ dec"eases$

#.". Perfect -ompetition

%his is one o# #ou" basic ma"ket st"uctu"es$ It cha"acte"i3ed by a +a" e numbe" o# sma++ #i"ms& !"oducin and se++in homo eneous !"oducts& *ithout any "est"iction o# ent"y into and e0it out o# the indust"y& and !e"#ect kno*+ed e o# !"ices$ It is an idea+i3ed ma"ket$ In the st"ict sense o# the te"m it is not obse")ed in the "ea+ *o"+d$ Lhi+e un"ea+istic& it does !"o)ide an e0ce++ent benchma"k that can be used to ana+y3e "ea+ *o"+d ma"ket st"uctu"es$ In !a"ticu+a"& !e"#ect com!etition e##icient+y a++ocates "esou"ces$ Some im!o"tant cha"acte"istic #eatu"es o# this ma"ket st"uctu"e a"e discussed he"eunde"$

#.".1 -haracteristics of Perfect -ompetition %he #ou" cha"acte"istics o# !e"#ect com!etition a"e: D,- +a" e numbe" o# sma++ #i"ms& D.- identica+ !"oducts& D9- !e"#ect "esou"ce mobi+ity& and D<- !e"#ect kno*+ed e$ +arge 1umber of Small ,irms: A !e"#ect+y com!etiti)e indust"y contains a

+a" e numbe" o# sma++ #i"ms& each o# *hich is "e+ati)e+y sma++ com!a"ed to the o)e"a++ si3e o# the ma"ket$ It ensu"es that no sin +e #i"m can in#+uence ma"ket !"ice o" :uantity$ I# one #i"m decides to doub+e its out!ut o" sto! !"oducin II

enti"e+y& the ma"ket is una##ected$ %he !"ice does not chan e and the"e *i++ be no chan e in the :uantity e0chan ed in the ma"ket$ Identical Products: Each #i"m in a !e"#ect+y com!etiti)e ma"ket se++s an oods$Y %he essentia+

identica+ !"oduct& *hat is o#ten te"med Yhomo eneous

#eatu"e o# this cha"acte"istic is not so much that the oods themse+)es a"e e0act+y& !e"#ect+y the same& but that buye"s a"e unab+e to #ind any di##e"ence$ In !a"ticu+a"& buye"s cannot te++ *hich #i"m !"oduces a i)en !"oduct$ %he"e a"e no b"and names o" distin uishin #eatu"es that di##e"entiate !"oducts$ ,reedom of entry and e"it& 8e"#ect+y com!etiti)e #i"ms a"e #"ee to ente"

and e0it an indust"y$ Go)e"nment "u+es and "e u+ations o" othe" ba""ie"s do not "est"ict the #i"ms$ Like*ise& a !e"#ect+y com!etiti)e #i"m is not !"e)ented #"om +ea)in an indust"y$ Perfect 3nowledge: In !e"#ect com!etition& buye"s a"e com!+ete+y a*a"e

o# se++e"sZ !"ices& such that one #i"m cannot se++ its ood at a hi he" !"ice than othe" #i"ms$ Each se++e" a+so has com!+ete in#o"mation about the !"ices cha" ed by othe" se++e"s$ So& they do not inad)e"tent+y cha" e +ess than the oin ma"ket !"ice$ A++ !e"#ect+y com!etiti)e #i"ms ha)e access to the same !"oduction techni:ues$ No #i"m can !"oduce its ood #aste"& bette"& o" chea!e" because o# s!ecia+ kno*+ed e o# in#o"mation$ #.".1.1 Pure Fersus Perfect -ompetition -ompetition is c+assi#ied into Pure and Perfect competition$ %he ma"ket is said to be !u"e com!etition i# it !ossess on+y #i"st th"ee conditions$ Cont"a"y to it& the ma"ket is conside"ed to be !u"e com!etition i# it !ossesses the si0 conditions +isted be+o*$ i- %he"e a"e +a" e numbe" o# buye"s and se++e"s ii- Goods !"oduced and so+d a"e homo eneous iii- %he"e is /"ee Ent"y o" E0it #o" any !"oduce" o" se++e" i)- 8e"#ect kno*+ed e on the !a"t o# the buye"s and se++e"s about ma"ket conditions

,GG

)- 8e"#ect mobi+ity o# the #acto"s o# !"oduction& and )i- 8"o0imity to the ma"ketA no e0t"a t"ans!o"t cost #.".2. Demand and Re enue -ur e of a Perfect -ompetiti e ,irm. %he conditions o# !e"#ect com!etiti)e ma"ket ensu"es that a sin +e !"ice must !"e)ai+ unde" !e"#ect com!etition and the demand cu")e Do" a)e"a e "e)enue cu")e- #aced by an indi)idua+ #i"m is !e"#ect+y e+astic at the "u+in !"ice in the ma"ket$ %hat is a !e"#ect+y com!etiti)e #i"m #aces a ho"i3onta+ demand cu")e$ It si ni#ies that the #i"m does not e0e"cise any cont"o+ o)e" the !"ice o# the !"oduct$ Each #i"m in a !e"#ect+y com!etiti)e ma"ket is a !"ice take" and can se++ a++ o# the out!ut that it *ants at the oin ma"ket !"ice$ A #i"m is ab+e to do this because it is a "e+ati)e+y sma++ !a"t o# the ma"ket and its out!ut is identica+ to that o# e)e"y othe" #i"m$ As a !"ice take"& the #i"m has no abi+ity to cha" e a hi he" !"ice and no "eason to cha" e a +o*e" one$ It can se++ a++ o# the out!ut it *ants at the oin ma"ket !"iceC hence& it has no "eason to cha" e +ess$ I# it t"ies to cha" e mo"e than the oin ma"ket !"ice& then buye"s can sim!+y buy out!ut #"om any o# the +a" e numbe" o# !e"#ect substitutes !"oduced by othe" #i"ms$ ;ecause the !"ice #aced by a !e"#ect+y com!etiti)e #i"m is un"e+ated to the :uantity o# out!ut !"oduced and so+d& this !"ice is a+so e:ua+ to the ma" ina+ "e)enue and a)e"a e "e)enue ene"ated by the #i"m$ I# a #i"m is ab+e to se++ any :uantity o# out!ut at the ma"ket !"ice& then the a)e"a e "e)enue& "e)enue !e" unit so+d& is a+so e:ua+ to ma"ket !"ice$ It cou+d be e0!+ained *ith the he+! o# the #i u"e <$,$ In the !e"#ect com!etiti)e ma"ket& ma"ket !"ice dete"mined by the ma"ket demand and ma"ket su!!+y cu")es$ In the #i u"e D<$, A-& Ma"ket !"ice DO8- dete"mined by the Ma"ket demand DDD- and ma"ket su!!+y cu")e DSS- at !oint E$ At this ma"ket !"ice +e)e+ an indi)idua+ #i"m cou+d se++ any amount o# the commodity$ %he"e#o"e& the demand cu")e Do" a)e"a e "e)enue cu")e- #o" an indi)idua+ #i"m is ho"i3onta+ to OE a0is$ At O8 ma"ket !"ice& 8 ARFMR is the demand cu")e #o" an indi)idua+ #i"m Din the !ane+ ; o# the #i u"e-$ Since& the #i"m cou+d se++ any amount o# commodity at the e0istin ma"ket !"ice its demand cu")e DAR cu")e- is ho"i3onta+ to OE a0is$ Lhen AR cu")e is ho"i3onta+ to OE a0is natu"a++y AR is e:ua+ to MR$ Since demand cu")e is ho"i3onta+ to OE a0is an

,G,

indi)idua+ #i"m cou+d not cha" e the !"ice mo"e than the ma"ket !"ice +e)e+$ Ma"ket !"ice *i++ inc"ease on+y i# the"e is u!*a"d shi#t in the ma"ket demand cu")e$ An indi)idua+ #i"m cou+d se++ its !"oduct at the hi he" !"ice on+y i# the"e is inc"ease in the ma"ket !"ice +e)e+$

/i u"e <$,$ Demand Cu")e o# a 8e"#ect Com!etiti)e /i"m$

#."." Price and (utput Determination under Perfect -ompetiti e Mar=et. 8"ice and out!ut dete"mination unde" !e"#ect com!etiti)e ma"ket in the sho"t "un is :uite di##e"ent #"om that in the +on "un$ %he"e#o"e a se!a"ate ana+ysis has been made #o" these time !e"iods$ As a+"eady e0!+ained in the !"ecedin cha!te"s& the sho"t "un means a !e"iod o# time *ithin *hich the #i"ms can a+te" thei" +e)e+ o# out!ut on+y by )a"yin the +e)e+ )a"iab+e in!ut use$ Mo"eo)e"& in the sho"t "un& ne* #i"ms can neithe" ente" the indust"y no" the e0istin #i"ms can +ea)e it$ Lhe"eas in the +on "un #i"ms can ad4ust thei" sca+e o# !"oduction acco"din to the chan in demand conditions$ ;esides& in the +on "un ne* #i"ms can ente" the indust"y and a+so e0istin #i"ms cou+d e0it the indust"y de!endin u!on the !"o#it +e)e+ in the indust"y$ In the be innin !"ice and out!ut ,G.

dete"mination in the sho"t "un is desc"ibed #o++o*ed by +on dete"mination$

"un !"ice and out!ut

As a+"eady discussed& Ma"ket !"ice is dete"mined by the ma"ket demand and ma"ket su!!+y #o"ces$ An indi)idua+ #i"m is a price taker that is it has to acce!t the !"e)ai+in !"ice as i)en datum$ %he #i"m has to ad4ust out!ut acco"din to its cost condition$ %he ana+ysis o# sho"t-"un !"oduction by a !e"#ect+y com!etiti)e #i"m !"o)ides insi ht into ma"ket su!!+y$ %he key assum!tion is that a !e"#ect+y com!etiti)e #i"m& +ike any othe" #i"m& is moti)ated by !"o#it ma0imi3ation$ %he #i"m chooses to !"oduce the :uantity o# out!ut that ene"ates hi hest !ossib+e +e)e+ o# !"o#it& based on !"ice& cost conditions& !"oduction techno+o y& etc$ An indi)idua+ #i"m is said to be in the e:ui+ib"ium *hen it attains the ma0imum !ossib+e !"o#it +e)e+$ It attains the ma0imum !ossib+e !"o#it +e)e+ at the !oint *he"e Ma" ina+ Cost DMC- e:ua+s Ma" ina+ Re)enue and MC is cuttin the MR cu")e #"om the be+o*$ It is *o"th to note that in the sho"t "un each #i"m need not necessa"i+y ea"n the no"ma+ !"o#it$ Some #i"ms may be ea"nin no"ma+ !"o#itsC some su!e" no"ma+ !"o#it o" e)en some may be incu""in +osses de!endin on thei" cost #unctions$ %his means& #i"ms makin su!e"no"ma+ !"o#it and ma0imum +osses can coe0ist a+on *ith the sho"t "un e:ui+ib"ium o# the Indust"y$ %he sho"t-"un !"oduction decision in !e"#ect com!etition is i++ust"ated usin the #i u"e <$.$

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/i u"e <$. 8"ice and Out!ut Dete"mination Unde" 8e"#ect Com!etiti)e Ma"ket

In #i u"e <$. D!ane+ A- Ma"ket e:ui+ib"ium !"ice O8 is dete"mined by the inte"section o# ma"ket demand cu")e DDD- *ith ma"ket su!!+y cu")e DSS- at the !oint E$ A++ the #i"ms in the indust"y ha)e to acce!t this !"ice +e)e+ and make ad4ustment in thei" out!ut +e)e+ acco"din to thei" cost conditions$ Sho"t-"un Ma" ina+ Cost DSMC- cu")e o# the #i"m ; inte"sected its Sho"t-"un Ma" ina+ Re)enue DSMR- cu")e at the !oint E Din the !ane+ ; o# the #i u"e-$ %he"e#o"e it is !"oducin OM +e)e+ o# out!ut$ At this out!ut +e)e+ Sho"t-"un A)e"a e Cost DSAC- !e" unit is MA *he"eas A)e"a e Re)enue" !e" unit is ME$ %he"e#o"e& the #i"m ; ea"nin AE amount o# !"o#it !e" unit$ %he tota+ amount o# !"o#it is DAE R OM- indicated by the shaded a"ea ;A8E$ /i"m C !"oducin ON amount o# out!ut because its SMC cu")e inte"sects its SMR cu")e at the !oint E Din !ane+ C-$ Since it(s SA? is "eate" than SAR the #i"m incu""in the +oss$ %he tota+ +oss incu""ed by the #i"m C is indicated by the shaded a"ea 8ELS$ /o" the i)en cost conditions& i# the ma"ket !"ice inc"eases !"o#it +e)e+ o# the #i"ms inc"ease$ %he"e#o"e& the"e is !ositi)e "e+ationshi! bet*een !"ice and su!!+y +e)e+$ %hus& in the sho"t "un some #i"ms may be ea"nin no"ma+ !"o#itsC some su!e" no"ma+ !"o#it o" e)en some may be incu""in +osses but indust"y is said to be in the e:ui+ib"ium i# the"e is no tendency #o" its tota+ out!ut to e0!and o" to cont"act$ In othe" *o"ds on an a)e"a e #i"ms shou+d ea"n no"ma+ !"o#it$ I# the"e is su!e"no"ma+ !"o#it it ,G<

att"act the ne* #i"ms to the indust"y cont"a"y i# it incu" +oss it encou"a e the e0istin #i"ms to :uit the indust"y$ A key im!+ication obtained #"om the sho"t-"un ana+ysis o# !e"#ect com!etition is !ositi)e "e+ation bet*een !"ice and the :uantity o# out!ut su!!+ied$ In !a"ticu+a"& the su!!+y cu")e #o" a !e"#ect+y com!etiti)e #i"m is !ositi)e+y s+o!ed$ %his "e+ation is ene"ated #o" t*o "easons: /i"st& a !e"#ect+y com!etiti)e #i"m !"oduces the :uantity o# out!ut that Second& the ma" ina+ cost cu")e& uided by the +a* o# diminishin e:uates !"ice and ma" ina+ cost$ ma" ina+ "etu"ns& is !ositi)e+y s+o!ed$ %aken to ethe" these t*o obse")ations indicate that a hi he" !"ice entices a !e"#ect+y com!etiti)e #i"m to inc"ease the :uantity o# out!ut !"oduced and su!!+ied$ In !a"ticu+a"& a !e"#ect+y com!etiti)e #i"mZs ma" ina+ cost cu")e is a+so its su!!+y cu")e$ %his conc+usion& ho*e)e"& on+y a!!+ies to !e"#ect com!etition$ /i"ms o!e"atin in ma"ket st"uctu"es that do not e:uate !"ice and ma" ina+ cost& but "athe" e:uate ma" ina+ "e)enue and ma" ina+ cost$ As such& the ma" ina+ cost cu")e is not the su!!+y cu")e #o" the #i"m$ In the sho"t "un& as a+"eady e0!+ained abo)e& #i"ms cou+d ad4ust thei" out!ut +e)e+ on+y by )a"yin the )a"iab+e in!ut use +e)e+$ Sho"t time !e"iod does not !e"mit the ne* #i"ms to ente" the indust"y and a+so e0istin #i"m cou+d not :uit the indust"y$ %he"e#o"e& in the sho"t #i"ms unde" !e"#ect com!etiti)e condition cou+d& on an a)e"a e& ea"n su!e"no"ma+ !"o#it o" e)en they may incu" hea)y +oss de!endin on the demand condition$ ;ut in the +on "un indust"y as a *ho+e& a++ the #i"ms to ethe"& cou+d not ea"n su!e" no"ma+ !"o#it and a+so the"e is no ine)itabi+ity #o" them to incu" the +oss in the +on "un$ I# the"e is su!e" no"ma+ !"o#it in the indust"y ne* #i"ms *i++ "ush into the indust"y "esu+tin "adua+ disa!!ea"ance o# su!e"no"ma+ !"o#it$ On the othe" hand i# the"e is hea)y +oss in the indust"y as a *ho+e some o# the #i"ms *hich a"e incu""in hea)y +oss *i++ "adua++y :uit the indust"y *hich "esu+ts in "adua+ disa!!ea"ance o# hea)y +oss in the indust"y$

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In the +on "un& *ith a++ in!uts )a"iab+e& a !e"#ect+y com!etiti)e indust"y "eaches e:ui+ib"ium at the out!ut that achie)es the e##icient sca+e o# !"oduction& that is& the minimum o# the +on ad4ustment !"ocess$ cost$ %he second is the !u"suit o# !"o#it ma0imi3ation by each #i"m in the indust"y$ %his ensu"es that #i"ms !"oduce the :uantity o# out!ut that e:uates !"ice Dand ma" ina+ "e)enue- *ith sho"t-"un and +on "un ma" ina+ cost$ %he end "esu+t o# this +on -"un ad4ustment is: 8 F AR F MR F MC F LRMC F AC F LRAC %his condition means that the ma"ket !"ice D8- D*hich is a+so e:ua+ to a #i"mZs A)e"a e Re)enue DAR- and Ma" ina+ Re)enue DMR-- is e:ua+ to Ma" ina+ Cost DMCDboth sho"t "un and +on "un- and A)e"a e Cost DAC- Dboth sho"t "un and +on "un-$ Lith !"ice e:ua+ to ma" ina+ cost& each #i"m is ma0imi3in !"o#it and has no "eason to ad4ust the :uantity o# out!ut o" #acto"y si3e$ Lith !"ice e:ua+ to a)e"a e cost& each #i"m in the indust"y ea"ns on+y a no"ma+ !"o#it$ Economic !"o#it is 3e"o and the"e a"e no economic +osses& meanin no #i"m is inc+ined to ente" o" e0it the indust"y$ %he #i"st is ent"y and e0it o# #i"ms into and out o# the indust"y$ %his "un a)e"a e cost cu")e$ %his is achie)ed th"ou h a t*o-#o+d

ensu"es that #i"ms ea"n 3e"o economic !"o#it and that !"ice is e:ua+ to a)e"a e

#.#. Monopol.
%he te"m Mono!o+y de"i)ed #"om the G"eek monos& one O polein& to se++$ %hus Monopol. is de#ined as Ma"ket situation *he"e the"e is on+y one !"o)ide" o# a kind o# !"oduct o" se")ice$ Mono!o+ies a"e cha"acte"i3ed by a +ack o# economic com!etition #o" the oods o" se")ice that they !"o)ide and a +ack o# )iab+e substitutes$ Since mono!o+ist !"oduce uni:ue !"oduct the"e is no c+ose substitute #o" the !"oduct$ %he c"oss e+asticity o# demand *ith e)e"y othe" !"oduct is a+most 3e"o$ Mono!o+y shou+d be distin uished #"om the ca"te+$ In a mono!o+y a single #i"m is the sole !"o)ide" o# a !"oduct o" se")iceC in a

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ca"te+ a cent"a+i3ed institution is set u! to !a"tia++y coo"dinate the actions o# several independent !"o)ide"s$ #.#.1. Primar. -haracteristics of a Monopol. Single Seller: A pure mono!o+y is an indust"y in *hich a sin +e #i"m is the

so+e !"oduce" o# a ood o" the so+e !"o)ide" o# a se")ice$ %his is usua++y caused by a b+ocked ent"y$ 4ni2ue product51o 'lose Substitutes: %he !"oduct o" se")ice is uni:ue in

*ays& *hich o beyond b"and identity& and cannot be easi+y "e!+aced$ Price )aker: In a !u"e mono!o+y a sin +e #i"m cont"o+s the tota+ su!!+y o#

the *ho+e indust"y and is ab+e to e0e"t a si ni#icant de "ee o# cont"o+ o)e" the !"ice& by chan in the :uantity su!!+ied$ It is not meant that mono!o+y #i"m is some thin +ike dictato" in the ma"ket$ I# it #i0es the !"ice #o" his !"oduct buye"s dete"mine the :uantity that they a"e *i++in to buy at that !a"ticu+a" !"ice +e)e+$ Mono!o+y #i"m cou+d not dete"mine the !"ice and :uantity simu+taneous+y$ (locked !ntry: %he "eason a pure mono!o+ist has no com!etito"s is that

ce"tain ba""ie"s a"e ke!t #o" ne* #i"ms to ente" the ma"ket$ De!endin u!on the #o"m o# the mono!o+y these ba""ie"s can be economic& techno+o ica+& +e a+ Dbasic !atents on ce"tain d"u s-& o" o# some othe" ty!e o# ba""ie" that com!+ete+y !"e)ents othe" #i"ms #"om ente"in the ma"ket #.#.2. ,orms of Monopol. Some im!o"tant #o"ms o# mono!o+y a"e discussed he"e unde":

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 +egal monopoly:

A mono!o+y based on La*s e0!+icit+y !"e)entin o)e"nment- "anted mono!o+yC *hen o)e"nment mono!o+y$ A o)e"nment

com!etition is a +e a+ mono!o+y o" de 6ure mono!o+y$ Lhen such a mono!o+y is "anted to a !"i)ate !a"ty& it is a o)e"nment itse+# o!e"ates it& it is a +oca+ity o" State-$

mono!o+y may e0ist at di##e"ent +e)e+s o# o)e"nment De$ $ 4ust #o" one "e ion o"

1atural monopoly) A natu"a+ !oo+ is a mono!o+y that a"ises in indust"ies *he"e

economies o# sca+e a"e so +a" e that a sin +e #i"m can su!!+y the enti"e ma"ket *ithout e0haustin them$ In these indust"ies com!etition *i++ tend to be e+iminated as the +a" est Do#ten the #i"st- #i"m de)e+o!s a mono!o+y th"ou h its cost ad)anta e$ Natu"a+ mono!o+y a"ises *hen the"e a"e +a" e ca!ita+ cost "e+ati)e to )a"iab+e cost& *hich a"ises ty!ica++y in net*o"k indust"ies such as e+ect"icity and "ai+*ay$ Lhethe" an indust"y is a natu"a+ mono!o+y may chan e o)e" time th"ou h the int"oduction o# ne* techno+o ies$ Go)e"nment can a+so a"ti#icia++y b"eak u! a natu"a+ mono!o+y indust"y& a+thou h De$ $ e+ect"icity +ibe"a+i3ation-$

+ocal monopoly) A +oca+ mono!o+y is a mono!o+y o# a ma"ket in a !a"ticu+a" a"ea&

usua++y a to*n o" e)en a sma++e" +oca+ity: the te"m is used to di##e"entiate a mono!o+y that is eo "a!hica++y +imited *ithin a count"y& as the de#au+t assum!tion is that a mono!o+y co)e"s the enti"e indust"y in a i)en count"y$ 'oercive monopoly: A coe"ci)e mono!o+y is one that a"ises and *hose e0istence is maintained as the "esu+t o# any so"t o# acti)ity that )io+ates the !"inci!+e o# a #"ee ma"ket and is the"e#o"e insu+ated #"om com!etition& *hich *ou+d othe"*ise be a !otentia+ th"eat to its su!e"io" status #.#.". Price and (utput Determination under Monopol. In mono!o+y *e ha)e 4ust one #i"m in the indust"y$ Lhat distin uishes the mono!o+ist #"om the !e"#ect+y com!etiti)e #i"m is that the +atte" is a !"ice take"& *hi+e the #o"me" is not$ A businessman *ith mono!o+y !o*e" can choose the !"ice he *ants to se++

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at$ I# he sets it hi he"& he se++s +ess$ I# he sets it +o*e"& he cou+d se++ mo"e$ %hus& the mono!o+ist can e0e"t some in#+uence o)e" the ma"ket !"ice& because the demand cu")e he #aces is the ma"ket demand cu")e& *hich is do*n*a"d-s+o!in $ %his cont"asts *ith the ho"i3onta+ demand cu")e #acin the !e"#ect+y com!etiti)e #i"m$ %his di##e"ence in the demand cu")e is *hat distin uishes mono!o+y #"om com!etition$ %o #ind out *hich !"ice-out!ut combination ma0imi3es the mono!o+istZs !"o#its *e need #i"st to e0!+o"e the im!+ications o# its do*n*a"d-s+o!in demand cu")e$ Le o#ten assume that the demand cu")e is +inea" P% a130 Lhe"e ! is !"ice and : is :uantity so+d$ %his i)es a st"ai ht +ine& do*n*a"d-s+o!in demand cu")e$ /"om the !oint o# )ie* o# the #i"m a demand cu")e indicates ho* much it can cha" e #o" each unit o# out!ut )a"ies as its out!ut )a"ies$ %he demand cu")e is& in othe" *o"ds& an A)e"a e Re)enue DAR- cu")e$ Lhen the AR cu")e is do*n*a"d s+o!in Ma" ina+ Re)enue DMR- cu")e *i++ a+so s+o!es do*n*a"d but the "ate o# s+o!e o# the +atte" is #aste" than the #o"me"$ In o"de" to ma0imi3e the !"o#it +e)e+& mono!o+ist !"oduce the out!ut at the !oint *he"e its Ma" ina+ Cost DMC- cu")e inte"sect the MR cu")e #"om the be+o*$ %he !"ice DAR- +e)e+ #o" any i)en out!ut +e)e+ is dete"mined on the basis o# demand condition$ %his to ethe" *ith cost conditions dete"mines the !"o#it +e)e+ o# mono!o+ist$ %his can be e0!+ained *ith the he+! o# the #i u"e <$9$ %he Ma" ina+ Cost DMC- o# the #i"m inte"sects its Ma" ina+ Re)enue DMR- cu")e at !oint E$ %he #i"m& the"e#o"e& is !"oducin OM +e)e+ o# out!ut$ ;uye"s a"e !"e!a"ed to buy the enti"e OM +e)e+ o# out!ut i# the #i"m #i0es the !"ice O8$ It cou+d be unde"stood by d"a*in a st"ai ht +ine #"om !oint M on the ho"i3onta+ a0is to*a"ds the demand cu")e$ 7e"e& this +ine meets the demand cu")e at !oint S$ It sho*s that the consume"s a"e !"e!a"ed to buy this +e)e+ o# out!ut at the !"ice +e)e+ O8$ At this +e)e+ o# out!ut A)e"a e Cost DAC- !e" unit is M% *he"e as the A)e"a e Re)enue DAR- is MS !e" unit$ %he"e#o"e& the #i"m is ea"nin %S amount o# net income !e" unit$ %he tota+ net income o" !"o#it ea"ned by the #i"m is sho*n by the shaded a"ea i$e$ 7%S8$ /i u"e$<$9$ 8"ice and Out!ut E:ui+ib"ium unde" Mono!o+y

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#.'. Monopolistic -ompetition 8e"#ect com!etition and Mono!o+y a"e e0t"eme cases& *hich a"e se+dom #ound in !"actice$ ;ut mono!o+istic com!etition and O+i o!o+y ma"ket situation cou+d be )e"y *ide+y #ound in !"actice$ )onopolistic 'ompetition refers to competition among large number of sellers producing and selling close but not perfect substitutes$

#.'.1. -haracteristics of Monopolistic -ompetition %his ma"ket condition !ossess the #o++o*in cha"acte"istics: +arge number of sellers: As in the !e"#ect com!etiti)e ma"ket& the"e *i++ be +a" e numbe" o# se++e"s in the mono!o+istic com!etiti)e ma"ket$ No se++e" by chan in his !"ice and out!ut !o+icy cou+d ha)e any !e"ce!tib+e e##ect on the sa+es o# othe"s as in the o+i o!o+y ma"ket$ Product $ifferentiation: A ene"a+ c+ass o# !"oduct is di##e"entiated i# any

si ni#icant basis e0ists #o" distin uishin the oods o# one se++e" #"om anothe"$ Such basis may be "ea+ o" ima ina"y$ 8"oduct di##e"entiation may be by: a- :ua+ity

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o# !"oduct such as du"abi+ity& si3e& sha!e& desi n etc$ o" b- ad)e"tisement& *hich cou+d c"eate ima ina"y uni:ueness in the !"oduct$ ,reedom of entry and e"it: Indi)idua+ #i"msAse++e"s and buye"s a"e #"ee to ente" o" +ea)e the ma"ket as in the !e"#ect com!etiti)e ma"ket$ 1ature of $emand curve: %he demand cu")e o# an indi)idua+ #i"m unde" mono!o+istic com!etition s+o!es do*n*a"d #"om +e#t to "i ht$ In the !"ecedin section you ha)e unde"stood that in the !e"#ect com!etiti)e ma"ket demand cu")e #o" an indi)idua+ #i"m is !e"#ect+y e+astic *he"eas in mono!o+y ma"ket it is "e+ati)e+y ine+astic$ In this ma"ket condition& e+asticity o# demand is in bet*een the t*o$ %hat is& in this ma"ket demand is hi h+y e+astic but not !e"#ect+y e+astic$ %hus& the cha"acte"istics o# a mono!o+istica++y com!etiti)e ma"ket a"e e0act+y the same as in !e"#ect com!etition& *ith the e0ce!tion o# the hete"o eneous !"oducts$ %his i)es the com!any a ce"tain amount o# in#+uence o)e" the ma"ketC it can "aise its !"ices *ithout +osin a++ the custome"s& o*in to b"and +oya+ty$ %his means its demand cu")e is do*n*a"ds s+o!in & in cont"ast to !e"#ect com!etition$ #.'.2 Price and (utput Determination under Monopolistic -ompetition. %he ma"ket o# an indi)idua+ #i"m unde" !u"e com!etition is com!+ete+y me" ed *ith the ene"a+ oneC it can se++ any amount o# the ood at the "u+in ma"ket !"ice$ ;ut& unde" mono!o+istic com!etition& indi)idua+ #i"m(s ma"ket is iso+ated to a ce"tain de "ee #"om those o# its "i)a+s *ith the "esu+t that its sa+es a"e +imited and de!end u!on !"ice& the natu"e o# its !"oduct and the sa+es !"omotion out+ay it makes$ %hus& the #i"m unde" mono!o+istic com!etition has to con#"ont a mo"e com!+icated !"ob+em than the !u"e+y com!etiti)e #i"m$ E:ui+ib"ium o# an indi)idua+ #i"m unde" mono!o+istic com!etition in)o+)es e:ui+ib"ium in th"ee "es!ects& that is& in "e a"d to the !"ice& the natu"e o# the !"oduct& and the amount o# ad)e"tisin out+ay it shou+d make$ /i"st+y& a #i"m unde" mono!o+istic com!etition has to decide about its !"ice !o+icy$ Lhat !"ice shou+d it cha" e #o" its !"oduct6 ;ecause o# the attachment o# some consume"s to its !a"ticu+a" b"and o" the !"oduct& it has some mono!o+istic in#+uence o)e" ,,,

the !"ice o# its !"oduct$ I# it "aises the !"ice o# its !"oduct a +itt+e& it may +ose many o# its custome"s but not a++$ On the othe" hand& i# it "educes its !"ice& it may att"act mo"e custome"s o# his "i)a+s$ %he"e#o"e& the demand cu")e con#"ontin a #i"m unde" mono!o+istic com!etition is not a ho"i3onta+ st"ai ht +ine& but a do*n*a"d s+o!in cu")e$ I# it sets a hi he" !"ice& it *i++ be ab+e to se++ +essC i# it sets a +o*e" !"ice it *i++ be ab+e to se++ mo"e$ %he #i"m *i++ choose that !"ice-out!ut combination *hich yie+ds ma0imum tota+ !"o#its$ Second+y& the #i"m *i++ t"y to ad4ust its !"oduct so as to con#i"m mo"e to the e0!ectation o# the buye"s$ %he )a"iation o# the !"oduct may "e#e" to an a+te"ation in the :ua+ity o# the !"oduct itse+#& a ne* desi n& bette" mate"ia+s& it may mean ne* !acka e o" containe"& it may a+so mean mo"e !"om!t o" cou"teous se")ice& a di##e"ent *ay o# doin business& o" !e"ha!s a di##e"ent +ocation$ %he amount o# the !"oduct& *hich a #i"m *i++ be ab+e to se++ in the ma"ket& de!ends in !a"t u!on the manne" in *hich its !"oduct di##e"s #"om othe"s$ 1Lhe"e the !ossibi+ity o# di##e"entiation e0ists& sa+es de!end u!on the ski++ *ith *hich the ood is distin uished #"om othe"s and made to a!!ea+ to a !a"ticu+a" "ou! o# buye"s2$ %he !"o#it ma0imisation !"inci!+e a!!+ies to the choice o# the natu"e o# the !"oduct as to its !"ice$ %hi"d+y& a se++e" unde" mono!o+istic com!etition can in#+uence the )o+ume o# his sa+es by )a"yin the amount o# e0!enditu"e on sa+es !"omotion$ %he e0!enditu"e incu""ed on ad)e"tisement is !"ominent amon the )a"ious ty!es o# sa+es !"omotion e0!enditu"e$ %he se++in out+ay chan es the demand #o" his !"oduct as *e++ as his cost$ Like the ad4ustment o# !"ice and !"oduct& a #i"m unde" mono!o+istic com!etition has to ad4ust the amount o# his e0!enditu"e on sa+es !"omotion in such a *ay as to ma0imi3e his tota+ !"o#it$ %he !"ob+em o# ad4ustin com!etition$ %he demand cu")e #o" the !"oducts o# an indi)idua+ #i"m& as e0!+ained abo)e& is do*n*a"d s+o!in $ Since the )a"ious #i"ms unde" mono!o+istic com!etition !"oduce !"oducts *hich a"e c+ose substitutes o# each othe"$ %he e+asticity o# demand cu")e #o" any o# them de!ends u!on the a)ai+abi+ity o# the com!etin substitutes and thei" !"ices$ his se++in out+ay is uni:ue to the mono!o+istic

,,.

%he"e#o"e e:ui+ib"ium ad4ustment o# an indi)idua+ #i"m cannot be e0!+ained in iso+ation to the ene"a+ #ie+d o# *hich it is a !a"t$ 7o*e)e"& #o" the sake o# sim!+icity in ana+ysis& conditions "e a"din a)ai+abi+ity o# substitute !"oducts and thei" !"ices a"e assumed to be constant *hi+e the e:ui+ib"ium ad4ustment o# an indi)idua+ #i"m is conside"ed in iso+ation$ Lith the assum!tions& an indi)idua+ #i"ms e:ui+ib"iumA!"oduction +e)e+ and !"ice ad4ustment cou+d be e0!+ained *ith the he+! o# the #i u"e <$<$ /i u"e <$<$ E:ui+ib"ium o# a /i"m Unde" Mono!o+istic Com!etition

AR and MR a"e a)e"a e and ma" ina+ "e)enue cu")es "es!ecti)e+y$ Lhen the a)e"a e "e)enue s+o!es do*n *a"d ma" ina+ "e)enue *i++ a+so dec+ine but at the #aste" "ate than the #o"me"$ AR o" demand cu")e #o" an indi)idua+ #i"m unde" mono!o+istic com!etition is a+most simi+a" to that in the mono!o+y ma"ket condition but the on+y di##e"ence is that the AR cu")e unde" the #o"me" is bit #+atte" than that in the +atte"$ It means the e+asticity o# demand is mo"e in mono!o+ist com!etiti)e ma"ket com!a"ed to the Mono!o+y ma"ket$ In this #i u"e Ma" ina+ cost cu")e DMC- inte"sects the Ma" ina+ Re)enue DMR- at !oint E$ %he #i"m& the"e#o"e& !"oduces the OM +e)e+ o# out!ut in o"de" to ea"n ma0imum !ossib+e !"o#it$ Lhen it !"oduces the OM +e)e+ o# out!ut it cou+d se++ it at the M> DO8- !"ice$ At this +e)e+ o# out!ut A)e"a e Cost DMS- is +ess than the A)e"a e Re)enue DM>-$ %hus& cou+d ea"n S> amount o# !"o#it !e" unit$ %he shaded a"ea RS8>& the"e#o"e& indicates the tota+ !"o#it +e)e+ at this +e)e+ o# out!ut$ #.+. (:I&(P(:;

,,9

O+i o!o+y is a ma"ket condition& *hich is most !"e)a+ent in ma4o"ity o# the indust"ia+ count"ies$ It is o#ten "e#e""ed to as 1com!etition amon the #e*2$ %his is a ma"ket situation *he"e #e* se++e"s in)o+)ed in se++in homo eneous o" di##e"entiated !"oducts$ I# !"oducts o# #e* se++e"s a"e homo eneous& then ma"ket "e#e""ed to as pure oligopoly$ Lhe"e as i# !"oducts o# #e* se++e"s a"e di##e"entiated& then ma"ket "e#e""ed to as differentiated oligopoly$ Some im!o"tant #eatu"es o# this ma"ket condition a"e discussed unde" the #o++o*in section$

<$@$, /eatu"es o# O+i o!o+y

,ew sellers: O+i o!o+y is a ma"ket situation in *hich the numbe" o# se++e"s dea+in in homo eneous o" di##e"entiated !"oduct is )e"y sma++$ Interdependency& In !e"#ect com!etition& mono!o+y and mono!o+istic com!etition each #i"m is mo"e o" +ess inde!endent o# the othe"& a+thou h each is de!endent on the ma"ket$ ;ut uni:ue #eatu"e o# the o+i o!o+y ma"ket is that the !o+icy o# e)e"y !"oduce" di"ect+y a##ects each othe" due to #e* numbe" o# #i"m and c+ose substitutabi+ity o# the oods$ #dvertisement: Ad)e"tisin and se++in costs ha)e st"ate ic im!o"tance to

o+i o!o+y #i"m$ Each #i"m t"ies to att"act the consume"s to*a"ds its !"oduct by inc"easin e0!enditu"e on the ad)e"tisement$ 4ncertainty: Lack o# ce"tainty is anothe" im!o"tant #eatu"e o# o+i o!o+y ma"ket condition$ Unde" this ma"ket condition it is di##icu+t to ana+yse the e##ect o# !"ice chan e initiated by a #i"m on its o*n sa+es due to unce"tain "eaction by his "i)a+s$ igh 'ross !lasticity of $emand: %he #i"ms unde" o+i o!o+y ha)e a hi h de "ee o# c"oss e+asticity o# demand #o" thei" !"oducts$ %he"e *i++ be a+*ays the #ea" o# "eta+iation by "i)a+s$

,,<

1ature of $emand 'urve: Due to inte" de!endency the natu"e o# demand cu")e is uni:ue unde" this ma"ket condition$ Acco"din o+i o!o+y ma"ket ha)e a kinked demand cu")e$ to 8au+ S*ee3y& #i"ms in an

#.+.2) Price and (utput Determination under (ligopol. Mar=et) No uni:ue !atte"n o# !"icin beha)io" e0ists in the o+i o!o+y ma"ket due to "e#e"s to the inte"de!endency amon the #i"ms$ ;"oad+y the"e a"e th"ee ty!es o# !"icin beha)io" )i3$ Inde!endent !"icin & ca"te+s and !"ice +eade"shi!$ Inde!endent !"icin inde!endent action o# each se++e" *ithin an o+i o!o+y indust"y$ Unde" inde!endent !"icin beha)io" each and e)e"y #i"ms t"y to ma0imi3e thei" !"o#it$ Since each #i"m t"yin to ma0imi3e thei" !"o#it it c"eate "i)a+"y amon the #i"ms$ Such an inde!endent !"icin beha)io" may "esu+t in !"ice *a" o" !"ice "i idity$ #.+.2.1 Price Ear) 8"ice *a" may sta"t *hen one se++e" "educes the !"ice o# his !"oduct +ine in o"de" to inc"ease his sa+es$ 7is "i)a+ a!!"ehendin a "eduction in thei" sa+es "eta+iate and each t"ies to unde"cut the othe"s$ 8"ice *a" ha"ms a++ the #i"ms in the indust"y$ %hus "adua++y a++ the #i"ms unde"stand the #uti+ity o# the !"ice *a" and desi"e #o" the !"ice stabi+ity$ Such desi"e "adua++y +eads to !"ice "i idity$ #.+.2.2. Price Rigidit.GDin=ed Demand -ur e) O+i o!o+y !"ice that "emains stab+e o)e" a !e"iod o# time a"e ca++ed "i id !"ice$ 8"ice "i idity is a+so !o!u+a"+y kno*n as S*ee3y Mode+$ ;ecause this mode+ *as de)e+o!ed in the +ate ,I9Gs by the Ame"ican 8au+ S*ee3y$ %he theo"y aims to e0!+ain the !"ice "i idity that is o#ten #ound in o+i o!o+istic ma"kets$ It assumes that i# an o+i o!o+ist "aises its !"ice its "i)a+ *i++ not #o++o* suit& as kee!in thei" !"ices constant *i++ +ead to an inc"ease in ma"ket sha"e$ %he #i"m that inc"eased its !"ice *i++ #ind that "e)enue #a++s by a !"o!o"tionate+y +a" e amount& makin this !a"t o# the demand cu")e "e+ati)e+y e+astic D#+atte"-$ Con)e"se+y i# an o+i o!o+ist +o*e"s its !"ice& its "i)a+s *i++ be #o"ced to #o++o* suit to !"e)ent a +oss o# ma"ket sha"e$ Lo*e"in !"ice *i++ +ead to a )e"y sma++ chan e in "e)enue& makin this !a"t o# the demand cu")e "e+ati)e+y ine+astic Dstee!e"-$

,,=

%he #i"m then has no incenti)e to chan e its !"ice& as it *i++ +ead to a dec"ease in the #i"mZs "e)enue$ %his causes the demand cu")e to kink a"ound the !"esent ma"ket !"ice$ 8"ices *i++ #u"the" stabi+i3e& as the #i"m *i++ abso"b chan es in its costs as can be seen in the #i u"e <$=$ /i u"e <$=$ 5inked Demand Cu")e

In this #i u"e +et us assume that the o"i ina+ !"ice is O8$ I# the #i"m inc"eases its !"ice its "i)a+s *i++ not #o++o* hence its demand cu"e become mo"e e+astic i$e$ it *i++ become R,E$On the othe" hand it dec"eases its !"ice "i)a+s *i++ #o++o* it thus its demand cu")e become ine+astic i$e$ it becomes ED$ %he"e#o"e& demand cu")e is kinked at !oint E$ %he"e is discontinuity in Ma" ina+ Re)enue cu")e at the co""es!ondin !osition i$e A to ;$ %he ma" ina+ "e)enue 4um!s D)e"tica+ discontinuity- at the :uantity *he"e the demand cu")e kinks& the ma" ina+ cost cou+d chan e "eat+y - e$ $& MCG to MC, Dbet*een !"ices a and b-- and the !"o#it$ In the +i ht o# this& the !"ice "i idity cou+d be att"ibuted to the #o++o*in "easons Indi)idua+ se++e"s may unde"stand the #uti+ity o# !"ice *a" and thus !"e#e" !"ice stabi+ity %hey may be content *ith the cu""ent !"ice& out!ut and !"o#its and a)oid any kind o# unnecessa"y insecu"ity and unce"tainty$ %he #i"ms may intensi#y thei" sa+es !"omotion e##o"ts at the cu""ent !"ice instead o# "educin it$ %hey may )ie* non-!"ice com!etition bette" than !"ice "i)a+"y$ ,,@

A#te" s!endin +ot o# money on the ad)e"tisement a se++e" may not +ike to "aise the !"ice o# his !"oducts to de!"i)e himse+# o# the #"uits o# his ha"d +abou"$ U+timate+y& It is the kinked demand cu")e& *hich is "es!onsib+e #o" the !"ice "i idity$

#.+.2.". -artel Unde" o+i o!o+y ma"ket condition #i"ms may& "adua++y& #o"m the ca"te+s$ A ca"te+ is an association o# inde!endent #i"ms *ithin the same indust"y$ %he !u"!ose #o"mu+ation o# ca"te+ is to inc"ease the !"o#it +e)e+ o# the membe" #i"ms by sub4ectin thei" com!etiti)e tendency to some #o"m o# a "eement$ %he ca"te+s& no"ma++y& #o++o* common !o+icies "e+atin to !"ices& sa+es and !"o#it$ %hese ca"te+s may be )o+unta"y& com!u+so"y& o!ened o" e)en it may be sec"ete de!endin u!on the !o+icy o# the o)e"nment "e+atin to ca"te+s$ %he"e a"e main+y t*o ty!es o# ca"te+s$ ,- 8e"#ect ca"te+s o" Koint !"o#it ma0imisation .- Ma"ket sha"in ca"te+$ Perfect cartel is an e0t"eme #o"m o# !e"#ect co++usion$ In this& #i"ms !"oducin a homo eneous !"oducts #o"m a cent"a+ised ca"te+ boa"d in the indust"y$ %he indi)idua+ #i"ms su""ende" thei" !"ice out!ut decisions to this cent"a+ boa"d$ Lhe"eas in the ma"ket sha"in ca"te+ the #i"ms ente" into ma"ket sha"in a "eement to #o"m a ca"te+ but kee! a conside"ab+e de "ee o# #"eedom "e+atin to !"ice and out!ut decisions$ #.+.2.# Price :eadership It is an im!e"#ect co++usion amon the #i"ms in the o+i o!o+y ma"ket$ It is a system unde" *hich a++ the #i"ms o# an o+i o!o+y indust"y #o++o* the +ead o# one o# the bi #i"m DLeade"-$ %he"e *i++ be tactics a "eement amon the #i"ms to se++ the !"oducts at a !"ice set by the +eade" o# the indust"y$ Some times the"e may be #o"ma+ meetin s and de#inite a "eement *ith the +eade" #i"m$ Unde" this system +eade" initiate the !"ice chan e and then #o++o*e" #i"m acce!ts the !"ice chan e and make co""es!ondin out!ut ad4ustments$

#.2 RI-IN& P(:I-IES

%he !"e)ious sections o# this cha!te" main+y dea+t *ith the theo"etica+ #"ame*o"k #o" the !"icin decisions$ In this section an attem!t has been made to e0!+ain ho* #i"ms in the "ea+ *o"+d set the !"ices$ 8"icin !o+icies and methods in !"actice is #ocused in this

,,B

section$ /o"mu+atin !"ice !o+icies and settin the !"ice a"e the most im!o"tant as!ects o# mana e"ia+ decision-makin $ 8"ice& in #act& is the sou"ce o# "e)enue& *hich the #i"m seeks to ma0imi3e$ A ain& it is the most im!o"tant de)ice a #i"m can use to e0!and its ma"ket$ I# the !"ice is set too hi h& a se++e" may !"ice himse+# out o# the ma"ket$ I# it is too +o*& his income may not co)e" costs& o" at best& #a++ sho"t o# *hat it cou+d be$ 7o*e)e"& settin !"ices is a com!+e0 !"ob+em and the"e is no c+ea"-cut #o"mu+a #o" doin so$ Lhethe" to set a +o* !"ice o" a hi h !"ice *ou+d de!end u!on a numbe" o# #acto"s and *ide )a"iety o# conditions$ #.2.1 ,actors In ol ed in Pricing Polic. In economic theo"y& on+y t*o !a"ties a"e ene"a++y em!hasi3ed& i$e$& buye"s and se++e"s$ In !"actice ho*e)e"& as !ointed out by O0en#e+dt& ce"tain othe" !a"ties a"e a+so in)o+)ed in the !"icin !"ocess$ i$e$& "i)a+ se++e"s& !otentia+ "i)a+s& midd+e men and o)e"nment$ A++ these !a"ties a+so e0e"cise thei" in#+uence in !"ice dete"mination$ Ce"tain ene"a+ conside"ations& *hich must be ke!t in )ie* *hi+e #o"mu+atin the !"icin !o+icy& a"e i)en be+o*: )arket Structure: 8"icin !o+icy is to be set in the +i ht o# com!etiti)e situation in the ma"ket$ I# the #i"m is o!e"atin unde" !e"#ect com!etition it acts on+y as !"ice take" and the"e is ha"d+y any choice +e#t$ %he #i"m has a !"icin !"ob+em& *hen the"e is im!e"#ect o" mono!o+istic com!etition$ Unde" mono!o+y the #i"m is a !"ice make"$ It has to set its o*n !"ice !o+icy$ Usua++y& a manu#actu"in #i"m today o!e"ates unde" im!e"#ect+y com!etiti)e ma"ket condition& and hence it has to set its o*n !"ice !o+icy& as may be #easib+e$ 'osts& Cost is an im!o"tant e+ement in !"ice dete"mination$ Cost data se")e as the base$ I# !"ice is be+o* the cost o# !"oduction it *ou+d mean +osses$ %hus& cost ana+ysis is im!o"tant$ A+on *ith the tota+ costs& a)e"a e and ma" ina+ costs a"e to be dete"mined$ /o" business decisions in the sho"t "un& di"ect o" )a"iab+e costs ha)e "eate" "e+e)ance$ %he #i"ms seek to co)e" #u++-a++ocated costs$ Economy in cost is a+so im!o"tant #o" settin a +o*e" !"ice #o" the !"oduct$ A hi h cost o# !"oduction ob)ious+y ca++s #o" a hi he" !"ice$

,,H

$emand: In !"icin !o+icy& demand can ne)e" be o)e"+ooked$ Rathe"& demand is mo"e im!o"tant #o" the e##ecti)e sa+es$ Demand #o" a #i"m(s !"oduct de!ends on consume"(s !"e#e"ences$ So& the consume" !sycho+o y is )e"y im!o"tant$ %h"ou h a!!"o!"iate ad)e"tisin and sa+es cam!ai n consume"s( !sycho+o y can be in#+uenced and thei" !"e#e"ences may be a+te"ed$ %hus demand can be mani!u+ated$ A +o* o" hi h !"ice !o+icy is to be set conside"in the e+asticity o# demand$ I# demand #o" the !"oduct is hi h+y ine+astic& then on+y "isin !"ice !o+icy *ou+d be a !ayin !"o!osition to the businessman$ /u"the"& in a++ cases demand is not !"ice e+astic$ In some cases& es!ecia++y& consume" du"ab+es& i$e$& %? set& ca"& etc$ demand is income e+astic$ %hus& *hen income o# the buye"s "ises& the #i"m can e0!ect to se++ mo"e such oods e)en at hi h !"ices$ In case o# e+astic demand #o" the oods& a !"ice cut *ou+d be bene#icia+ in boostin the sa+e$

Profit: In dete"minin !"ice !o+icy& !"o#it conside"ation is a+so si ni#icant$ In !"actice& ho*e)e"& "a"e+y the"e is a oa+ o# !"o#it ma0imi3ation$ Usua++y& !"icin !o+icy is based on the oa+ o# obtainin a "easonab+e !"o#it$ /u"the"& most o# the businessmen *ou+d !"e#e" to ho+d constant !"ice #o" thei" !"oducts "athe" than oin #o" a !"ice "ise o" a !"ice cut& as #a" as !ossib+e$ %hus& !"ice "i idity may be the no"m o# the !"ice !o+icy$ ;ut& "i idity does not mean in#+e0ibi+ity$ 8"ice #+uctuations do con#o"m to cost chan es$

.b6ectives of business: 8"icin is not an end in itse+# but a means to an end$ %he #undamenta+ uides to !"icin & the"e#o"e& a"e the #i"m(s o)e"a++ ob4ecti)e$ %he b"oadest o# these is su")i)a+$ ?e"y o#ten com!anies #i0 a ta" et "ate o# !"o#it$ Lhethe" the com!any *i++ be ab+e to achie)e the ta" et "ate o# !"o#it& *i++ de!end u!on the #o"ces o# com!etition$ %he )a"ious ob4ecti)es may not a+*ays be com!atib+e and hence the need #o" thei" "econci+iation$ A !"icin !o+icy shou+d ne)e" be estab+ished *ithout #u++ conside"ation as to its im!act on the othe" !o+icies and !"actices o# the #i"m$

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Product and Promotional Policies: 8"icin is on+y one as!ect o# ma"ket st"ate y and a #i"m must conside" it to ethe" *ith its !"oduct and !"omotiona+ !o+icies$ %he :ua+ity o# the !"oduct& sa+es !"omotion !"o "ammes and othe" such e+ements ha)e to be conside"ed *hi+e #o"mu+atin the !"icin !o+icies$

1ature of Price Sensitivity& ;usinessman o#ten tends to e0a e"ate the im!o"tance o# !"ice sensiti)ity and i no"e the many identi#iab+e #acto"s at *o"k& *hich tend to minimi3e it$ %he )a"ious #acto"s *hich may ene"ate insensiti)ity to !"ice chan es a"e )a"iation in the e##ecti)eness o# ma"ketin e##o"t& natu"e o# the !"oduct& im!o"tance o# se")ice a#te" sa+es *hich ha)e to be taken into account *hi+e #o"mu+atin the !"icin !o+icies$

'onflicting Interests of )anufacturers and )iddlemen$ %he inte"ests o# manu#actu"e"s and midd+emen th"ou h *hom the #o"me" o#ten se++ a"e sometimes in con#+ict$ /o" instance& the manu#actu"e" *ou+d desi"e that the midd+eman shou+d se++ his !"oduct at a minimum ma"k-u!& *he"eas the midd+eman *ou+d +ike his ma" in to be +a" e enou h to stimu+ate him !ush u! the !"oduct$

Go)e"nment 8o+icy: 8"icin !o+icy o# a #i"m is a+so a##ected by the o)e"nment !o+icy$ I# the o)e"nment "eso"ts to !"ice cont"o+& the #i"m has to ado!t the !"ice as !e" the #o"mu+a and cei+in !"esc"ibed by the Go)e"nment& then the"e is +itt+e sco!e to !u"sue its o*n !"icin $ /o" instance& in India *e ha)e d"u !"ice cont"o+& etc

#.2.2. (34ecti es of Pricing Polic. 8"icin is not an end in itse+#$ 8"icin is a means to an end$ %he"e#o"e& the #i"m must e0!+icit+y +ay do*n its !"icin ob4ecti)es$ %he #i"m(s o)e"a++ ob4ecti)es se")e as uidin !"inci!+e to !"icin $ %hus& #i"m(s business ob4ecti)es a"e no"ma++y s!e++ed out as the ob4ecti)es o# its !"ice !o+icy$ Em!i"ica+ e)idences "e#+ect that theo"etica+ oa+ o# !"o#it ma0imi3ation is "a"e+y taken in !"actice by the business #i"ms in thei" !"ice !o+icy$ %he #o++o*in a"e the common+y ado!ted ma4o" !"icin ob4ecti)es o# a business #i"m: Survival: basica++y& in these days o# mono!o+istic com!etition o" dynamic chan es and business unce"tainties& a #i"m is a+*ays inte"ested in its continued

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su")i)a+$ /o" the sake o# assu"in continued e0istence& ene"a++y& a #i"m is "eady to to+e"ate a++ kinds o# u!hea)a+ in !"oduct +ines& o" ani3ationa+ and e)en !e"sonne+ chan es$ %hus a #i"m may !u"sue the !"omotion o# the +on "an e *e+#a"e o# the #i"m /ate of Growth and Sales )a"imi7ation: A #i"m may be inte"ested in settin a !"ice !o+icy& *hich *i++ !e"mit a "a!id e0!ansion o# the #i"m(s business and its sa+es ma0imi3ation$ )arket Shares: ;y ado!tin a !"ice !o+icy the #i"m may *ish to ca!tu"e a +a" e" sha"e in the ma"ket and ac:ui"e a dominatin +eade"shi! !osition$ )a"imi7ation of profits for the entire product line& As 5ot+e" has !ointed out& #i"ms set !"ice& *hich *ou+d enhance the !"o#it #"om the enti"e !"oduct +ine "athe" than yie+d a !"o#it on one !"oduct on+y$ Preventing 'ompetition& In !"icin its !"oduct& the #i"m may kee! an eye on "i)a+(s ent"y$ So& it may #i0 u! the !"ice such that *ou+d !"e)ent com!etition$ )arket Penetration: 7e"e& "e+ati)e+y +o* !"ice may be set to stimu+ate ma"ket "o*th and ca!tu"e a +a" e sha"e the"eo#$ )arket Skimming: 7e"e& hi h initia+ !"ice is cha" ed to take ad)anta e o# the #act that some buye"s a"e *i++in to !ay a much hi he" !"ice than othe"s as the !"oduct has hi h )a+ue to them$ !arly 'ash /ecovery& Some #i"ms t"y to set a !"ice& *hich *i++ enab+e "a!id cash "eco)e"y as they may be #inancia++y ti ht o" may "e a"d #utu"e as too unce"tain to 4usti#y !atient cash "eco)e"y$ #.2." Pricing Methods In Practice In the "ea+ *o"+d most o# the business o" anisaitons a"e o!e"atin thei" business unde" im!e"#ect com!etiti)e condition$ %hus it is the #undamenta+ duties o# the #i"ms to #i0 the

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suitab+e !"ice #o" thei" !"oducts in such a *ay as to #u+#i++ the o)e"a++ ob4ecti)e o# thei" o" ani3ation$ Numbe"s o# !"icin methods ha)e e)o+)ed o)e" the !e"iod$ %he"e is no c+ea"-cut c"ite"ion to se+ect a !a"ticu+a" !"icin method$ ;ut any business o" ani3ation *i++ ado!t the !"icin method& *hich suits thei" ob4ecti)es$ Some o# the im!o"tant !"icin methods that a"e bein !"actica++y ado!ted by one o" the othe" #i"m a"e discussed be+o*: #.2.".1. -ost1Plus or ,ull1-ost Pricing Unde" this method& the !"ice is set to co)e" costs and a !"edete"mined !e"centa e o# !"o#it$ %he !"o#it !e"centa e *i++ be dete"mined on the basis o# intensity o# com!etition in the ma"ket& "ate o# "etu"ns& cost base& "isk etc$ natu"a++y the !"o#it !e"centa e di##e"s amon indust"ies& amon membe" #i"ms$ /u++ cost !"icin method is bein )e"y *ide+y ado!ted by the #i"ms$ %his is main+y becauseC /u++-cost !"icin o##e"s a means by *hich #ai" and !+ausib+e !"ices can be #ound *ith ease and s!eed& no matte" ho* many !"oducts the #i"m hand+es$ /i"ms !"e#e""in stabi+ity use #u++ cost as a uide to !"icin in an unce"tain ma"ket *he"e kno*+ed e is incom!+ete$ In !"actice& #i"ms a"e unce"tain about the sha!e o# thei" demand cu")e and about the !"obab+e "es!onse to any !"ice chan e$ %his makes it too "isky to mo)e a*ay #"om #u++-cost !"icin A ma4o" unce"tainty in settin a !"ice is the unkno*n "eaction o# "i)a+s to that !"ice$ Lhen !"oducts and !"oduction !"ocess a"e simi+a"& cost-!+us !"icin yie+d acce!tab+e !"o#it to most othe" membe" so the indust"y a+so$ Unce"tainty cou+d be minimi3ed to some e0tent$ :imitations of ,ull -ost Pricing Method %hou h it is "e+ati)e+y easy to ado!t this method o# !"icin it is ha)in ce"tain +imitations$ Most im!o"tant +imitations o# this method a"eC It i no"es demand J it does not ca"e #o" *hat !eo!+e !"e!a"ed to !ay$ It does not "e#+ect ma"ket #o"ces$

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/u++ cost !"icin i no"es ma" ina+ o" inc"ementa+ costs and uses a)e"a e costs instead$

#.2.".2. Rate of Return Pricing In this method the #i"ms dete"mine the a)e"a e !"o#it ma"k-u! on costs necessa"y to !"oduce a desi"ed "ate o# "etu"n on its in)estments say& #o" instance& a #i"m may set its !"ice o# the !"oduct in o"de" to et on an a)e"a e a H !e" cent "etu"n on net in)estment$ Unde" the "ate o# "etu"n !"icin !o+icy& !"ice is dete"mined a+on a !+anned "ate o# "etu"n on in)estment$ %he "ate o# "etu"n is to be t"ans+ated into a !e"cent ma"k-u! as !"o#it ma" in on cost$ %he !"o#it ma" in is dete"mined on the basis o# no"ma+ "ate o# !"oduction$ Rate o# "etu"n !"icin is a "e#ined method o# #u++ cost !"icin $ %hus& !"icin is based on cost& *hich may not "e+e)ant to the !"icin decision$ Natu"a++y& it has the same inade:uacy as the #u++ cost !"icin method$ #.2.".". Marginal -ost Pricing 8"icin methods discussed abo)e a"e based on the tota+ cost o# !"oduction$ Unde" this method !"ice is to be #i0ed based on the ma" ina+ cost o# !"oduction$ Ma" ina+ cost is the addition made to tota+ cost by !"oducin an additiona+ unit o# out!ut$ It is the cost o# !"oducin ONE e0t"a unit o# !"oduction$ Unde" the ma" ina+ cost !"icin & as !e" the accountin a!!"oach& #i0ed cost conside"ed to be i no"ed and !"ices a"e dete"mined on the basis o# ma" ina+ cost$ It is most a!!"o!"iate method in the indust"ies *he"e #i0ed cost is "e+ati)e+y hi h$ It A++o*s )a"iab+e !"icin st"uctu"e J e$ $ on a #+i ht #"om London to Ne* Mo"k J !"o)idin the cost o# the e0t"a !assen e" is co)e"ed& the !"ice cou+d be )a"ied a ood dea+ to att"act custome"s and #i++ the ai"c"a#t$ %hus& it a++o*s #+e0ibi+ity in !"icin $ It cou+d be e0!+ained *ith a nume"ica+ e0am!+e$ In Ai"c"a#t #+yin #"om ;"isto+ to Edinbu" h J %ota+ Cost Dinc+udin no"ma+ !"o#it- F \,=&GGG o# *hich \,9&GGG is #i0ed cost$ Numbe" o# seats F ,@G& a)e"a e !"ice F \I9$B=$ MC o# each !assen e" F .GGGA,@G F \,.$=G$ I# #+i ht not #u++& bette" to o##e" +ast !assen e"s chance o# #+yin at \,.$=G and #i++ the seat than to #+y *ith em!ty seats$ In such situation Ma" ina+ cost !"icin method is suitab+e$

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#.2.".#. &oing Rate Pricing. Goin "ate-!"icin !o+icy #ound to be a "ationa+ method *he"e it is di##icu+t to estimate the di##e"ent cost o# !"oduction$ Unde" this method #i"ms ad4ust its o*n !"ice !o+icy to the ene"a+ !"icin st"uctu"e in the indust"y$ Goin "ate "e#+ects the co++ecti)e *isdom o# the indust"y$ It is a kind o# !"ice +eade"shi!$ Lhe"e !"ice +eade"shi! is *e++ estab+ished& cha" in acco"din to *hat com!etito"s a"e cha" in may be the on+y sa#e !o+icy$ In case o# !"ice +eade"& "i)a+s ha)e di##icu+ty in com!etin on !"ice J too hi h and they +ose ma"ket sha"e& too +o* and the !"ice +eade" *ou+d match !"ice and #o"ce sma++e" "i)a+s out o# ma"ket$ Lhe"e com!etition is +imited& ' oin "ate( !"icin may be a!!+icab+e J banks& !et"o+& su!e"ma"kets& e+ect"ica+ oods J #ind )e"y simi+a" !"ices in a++ out+ets It must be noted that oin "ate !"icin is not :uite the same as acce!tin the !"ice im!e"sona++y set by nea" !e"#ect ma"ket$ Rathe" it *ou+d seem that the #i"m has some !o*e" to set its o*n !"ice and cou+d be a !"ice make" i# it chooses to #ace a++ the conse:uences$ It !"e#e"s& ho*e)e"& to take the sa#e cou"se and con#i"m to the !o+icy o# othe"s$ #.2.".'. Penetration Price. It is a method unde" *hich "e+ati)e+y +o* !"ice is set in o"de" to !enet"ate into the ne* ma"ket$ %hus& it is the 8"ice set to '!enet"ate the ma"ket( and 'Lo*( !"ice to secu"e hi h )o+umes$ Lhi+e int"oducin ne* !"oducts o" ente"in in ne* eo "a!hica+ ma"ket& #i"ms may set "e+ati)e+y +o*e" !"ice in the ho!e o# !enet"atin into the ma"ket$ %he idea is to estab+ish a ma"ket sha"e #i"st and than "adua++y mo)e to a !"ice *hich is mo"e desi"ab+e #"om the !"o#it an +e$ %his method is ene"a++y suitab+e to the ne* !"oducts o" to +aunch the !"oduct into a ne* ma"ket$ It is ty!ica+ in mass-ma"ket !"oducts$ 7o*e)e"& this st"ate y *o"ks *e++ !"o)ided the demand is hi h+y !"ice e+astic and the natu"e o# the !"oduct di##e"entiation is such that many custome"s a"e in a !osition to et att"acted by +o* !"ice$ #.2.".+. S=imming Price.

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It is a !"icin method unde" *hich the #i"m sta"ts *ith a hi h !"ice a!!ea+in to those custome"s *ho a"e *i++in to !ay hi he" !"ice #o" bette" :ua+ity o" because they !ut some additiona+ )a+ue on the !"oducts$ 7o*e)e"& at the +atte" sta e a s+i ht+y #a++in !"ice may att"act the ne* custome"s$ Each successi)e #a++ in !"ice may b"in in mo"e and mo"e custome"s$ ;ut the"e is dan e" in +ettin the !"ice to #a++ beyond a !oint because o# the !e"cei)ed co""e+ation bet*een !"ice and :ua+ity$ %his method is suitab+e #o" !"oducts that ha)e sho"t +i#e cyc+es o" *hich *i++ #ace com!etition at some !oint in the #utu"e De$ $ a#te" a !atent "uns out-$ E0am!+es inc+ude: 8+ay station& 4e*e++e"y& di ita+ techno+o y& ne* D?Ds& etc #.2.".2. *dministered Price. Administe"ed !"ice is the !"ice& *hich is #i0ed by the o)e"nment and is the !"ice the mandato"y in cha"acte"$ In this method o)e"nment #i0 the !"ice #o" the !"oducts& *hich shou+d be st"ict+y #o++o*ed by the !"oduce"s$ 7o*e)e"& *hi+e #i0in o)e"nment *i++ conside" the cost o# !"oduction and a+so #ai" "etu"ns to the !"oduce"$ %he "ationa+ity behind this method is that the essentia+ commodities ha)e to be made a)ai+ab+e to the !eo!+e at "easonab+e !"ice$ %he !"ice shou+d not be !"ohibiti)e$ I# they become mono!o+y !"oducts& the !"oduce"s may cha" e hea)y !"ice& *hich !"e)ents the *eake" section to !u"chase them$ In such situation it is the duty o# the o)e"nment to make !"oducts a)ai+ab+e at #ai"+y "easonab+e !"ice to the consume"s$ 8ub+ic uti+ity conce"ns a"e mana ed by the o)e"nment *ith the ob4ecti)e o# !"o)idin se")ices to the !eo!+e at "easonab+e !"ice$ E)en in case o# essentia+ commodities !"oduced in !"i)ate secto"& the o)e"nment inte")enes and #i0es the !"ice at *hich the !"oduce"s se++ those !"oducts$ %he ma4o" +imitation o# this method o# !"icin does not a++o* the #"ee !+ay o# ma"ket #o"ces +ike su!!+y and demand$ Due to the +ibe"a+ised economic !o+icy& this !"icin method is +oosin the im!o"tance$ #.2.".6. :oss1:eader Pricing. It is method unde" *hich oodsAse")ices de+ibe"ate+y so+d be+o* cost to encou"a e sa+es o# the othe" !"oducts$ A #i"m se++in both "a3o" and b+ade may cha" e the !"ice o# "a3o"& *hich is be+o* the a)e"a e )a"iab+e cost i# it is con#ident o# se++in a +a" e )o+ume

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o# the b+ades in o"de" to o)e" com!ensates the +oss in the "a3o"$ ;ecause o# the +oss makin !"oduct& custome"s a"e induced into buyin othe" com!+imenta"y items in the +ine and the *ho+e set becomes !"o#itab+e$ It is ty!ica+ in su!e"ma"kets& e$ $ at Ch"istmas& se++in bott+es o# Gin at \9 in the ho!e that !eo!+e *i++ be att"acted to the sto"e and buy othe" thin s$ Such a !"icin st"ate y is suitab+e e)en in the ca!ita+ oods *ith hea)y "e:ui"ement o# the "e!+acement !a"ts and consumab+es$ #.2.".7. Discriminating Price. In this method& the same !"oduct *i++ ha)e di##e"ent !"ice in di##e"ent ma"ket se ments$ In othe" *o"ds #i"ms cha" in a di##e"ent !"ice #o" the same oodAse")ice in di##e"ent ma"kets$ ;est e0am!+e #o" this method is e+ect"ic 8o*e"$ E+ect"icity boa"d *i++ cha" e di##e"ent !"ice to the same !o*e" to di##e"ent !o*e" use"s +ike a "icu+tu"ists& indust"ia+ units& domestic use"s& comme"cia+ use"s etc$ 7o*e)e"& its ado!tion "e:ui"es each ma"ket to be im!enet"ab+e$ Re:ui"es di##e"ent !"ice e+asticity o# demand in each ma"ket %hus& the"e a"e many di##e"ent !"icin methods& *hich a"e bein !"actica++y its

ado!ted by one o" the othe" kind o# #i"ms$ 7o*e)e"& *hi+e choosin a !a"ticu+a" !"icin method a #i"m has to ca"e#u++y ana+yse *hich method is suitab+e in !e"usin ob4ecti)es$

#.6. Self Re iew 8uestions

,$ .$ 9$ <$ =$ !o+icy6 @$ cu")e B$ E0!+ain the #eatu"es o# mono!o+istic com!etition Lhat is kinked demand cu")e6 E0!+ain the "easons #o" kinked demand Lhat is ma"ket6 7o* ma"kets a"e c+assi#ied6 Distin uish mono!o+y and mono!sony De#ine o+i o!o+y Lhat is !enet"atin !"ice6 Lhen this !"icin st"ate y is suitab+e6 De#ine disc"iminatin !"ice6 Lhat a"e the conditions "e:ui"ed to ado!t this

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H$ ma"ket I$ ,G$ ,,$

Desc"ibe the !"ice and out!ut dete"mination unde" !e"#ect com!etiti)e E0!+ain the !"icin !"ob+ems in o+i o!o+y ma"ket condition Discuss the #acto"s in)o+)ed in !"icin !o+icies E0!+ain the di##e"ent !"icin methods that a"e bein !"actica++y #o++o*ed

by the business o" anistions$ <$I$ Re#e"encesA Su

ested Readin s

,$ Mote& ?$ L$& Samue+ 8au+& Gu!ta&G$ S: 1 Mana e"ia+ Economics: Conce!ts and Cases2& %ata McG"a*-7i++ 8ub+ishin Com!any Limited& Ne* De+hi .$ D$M$Mithani : 1Mana e"ia+ Economics: %heo"y and A!!+ications2& 7ima+aya 8ub+ishin 7ouse& Mumbai-<GG GG< 9$ Reddy&8$ N$ and A!!anniah& 7$ R$ : 18"inci!+es o# ;usiness Economics2& S$Chand N Com!any Ltd$ Ne* De+hi-,,G G== <$ Dominick Sa+)ato"e: 1Mana e"ia+ Economics2& McG"a*-7i++ Inte"nationa+ Editions& Sin a!o"e =$ Ahu4a& 7$ L$: 1Ad)anced Economic %heo"y2& S$Chand N Com!any Ltd$ Ne* De+hi,,G G== @$ ?a"shney RL& and Mahesh*a"i 5$L: 1Mana e"ia+ Economics2& Su+tan Chand N Sons& Ne* De+hi-,,GGG.

MODULE-?: 8RO/I% ANALMSIS

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8"o#it is one o# the main moti)es behind any kind o# business acti)ities$ Mana ement students need to ha)e !"o!e" unde"standin dea+s *ith the b"eak-e)en ana+ysis a+so$ %he unde"standin about the conce!t and o# this too+ e:ui!s the measu"ement o# !"o#it$ So& this cha!te" #ocuses on the conce!t o# !"o#it$ %his modu+e mana ement students in the !"o#it !+annin o# a #i"m$ %he +ast section o# this modu+e dea+s *ith +inea" !"o "ammin a!!"oach& *hich is most use#u+ in o!timi3ation decisions$

'.1 Meaning and Nature of Profit

In economic theo"y& !"o#its a"e !ayments #o" the *o"k o# the ent"e!"eneu"& as he is a #acto" o# !"oduction +ike othe" #acto"s$ ;ut this conce!t o# !"o#it has become a vexe$ an$ mixe$ one. %hou h !"o#it is an income #o" the ent"e!"eneu" #o" his *o"k& he is ettin the income ca++ed !"o#its$ 8"o#its ha)e been de#ined& as wages of management o" it is the rewar$ for entrepreneur. It is a+so a "e*a"d #o" o*ne"shi! o# ca!ita+$ Since the ent"e!"eneu" ets his income in a )a"iety o# *ays& !"o#its ha)e become a mixe$ in%ome. It is a+so a )e0ed one& as the"e is no unanimity amon economists about the de#inition$ %hat is *hyC 8"o#$ 5ni ht has obse")ed 1no te"m o" conce!t in economic discussion is used *ith a mo"e be*i+de"in )a"iety o# *e++-estab+ished meanin than !"o#it2$ 8"o#it is the !e"centa e o# "etu"n on in)estmentC it is the "e*a"d #o" takin "isk in business$ It is a "esidua+ income #o" the ent"e!"eneu" a#te" !ayin o## othe" #acto"s$ It is the di##e"ence bet*een the tota+ sa+e !"oceeds obtained and the tota+ e0!ense o# !"oduction$ %hus the te"m !"o#it has been inte"!"eted in a )a"iety o# *ays$ 8"o#its *hen com!a"ed to othe" "e*a"ds o# #acto"s& is )ita++y im!o"tant& as it is the "e*a"d #o" the ent"e!"eneu" *ho unde"takes the *o"k o# coo"dination o# the #acto"s and !"oduces the commodity$ In the absence o# !"o#its& the"e *ou+d not be incenti)e #o" !"oduction and !"o#its act as a sou"ce o# ca!ita+ #o"mation and economic !"o "ess$ 7o*e)e"& 5a"+ Ma"0 has condemned !"o#its as !"edato"y income& b"andin it as +e a+ "obbe"y$ Cont"a"y to it Koe+ Dean is o# the o!inion that 1A business #i"m is an o" ani3ation desi ned to make !"o#its& and !"o#its a"e the !"ima"y measu"e o# its success$2 and this b"in s the im!o"tance o# !"o#it in the conte0t o# mana e"ia+ decisions$

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%heo"etica++y& the de#inition o# !"o#it is that the "e*a"d #o" the ent"e!"eneu" is acce!tab+e& as he b"in s the th"ee #acto"s o# !"oduction to ethe" #o" !"oducin some consumab+e commodity$ ;ut in the case o# Mode"n Co"!o"ation& o" the Koint-stock Com!any& *ho shou+d be identi#ied as the ent"e!"eneu"6 Is it the e:uity sha"eho+de"s *ho unde"take the "isk o# in)estin thei" money& o" the sa+a"ied mana e"s *ho unde"take ent"e!"eneu"ia+ #unctions6 ?e"a Anstey be+ie)es that the te"m shou+d co)e" both these "ou!s$ 8"o#it is the "esu+t o# )a"iety o# in#+uences in a business$ As a "esu+t& many theo"ies o# !"o#its a"e eme" ed$ /o" the bette" unde"standin o# the conce!t o# !"o#it one shou+d unde"stand the difference between 8profiteering9 and profit earning$ %he te"m '8"o#itee"in ( is di##e"ent #"om '8"o#it-ea"nin ($ %he #o"me" connotes 1earnings which are e"cessive and beyond the socially desirable and acceptable limit by 2uestionable methods:. 8"o#it ea"nin & on the othe" hand denotes makin !"o#its *ithin socia++y desi"ab+e and acce!tab+e +imit$ 8"o#itee"in is a de+ibe"ate attem!t to ea"n e0t"a !"o#its at the cost o# e)en business ethics$ 7oa"din is one !"ominent *ay o# !"o#itee"in $ 8"o#itee"in is socia++y un4ust$ Simi+a"+y one shou+d ha)e the bette" unde"standin about the difference between 8accounting9 and 8economic profit($ %he"e is a *ide di##e"ence bet*een !"o#it in the accountin sense and !"o#it in the economic sense$ In the accountin sense& !"o#it is "e a"ded as the "e)enue "ea+i3ed du"in the !e"iod minus the cost and e0!enses incu""ed in !"oducin the "e)enue$ %his conce!t o# !"o#it is a+so kno*n as Resi$ual Con%ept$ %he economists& ho*e)e"& do not a "ee *ith the accountant(s a!!"oach to !"o#it$ Economists conside" both e0!+icit and im!+icit costs in a""i)in at !"o#its$ %hey deduct both e"plicit and implicit costs #"om the tota+ sa+es "ecei!ts in dete"minin !"o#its$ Acco"din to Accountants& the money-cost o# !"oducin an a"tic+e inc+udes on+y those costs *hich a"e di"ect+y !aid out o" accounted #o" by the !"oduce"$ %hese a"e *a es& inte"est& "ent& de!"eciation cha" es on #i0ed ca!ita+& ta0es !aid and othe" sund"y e0!enses$ %hese items to ethe" constitute !"plicit costs of production. Economists think that in addition to these& the"e a"e othe" items& *hich ou ht to be inc+uded in the te"m& money-cost o# !"oduction$ %hese a"e as #o++o*s:

,.I

La es #o" the *o"k !e"#o"med by the ent"e!"eneu"C Inte"est on ca!ita+ su!!+ied by himC Rent on +and and bui+din s be+on in to him and used in !"oductionsC Such !"o#its a"e conside"ed usua+ o" no"ma+ in the +ine o# business$

Economists ca++ them im!+icit cost o# !"oduction$ Accountants do not inc+ude these items in dete"minin !"o#it$ %hey deduct on+y e0!+icit o" actua+ costs #"om the tota+ "e)enue ea"ned *hi+e dete"minin the !"o#its$ Economic cost F E0!+icit Cost O Im!+icit Costs O" Economic Costs F Accountin Cost O Im!+icit Costs$ %he #i"m *i++ be ea"nin Economic 8"o#its on+y i# it is makin "e)enue in e0cess o# the tota+ o# accountin and im!+icit costs$ %hus& *hen the #i"m is in no !"o#it and no +oss !osition& it means that the #i"m is makin "e)enue e:ua+ to the tota+ o# accountin and im!+icit costs and no mo"e$ %he"e#o"eC Economic 8"o#it F %ota+ Re)enue J Economic Costs$ Economic !"o#its a"e "e+e)ant #"om the mana e"ia+ !oint o# )ie*& as they t"u+y "e#+ect the !"o#itabi+ity o# a business conce"n$ # business firm may be making profits in the accounting sense; but it may be actually incurring losses in the economic sense. Such a #i"m *i++ not su")i)e in the +on "un$ 7ence& economic !"o#its a"e mo"e use#u+ than the accountin !"o#its& #o" mana e"ia+ !u"!oses$ ,unctional /ole of (usiness Profits) Acco"din to 8"o#$ 8ete" Ducke"& business !"o#its !+ay a #unctiona+ "o+e in th"ee di##e"ent *ays$ They indicate the effectiveness of business efforts: %he success o" e##ecti)eness o# the business is indicated th"ou h the !"o#it it ea"ns$ 7i he" the !"o#it o# conce"n& *e ene"a++y conside" that the business is mo"e success#u+$ E)en thou h it may be a" ued that !"o#it is not a !e"#ect measu"e o# business e##iciency& it is an easy and

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:uick basis on *hich business !e"#o"mance can be com!a"e amon the )a"ious #i"ms$ They provide the premium to cover costs of staying in business: 8"o#it is a sou"ce o# #unds #"om *hich a business #i"m *i++ be ab+e to de#"ay ce"tain e0!enses +ike "e!+acement& obso+escence& ma"ketin & etc$ ;usiness #i"ms must ene"ate !"o#its su##icient to !"o)ide #o" these costs$ They ensure supply of future capital: 8"o#its a"e the !"inci!a+ sou"ce #o" a #i"m(s #utu"e ca!ita+ "e:ui"ements #o" inno)ation and e0!ansion$ ;usiness conce"ns he+! themse+)es by ene"atin !"o#its in meetin !a"t o# thei" ca!ita+ "e:ui"ement a!a"t #"om "aisin #unds th"ou h e0t"aneous sou"ces$

'.2 /heories of Profit

%he"e a"e se)e"a+ theo"ies o# !"o#it !"o!ounded by economists$ None o# these dea+ *ith a++ as!ects o# !"o#it$ Each theo"y #ocuses on the di##e"ent as!ects o# !"o#it$ Le sha++ study some o# the theo"ies o# !"o#it$ '.2.1. Hawle.Bs Ris= /heor. An Ame"ican economist 7a*+ey ad)ocated this theo"y$ Acco"din to him& !"o#its a"ise because the entrepreneur un$erta+es the ris+ of the usiness and he has to be "e*a"ded #o" that$ As !e" this theo"y& hi he" the "isk& "eate" is the !ossibi+ity o# !"o#it$ ;ut this theo"y is c"itici3ed on the #o++o*in '.2.2 "ounds: %he"e is no "e+ationshi! bet*een "isk and !"o#it$ Insu"ab+e "isks a"e no "isk at a++$ On+y uninsu"ab+e "isks a"e "ea+ "isks$ 8"o#it is the "esu+t o# not on+y "isk bea"in & but a+so due to othe" #acto"s$ DnightBs 9ncertaint.13earing /heor. %his theo"y& ad)ocated by 8"o#$ 5ni ht& a "ees *ith 7a*+ey(s theo"y that !"o#it is a "e*a"d #o" "isk-takin $ 7o*e)e"& the te"m "isk is c+a"i#ied and the"e a"e t*o ty!es o# "isks: a- /o"eseeab+e "isksC and b- Un#o"eseeab+y "isks$ %he +atte" "isk is ca++ed unce"tainty bea"in $ I# "isk can be insu"ed a ainst& it is not "isk at a++$ /o" instance& #i"e&

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#+ood& the#t& etc$& a"e "isks in business& *hich can be insu"ed& and the +oss a"isin out o# these *i++ be made ood by the insu"ance com!any$ %he !"emium !aid #o" insu"ance is inc+uded in the cost o# !"oduction$ Insu"ab+e "isk& thus& does not i)e "ise to !"o#it$ So& acco"din to 8"o#$ 5ni ht& !"o#it is due to non-insu"ab+e "isk o" un#o"eseen "isk$ Some o# the non-insu"ab+e "isks: Com!etiti)e "iskC %echnica+ "iskC Risk o# o)e"nment(s inte")entionC and Risk a"isin out o# business cyc+e$ Since& these "isks cannot be #o"eseen and measu"ed& they become non-insu"ab+e and unce"tainties ha)e to be bo"ne by the ent"e!"eneu"$ Acco"din to this theo"y& the"e is a di"ect "e+ationshi! bet*een !"o#it and unce"tainty bea"in $ 5ni ht(s theo"y is c"itici3ed on the #o++o*in "ounds: I# !"o#its a"e due to unce"tainty bea"in & *hat e0!+anation cou+d be i)en in cases *he"e !"o#its do not acc"ue in s!ite o# unce"tainty bea"in $ Unce"tainty bea"in is one o# the dete"minants o# !"o#it& and that is not the on+y dete"minant$ %he theo"y em!hasi3es too much about unce"tainty-bea"in as to e+e)ate it into a se!a"ate #acto" o# !"oduction %his theo"y does not se!a"ate the t*o #unctions in mode"n business& name+y o*ne"shi! and cont"o+ %he theo"y does not e0!+ain mono!o+y !"o#it$ 7o* do !"o#its a"ise& *hen the"e is no :uestion o# unce"tainty bea"in in mono!o+y6 It is not !ossib+e to measu"e unce"tainty in :uantitati)e te"ms to asc"ibe !"o#it$

'.2.". D.namic /heor. of Profit %his theo"y ad)ocated by K$;$ C+a"k assumes that !"o#its a"ise as a 'Dynamic Su"!+us($ Acco"din to this theo"y& in a static state& the"e is no chan e in demand and su!!+y and !"o#its do not a"ise$ %his is becauseC unde" static conditions !ayments made to the #acto"s o# !"oduction on the basis o# ma" ina+ !"oducti)ity e0haust the tota+ out!ut$ In this condition& in e:ui+ib"ium& !"ice o# each commodity e0act+y e:ua+s its money cost o# ,9.

!"oduction& inc+udin no"ma+ !"o#its and the"e is no su"!+us o# any kind$ 8"o#its "esu+t on+y *hen se++in !"ices o# oods e0ceed thei" cost o# !"oduction$ %he"e#o"e& in a static state& the"e a"e no !ossibi+ities o# ettin !"o#it and it a"ises on+y in dynamic condition$ It is a dynamic su"!+us$ 8"o#its a"ise due to dise:ui+ib"ia caused by the chan es in demand and su!!+y conditions$ No*& the :uestion a"ises *hat C+a"k mentions about #i)e chan es& *hich may occu" in a dynamic economy to i)e "ise to !"o#its$ Chan es in the :uantity and :ua+ity o# human *ants Chan es in the methods and techni:ues o# !"oduction Chan es in the amount o# ca!ita+ Chan es in the #o"m o# business o" ani3ation Chan es in !o!u+ation Such chan es i)e some ent"e!"eneu"s ad)anta es o)e" othe" ent"e!"eneu"s and they mana e to ea"n su"!+us$ %his theo"y is c"itici3ed as #o++o*s: %his theo"y does not #u++y a!!"eciate the natu"e o# ent"e!"eneu"ia+ #unctions$ I# the"e a"e no !"o#its in a static state& it means the"e is no ent"e!"eneu"$ ;ut *ithout an ent"e!"eneu"& it is not !ossib+e to ima ine the coo"dination o# #acto"s o# !"oduction$ 7ence& Ma"sha++ so+)ed this di##icu+ty by his conce!t o# normal profit& *hich is ea"ned in a static state a+so$ Me"e chan e in an economy *ou+d not i)e "ise to !"o#its& i# these chan es *e"e !"edictab+e$ %his theo"y has c"eated an a"ti#icia+ distinction bet*een '8"o#it( and 'La es o# Mana ement($ '.2.#. SchumpeterBs Inno ation /heor. %his theo"y !"o!ounded by Schum!ete" is mo"e o" +ess simi+a" to C+a"k(s theo"yC but this theo"y i)es im!o"tance to innovations in the !"oducti)e !"ocess$ Acco"din to this theo"y& !"o#it is the "e*a"d #o" inno)ation$ Inno)ations "e#e" to a++ these chan es in the !"oduction !"ocess *ith an ob4ecti)e o# "educin the cost o# the commodity& so as to c"eate a a! bet*een the e0istin !"ice o# the commodity and its ne* cost$ Schum!ete"(s innovation may take any sha!e$ It may be the "esu+t o# int"oduction o# a ne* techni:ue o" a ne* !+ant& a chan e in the inte"na+ st"uctu"e o" o" ani3ationa+ set u! o# the #i"m$ It may

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be a chan e in the :ua+ity o# the "a* mate"ia+& a ne* #o"m o# ene" y& bette" method o# sa+esmanshi!& etc$ 1Inno)ation is much mo"e than in)ention$ In)ention is not inno)ation& i# it is sti++bo"n& that is& i# it is not used$ An in)ention becomes an inno)ation on+y *hen it is a!!+ied to indust"ia+ !"o "ess$2 Inno)ation is b"ou ht about main+y #o" "educin the cost o# !"oduction and it is a cost "educin a ent$ Inno)ations a"e not !ossib+e by a++ ent"e!"eneu"s$ On+y e0ce!tiona+ ent"e!"eneu"s *ith e0t"ao"dina"y abi+ities can inno)ate and c"eate o!!o"tunities th"ou h thei" ima ination and bo+d action$ 8"o#it is the "e*a"d #o" this st"ate ic "o+e$ /u"the"& acco"din to Schum!ete"& !"o#its a"e o# tem!o"a"y natu"e$ %he !ionee"& *ho inno)ates& ets abno"ma+ !"o#its #o" a sho"t !e"iod$ Soon othe" ent"e!"eneu"s swarm in %lusters and com!ete #o" !"o#it in the same manne"$ So& the !ionee" *i++ make anothe" inno)ation$ %hus !"o#it *i++ a!!ea" and disa!!ea" and a ain "ea!!ea"$ Profits are caused by innovation and disappear by imitation. %he theo"y is c"itici3ed on the #o++o*in #unction$ It does not "eco ni3e the "isk-takin #unctions o# the ent"e!"eneu"$ No* inno)ations bea" the e+ement o# unce"tainty and "isks$ Mono!o+y !"o#its a"e !e"manent in natu"e *hi+e Schum!ete" att"ibutes the :ua+ity o# tem!o"a"ies to !"o#its$ '.2.'. Marginal Producti it. /heor. of Profit %he theo"y o# ma" ina+ !"oducti)ity is a+so a!!+ied in the case o# !"o#it$ Acco"din to 8"o#$ Cha!man& !"o#its a"e e:ua+ to the ma" ina+ *o"th o# the ent"e!"eneu" and a"e dete"mined by the ma" ina+ !"oducti)ity o# the ent"e!"eneu"$ Lhen the ma" ina+ !"oducti)ity is hi h& !"o#its *i++ a+so be hi h$ ;ut& the #undamenta+ di##icu+ty in this theo"y is in measu"in inc"easin o" dec"easin the units o# #acto"s can assess the ma" ina+ !"oducti)ity$ In ent"e!"eneu"ia+ #unction& it is not !ossib+e& as a #i"m *i++ ha)e on+y one ent"e!"eneu"$ %o assume that a++ ent"e!"eneu"s a"e a+ike is hi h+y un"ea+istic$ %hus theo"ies o# !"o#its ha)e become hi h+y cont"o)e"sia+ and +east satis#acto"y$ "ounds: Inno)ation is on+y one o# the many #unctions o# the ent"e!"eneu" and not the on+y

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Mana e"ia+ economics& thou h it makes use o# the assum!tions o# !"o#it ma0imi3ation& makes +itt+e di"ect use o# the theo"ies o# !"o#its$ %he"e is no sin +e theo"y i)in satis#acto"y e0!+anation "e a"din !"o#it$ Acco"din to ;"i s and Ko"dan& 1It is di##icu+t to #"ame a sim!+e theo"y o# !"o#its *hich *ou+d inc+ude the sma++ inde!endent t"ade"& the +a" e em!+oye"& the sma++ ho+de"& and the sha"eho+de"& o# a Koint-Stock Com!any& *hi+st e0c+udin "es!onsib+e mana e"s$2 7o*e)e"& thou h none o# these theo"ies is a co""ect e0!+anation o# !"o#its& they a"e in sense com!+ementa"y theo"ies$ It is !ossib+e that mono!o+y& unce"tainty and inno)ations a"e #acto"s o# )ita+ im!o"tance& as they a##ect !"o#it-ea"nin ca!acity o# the #i"m$ 7ence& kno*+ed e o# these theo"ies he+!s businessmen in #o"mu+ation o# thei" !"o#it !o+icies$

'.". Measurement of Profit

%he measu"ement o# the amount o# !"o#it ea"ned by a business #i"m du"in a i)en !e"iod& is not so sim!+e as it may a!!ea"$ E)en in the accountin sense& measu"ement o# !"o#it is not an easy task$ Se)e"a+ !"actica+ di##icu+ties a"e in)o+)ed he"e$ Some o# them a"ise out o# conce!tua+ di##e"ences *ith "e#e"ence to costs& income& )a+uation o# assetsC some di##e"ences a"ise due to the de#inition o# !"o#its by accountants and economists and a+so due to #inancia+ accountin con)entions& and +e a+ "e:ui"ements$ In !a"ticu+a"& the !"ob+em a"ises in the :uestion 8what is included in the costs to be subtracted from revenues to obtain profits, remains the cru" of the problem9. %he"e is *ide )a"iety o# ene"a++y acce!ted accountin !"inci!+es& *hich !"o)ide #o" di##e"ent methods o# methods a"e t"eatment #o" ce"tain items o# "e)enue" o# e0!enditu"e$ %he #o++o*in ene"a++y conside"ed *hi+e measu"in !"o#itsC they a"e: De!"eciation ?a+uation o# Stock %"eatment o# de#e""ed e0!enses Ca!ita+ ains and +osses

'.".1. Depreciation Le kno* that in e)e"y business& e:ui!ment& machines and bui+din a"e used and they *ea" out o)e" a !e"iod due to #"e:uent use$ In cou"se o# time& these assets become use+ess #"om the !oint o# )ie* o# business and they ha)e on+y sc"a! )a+ue$ %he use-)a+ue o# the assets o# the #i"m oes on diminishin due to *ea" and tea"$ In due cou"se thei" ,9=

)a+ue #"om the )ie*!oint o# business dec+ines$ %he"e#o"e& to measu"e t"ue income o# the business& accountants make periodic charges to income to recover the cost of e2uipment before its usefulness is e"hausted. This charge is known as depreciation which represents the decrease in the value of the assets due to use during a particular period, say a year. %his !"o)ision #o" de!"eciation cha" es *i++ not be uni#o"m in a++ #i"ms$ It )a"ies in im!o"tance #"om com!any to com!any$ In the case o# hea)y indust"ies +ike i"on and stee+& "ai+*ays& t"ans!o"t& etc$& )e"y hea)y de!"eciation cha" es a"e !"o)ided$ In the case o# #i"ms +ike insu"ance com!anies& banks& #inancia+ institutions& *ho+esa+e business and "etai+ business& etc$& the de!"eciation cha" es *i++ be "e+ati)e+y +o*e"$ )ethods of measuring depreciation& %he"e a"e a numbe" o# methods o# measu"in de!"eciation #o" the !u"!ose o# "e!o"tin business !"o#its to the sha"eho+de"s and ta0ab+e !"o#it to the income-ta0 autho"ities$ De!"eciation is an im!o"tant inte"na+ sou"ce o# #unds and hence the method o# de!"eciation becomes )e"y si ni#icant as a too+ o# ca!ita+ #o"mation$ %he"e a"e th"ee common+y acce!ted methods o# de!"eciationC they a"e: St"ai ht Line Method Dec+inin ;a+ance Method Sum o# the yea"s di its method

Le sha++ discuss these methods o# measu"in de!"eciation in a "eate" detai+$ '.".1.1. Straight :ine Method: Acco"din to this method& an asset is su!!osed to *ea" out e)en+y du"in its no"ma+ +i#e$ 7ence de!"eciation is !"o)ided on a uni#o"m basis "e a"d+ess o# the #act that the asset de!"eciates mo"e "a!id+y at some sta es$ %his is ca+cu+ated by usin #o"mu+a: Initia+ cost o# the asset De!"eciation F Estimated +i#e s!an o# the asset in yea"s %he amount o# annua+ de!"eciation is obtained by di)idin the initia+ cost o# the asset by the estimated +i#e in yea"s& assumin that the"e is no sc"a! )a+ue$ I# the asset has an estimated sc"a! )a+ue its amount *i++ ha)e to be deducted #"om the initia+ cost be#o"e di)idin it by the estimated +i#e in yea"s$ this

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Illustration& su!!ose that an asset has an o"i ina+ )a+ue o# Rs$,GGGG *ith a sc"a! )a+ue o# Rs$,GGG and its +i#e s!an is estimated to be ,Gy"s$ %he annua+ de!"eciation cha" e on the asset *i++ be: Rs$,G& GGG J Rs$,GGG F Rs$IGG ,G Unde" the *o"kin hou"s method& the +i#e s!an o# the asset is e0!"essed in te"ms o# *o"kin hou"s& "athe" than in yea"s$ In those cases& de!"eciation is ca+cu+ated by di)idin the initia+ cost +ess sc"a! )a+ue by the numbe" o# *o"kin hou"s$ Su!!ose that an asset has a *o"kin +i#e o# ,GGGG hou"s and its o"i ina+ cost is Rs$..GGG and its sc"a! )a+ue is Rs .GGG$ %he de!"eciation !e" *o"kin hou" *i++ be ca+cu+ated as #o++o*s: Rs$ ..GGG J Rs$ .GGG F Rs$ . 8e" *o"kin hou" ,GGG %he st"ai ht-+ine method is )e"y sim!+e in ado!tion$ Lhen the"e a"e no !ossibi+ities o# !"ematu"e "eti"ement o# assets due to accidents& obso+escence o" inade:uate ca!acity$ %his method does not take into account the inc"easin cost o# "e!ai"s in the +ate" yea"s o# the +i#e o# the asset and as a "esu+t& the tota+ cost o# o!e"ation is +ike+y to be dis!"o!o"tionate in the +ate" yea"s$ '.".1.2. Declining Aalance Method

Unde" this method& de!"eciation is !"o)ided on a uni#o"m "ate on the *"itten do*n )a+ue o# the asset at the be innin o# the yea"$ I# the cost o# the asset is Rs$=GGG and the "ate o# de!"eciation is ,GV& the de!"eciation #o" the #i"st yea" *ou+d be Rs$=GG$ in this case the *"itten-do*n )a+ue o# the asset #o" the ne0t yea" *ou+d be Rs=GGG- Rs$=GG F <=GG and the de!"eciation #o" the second yea" *ou+d be ca+cu+ated at ,GV #o" Rs$<=GG *hich *ou+d be Rs$<=GG J Rs$<=G F <G=G$ Du"in the thi"d yea" the de!"eciation *ou+d be ,GV o# Rs$<G=G& i$e$& Rs$<G=$ %hus& the de!"eciation amount *i++ sho* a dec+inin t"endC Rs$=GG in the #i"st yea"C Rs$<=G in the second yea"C and Rs$<G= in the thi"d yea"$ Unde" this method& the *"itten do*n )a+ue ho*e)e" sma++& *i++ ne)e" be 3e"o$ 7ence& the asset is assumed to ha)e some sc"a! )a+ue$ %he #o"mu+a #o" dete"minin the #i0ed "ate o# de!"eciation unde" 'Dec+inin ;a+ance Method( is as #o++o*s: D F,GG ],-n^sAc_ Lhe"e& ,9B

D F V o# de!"eciation s F Sc"a! o" "esidua+ )a+ue o# the asset c F Initia+ cost o# the asset n F Estimated +i#e o# the asset in the yea"s$ %he method o# com!utin the #i0ed "ate o# de!"eciation as desc"ibed abo)e is "athe" com!+icated$ A simi+a" and mo"e *ide+y used method is to use a uni#o"m V& *hich is doub+e the "eci!"oca+ o# the estimated +i#e: 4niform rate or d < = 0>5n%he basic idea behind this method is to !"o)ide #o" a mo"e o" +ess uni#o"m tota+ cost o# o!e"ation o# the asset o)e" di##e"ent yea"s o# its +i#e$ On the othe" hand& unde" this method& de!"eciation is hi he" in ea"+ie" !a"t o# the asset(s +i#e& but it dec+ines !"o "essi)e+y in the +ate" yea"s$ %he combined e##ect is that the tota+ cha" e in the !"o#it and +oss account so #a" as the asset is conce"ned& is e:uated o)e" di##e"ent yea"s$ '.".1.". /he Sum of the ;earBs Digits Method) %he basic idea o# this method is simi+a" to that o# the Dec+inin ;a+ance Method& i$e$& to !"o)ide #o" a uni#o"m tota+ cost o# o!e"ation o# the asset$ %he amount o# de!"eciation in the be innin o# the +i#e o# the asset is hi he" and it !"o "essi)e+y dec+ines *ith the !assa e o# time$ %his method di##e"s #"om the dec+inin ba+ance method in that the base or book value remains constant while the annual rate of depreciation changes. %he )a"iab+e "ate o# de!"eciation is ca+cu+ated as #o++o*s: Each di it o# the yea"s o# the use#u+ +i#e o# the asset is added u! and the "esu+tin #i u"e is the denominato" o# the #"action to #ind out the de!"eciation "ate$ %he nume"ato" o# the #"action #o" each yea" is the e0!ected +i#e o# the asset in that !a"ticu+a" yea" and this dec+ines by one each yea"$ %hus the de!"eciation "ate is com!osed o# a )a"yin nume"ato" and an un)a"yin denominato"$ And this "ate is a!!+ied each yea" to the asset(s o"i ina+ cost$ Illustration& %he sum o# the Mea"(s di it method can be e0!+ained *ith the #o++o*in i++ust"ation: Su!!ose the o"i ina+ cost o# the asset is Rs$,.GGG and its sc"a! )a+ue is Rs$.GGG and its e0!ected +i#e is < yea"s$ In the be innin & the asset has an e0!ected +i#e o#

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< yea"sC one yea" +ate" it has an e0!ected +i#e o# 9 yea"s and so on$ %hus the e0!ected +i#e !e"iods o# the asset a"e <&9&. and , yea"s$ %he sum o# these e0!ected +i#e !e"iods is ,G& *hich *i++ be the common denominato" o# the annua+ "ates$ %he nume"ato"s a"e "es!ecti)e+y <&9&. and ,$ %hus the annua+ "ates a"e <A,G& 9A,G& .A,G and ,A,G "es!ecti)e+y$ %he o"i ina+ )a+ue o# the asset is Rs$ ,.GGG and the sc"a! )a+ue is assumed to be Rs$.GGGC the annua+ de!"eciation cha" e shou+d be made #o" Rs$ ,GGGG$ In the #i"st yea"& the "ate o# de!"eciation is <A,G *hich is <GV and the de!"eciation amount is Rs$<GGG$ in the second yea" the "ate o# de!"eciation is 9A,G o" 9GV o" Rs$9GGG$ in the thi"d yea"& the "ate o# de!"eciation is .A,G o" .GV o" Rs.GGG and in the #ou"th yea"& the "ate o# de!"eciation is ,A,G o" ,GV *hich is e:ua+ to Rs$,GGG$ %hese data can be tabu+ated as sho*n in the tab+e$ /*A:E 5'.1 /he *nnual Depreciation #ge of the asset in years , . 9 < Rate o# de!"eciation <A,G o" <GV 9A,G o" 9GV .A,G o" .GV ,A,G o" ,GV #nnual depreciation Rs <GGG 9GGG .GGG ,GGG #ccumulated depreciation Rs$ <GGG BGGG IGGG ,GGGG (ook value of the asset Rs$ HGGG =GGG 9GGG .GGG

%he Dec+inin ;a+ance Method and the Sum o# the Mea"(s Di it method a"e use#u+& as *e++ as e:uitab+e in ca+cu+atin de!"eciation cha" es dec"ease$ Depreciation and Profit) Le studied th"ee methods o# ca+cu+atin de!"eciation o# an asset$ Unde" the St"ai ht Line Method& the cha" e o# de!"eciation is the same th"ou hout the +i#e o# the asset$ As a "esu+t& the profits are affected e2ually throughout. Unde" the $eclining (alance )ethod, and the Sum of the ?ear9s $igits )ethod, the charge for depreciation is higher towards the end. In )ie* o# the #act that de!"eciation is hi he" in the initia+ yea"s& both these methods a"e ca++ed #ccelerated $epreciation )ethods. As bet*een the t*o methods& the cha" e is hi he" in the #i"s yea" in the case o# Dec+inin ;a+ance Method than unde" the Sum o# the Mea"(s Di its Method$ ;ut in othe" yea"s& the de!"eciation is hi he" unde" the Sum o# the Mea"(s di its method$ /"om this& *e can unde"stand that the amount o# !"o#it o# a #i"m de!ends on the method o# de!"eciation de!"eciation& *he"e the cost o# "e!ai"s inc"ease as

,9I

ado!ted$ %ith the same machine, e2uipment, plant, building, etc., different firms can show different amounts of depreciation and conse2uently, different amounts of profit. /o" the youn and "o*in #i"m& the 'Acce+e"ated De!"eciation method( o##e"s ad)anta es as the ne* com!anies *i++ ha)e +imited ca!ita+ and they may need #unds #o" e0!ansion$ E)en #o" *e++-estab+ished com!anies *ith e0ce++ent c"edit #aci+ities& this method is bette" suited than the 'St"ai ht-Line Method( i# the com!anies a"e en a ed in the !"o "amme o# ca!ita+ e0!ansion and "e!+acement o# assets$ %he ad)anta es a"e as #o++o*s: %a0ab+e income and income-ta0 +iabi+ity *ou+d be substantia++y +a" e" to*a"ds +ate" yea"s on+y unde" the dec+inin ba+ance method and the sum o# yea"(s di it method$ Unde" the acce+e"ated de!"eciation method& the ta0 +iabi+ity bein +o*e" in the ea"+ie" yea"s o# the +i#e o# the asset& the com!any has the bene#it o# "etainin a !a"t o# the #unds *hich *ou+d ha)e been !ayab+e as ta0 unde" the st"ai ht-+ine method$ %hese #unds& in e##ect& amount to an inte"est-#"ee +oan #"om the Go)e"nment to the com!any& since the acce+e"ated methods "esu+t on+y in !ost!onement o# ta0 "athe" than its !e"manent a)oidance$ In the case o# assets sub4ect to "a!id obso+escence& it is desi"ab+e to *"ite-o## the asset as soon as !ossib+e in this "es!ect& acce+e"ated methods o# de!"eciation a"e mo"e e##ecti)e than the st"ai ht-+ine method$ %he ca!acity o# a #i"m to ea"n !"o#its #"om the use o# an asset is +o*e" in the ea"+ie" !a"t o# the +i#e o# the asset$ Conse:uent+y& the ca!acity to !ay ta0 is a+so +o*e"& unde" the acce+e"ated de!"eciation methodsC the ta0 +iabi+ity is +o*e" in the be innin and hi he" to*a"ds the end$ %hus& the"e is an ad4ustment in the ca!acity to !ay ta0es and the ta0 +iabi+ity is ad4usted *ith the ca!acity to !ay$ 7o*e)e"& the"e a"e ce"tain "est"ictions about the ado!tion o# de!"eciation methods by the ta0 "u+es o# di##e"ent count"ies& and these ta0 "u+es im!ose const"aints on the mana e"ia+ choice about de!"eciation method$ In the U$S$A$ a com!any can choose any ,<G

one o# the th"ee methods *e studied abo)e and the Inte"na+ Re)enue Act !e"mits this$ Othe" count"ies such as Denma"k& /"ance& 7o++and and S*eden ha)e int"oduced 'Acce+e"ated De!"eciation Method( *ith the ob4ect o# stimu+atin in)estment$ In Aust"a+ia& the St"ai ht-Line o" the Dec+inin ;a+ance Method may be used$ In India& the"e a"e !"esc"ibed "ates o# de!"eciation to be a!!+ied to the *"itten do*n )a+ue o# the asset unde" the dec+inin ba+ance method$ /o" ene"a+ machine"y and !+ant& the de!"eciation is ,GV$ In the case o# #u"nitu"e and #ittin s& the de!"eciation is ,=V *hen used in hote+s& "estau"ants& cinema theate"s& etc$ In the case o# bui+din it is .$=V$ '.".2. Faluation of Stoc= In business& the )a+uation o# stock *i++ in#+uence the !"o#it and the method ado!ted in a""i)in at the )a+uation o# the stock *ou+d ha)e decisi)e im!act on the !"o#it$ %he"e a"e th"ee methods )i3C :I,( ?:ast In ,irst (ut@ Method) Acco"din to this method& it is assumed that the units ac:ui"ed +ast a"e the units to be issued #i"st$ As a "esu+t& the in)ento"y is su!!osed to consist o# mate"ia+s !u"chased ea"+iest$ ,I,( Method ?,irst In ,irst (ut@) Acco"din to this method& it is assumed that the units o# stock ac:ui"ed #i"st shou+d be issued #i"st& i$e$& /i"st in stock shou+d o out #i"st& and stock ac:ui"ed )e"y "ecent+y *i++ be issued on+y +ate"$ Unde" this method& the in)ento"y is su!!osed to consist o# oods !u"chased most "ecent+y$ %he si ni#icance behind this is that the com!any may not ha)e ac:ui"ed the stock at the uni#o"m !"ice th"ou hout$ Lith "isin !"ices& at the be innin & the !u"chase cost *ou+d ha)e been +esse" and +ate" it *ou+d ha)e been +a" e"$ Eeighted * erage Method) %his method assumes that it is not !ossib+e to identi#y se!a"ate+y the mate"ia+s !u"chased at di##e"ent times at di##e"ent !"ices$ Conse:uent+y the cost o# one unit cannot be distin uished #"om the cost o# anothe"$ Units a"e issued at a cost o# *hich is an a)e"a e o# the cost o# each !u"chase& *ei hted by the :uantity !u"chase at that accost$ %he c+osin stock is )a+ued at the a)e"a e cost$

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Illustration& Let us take a hy!othetica+ case to i++ust"ate the th"ee methods mentioned abo)e in the )a+uation o# stock$ Su!!ose a #i"m !u"chases #o" its #acto"y !"oduction =GG 5 s& o# a !a"ticu+a" chemica+ at di##e"ent times and at di##e"ent !"ices as stated be+o*: 8u"chased on /eb"ua"y ,Hth 8u"chased on Ma"ch .Gth 8u"chased on Ma"ch 9,st : ,GG5 s$ At Rs$ 9$.= !e" 5 : .=G5 s$ At Rs$ 9$=G !e" 5 : ,=G5 s$ At Rs$ 9$B= !e" 5

Su!!ose that on A!"i+ ,G& the mate"ia+s de!a"tment issued a :uantity o# .=Gk s& o# the chemica+ to the !"oduction de!a"tment$ 7o* *i++ the stock on hand be )a+ued unde" di##e"ent methods6 Unde" /I/O method& the :uantity issued to the !"oduction de!a"tment *i++ be )a+ued at Rs$H=GA- and the stock on hand *ith the mate"ia+s de!a"tment *i++ be )a+ued at Rs$I,.$=G$ Acco"din to this method& the #i"st ac:ui"ed shou+d o out #i"st$ 7ence the #i"st ,GGk s& a"e )a+ued at Rs$9$.= and the subse:uent ,=Gk s& a"e )a+ued at Rs$9$=G& *hich is the !u"chase !"ice$ %he tota+ )a+ue o# .=Gk s comes to Rs$H=G$ the tota+ )a+ue o# the stock be#o"e issue comes to Rs$,B@.$=G on the basis o# abo)e !u"chase !"ice and :uantity$ 7ence& the )a+ue o# the stock on hand a#te" issue to the 8"oduction De!a"tment *i++ be Rs$I,.$=G$ Unde" LI/O Method& the mate"ia+s issued *i++ be )a+ued at Rs$I,.$=G and the stock *i++ be )a+ued at Rs$H=G a#te" issue$ Unde" this method& "ecent+y !"ocu"ed mate"ia+s shou+d be issued #i"st DLast In /i"st Out-$ 7ence& the #i"st ,=Gk s shou+d be )a+ued at Rs$9$=G !e" k $ %his *i++ *o"k out to Rs$I,.$=G$ Le kno* that the tota+ !"ocu"ement cost unde" LI/O method is Rs$I,.$=G$ soC the stock on hand comes to Rs$H=G$ %hus& *e can see that the stock on hand a#te" issue is )a+ued at Rs$I,.$G unde" /I/O method& and the stock on hand a#te" issue is )a+ued at Rs$H=G unde" LI/O method$ In othe" *o"ds& the )a+uation o# stock is hi he" unde" /I/O method and +esse" unde" LI/O method in this !a"ticu+a" case$ Unde" *ei hted a)e"a e method& the mate"ia+s issued *i++ be )a+ued at Rs$HH,$.= and the stock *i++ a+so be )a+ued at Rs$HH,$.=$ %hus& it *i++ be seen tat the )a+ue o# the stock is di##e"ent unde" di##e"ent methods$ Faluation of Stoc= and Profit) %he im!act o# the method used in dete"minin the )a+ue o# the stock de!ends on the mo)ement o# !"ices o# the commodity in :uestion$ Gene"a++y&

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in an in#+ationa"y !e"iod& the LI/O method o" A)e"a e method$ %he "eason is that du"in the !e"iod o# in#+ation& the costs a"e hi h and since most "ecent costs a"e taken into conside"ation unde" LI/O method& the !"o#its a"e dete"mined acco"din +y$ %he stock is )a+ues at the ea"+ie" cost& i$e$& unde" +o*e" cost$ Unde" /I/O method& these +o*e" costs *ou+d be debited to the 8"o#it and Loss AccountC the "esu+tant !"o#it *i++& the"e#o"e& be hi he"$ %he in)ento"y *i++ be )a+ued at the hi he" costs& i$e$& +ate" costs$ %his a+so *i++ +ead to hi he" !"o#its$ %he A)e"a e method +ies some*he"e in bet*een LI/O and /I/O methods$ In !e"iod o# de#+ation$ LI/O method *i++ tend to !"oduce hi he" income than /I/O method o" A)e"a e method$ Ou" e0!e"ience a#te" the Second Lo"+d La" sho*s that in out economy& "isin !"ices due to in#+ation ha)e become the ene"a+ t"end and de#+ation is a "emote !ossibi+ity& o" a+most ni+$ So& the businessmen #ind it e0!edient to ado!t LI/O method in the )a+uation o# stock$ As LI/O method tends to sho* +o*e" !"o#its in an in#+ationa"y !e"iod& it tends to "educe income-ta0 +iabi+ity$ It is stated that an Ame"ican manu#actu"e" sa)ed nea"+y ,I&=GG&GGG do++a"s in income ta0& o)e" a !e"iod o# ,I yea"s by ado!tion o# the LI/O method$ In times o# de#+ation the /I/O method is mo"e bene#icia+$ ;ut& the income-ta0 autho"ities *ou+d insist on usin on+y one !a"ticu+a" method and it shou+d be adhe"ed to consistent+y and a de!a"tu"e #"om the method *i++ not be a++o*ed$ %he Income %a0 Act does not +ay do*n any s!eci#ic method about the )a+uation o# stock$ ;ut& Section ,<= !"o)ides that !"o#its sha++ be com!uted in acco"dance *ith the method o# accountin "e u+a"+y em!+oyed by the assessed$ A method "e u+a"+y em!+oyed *i++ inc+ude the method o# )a+uation o# stock a+so and it cannot be chan ed to suit the con)enience o# the assessee$ 8"o#$ Koe+ Dean has "ecommended the ado!tion o# LI/O method and the accountin bodies o# U5 ha)e a+so "ecommended the same$ '.".". /reatment of Deferred EHpenses 5 *llocation of eHpenses o er /ime Periods %he #i"m *i++ ha)e intan ib+e #i0ed assets and the !"ob+ems come in *"itin o## these intan ib+e assets du"in thei" +i#etime$ Intan ib+e #i0ed assets can be c+assi#ied into t*o cate o"ies$ %hose ha)in a +imited +i#e& e$ $& Co!y"i ht& Leaseho+d& !e"mits& etc$& and

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%hose ha)in no such +imited +i#e& e$ $& %"ade Ma"ks& Good-Li++ o# the business& 8"e+imina"y E0!enses& etc$

;usinessmen !"e#e" to *"ite o## the intan ib+e assets ha)in +imited +i#e be#o"e thei" use#u+ +i#e e0!i"es$ %his is based on conse")atism& i$e$ to e+iminate these intan ib+e assets as soon as !ossib+e$ %he e0am!+e o# this ty!e is !"o)ided in the case o# 'Co!y"i hts($ Le a++y& co!y"i hts ha)e +i#e e:ua+ to autho"(s +i#e !+us =G yea"s the"ea#te"$ ;ut !ub+ications may not ha)e an acti)e ma"ket #o" such a +on !e"iod$ It is& the"e#o"e& conside"ed ad)isab+e to *"ite o## the cost o# co!y"i ht a ainst the income #"om the #i"st edition$ Intan ib+e assets *ith no +imited +i#e !ose mo"e com!+icated !"ob+ems #o" t*o "easons: %he"e is a di##e"ence o# o!inion *hethe" the assets shou+d be *"itten o## at a++ o" not I# they ha)e to be *"itten o##& *hat shou+d be the !e"iod #o" thei" amo"ti3ation6 %his amo"ti3ation can be done eithe" "adua++y o" by an immediate *"ite o##$ %o i++ust"ate this !oint& 1Good-Li++2 can be taken #o" discussion$ %he conse")ati)e )ie* is that the ood *i++ is on+y a #ancy asset ha)in no !+ace in the ba+ance sheet$ ;ut this )ie* cannot be #u++y endo"sed& as in some casesC a!!"o!"iate !e"iod o# time$ '.".#$ -apital &ains and :osses Ca!ita+ ains and +osses& o" 1Lind#a++s2 may be de#ined as 1unantici!ated chan es in the )a+ue o# !"o!e"ty "e+ati)e to othe" "ea+ oods$ %hat is& *ind#a++ "e#+ects a chan e in someone(s antici!ation o# the !"o!e"ty(s ea"nin !o*e"$ /+uctuations in stock ma"ket !"ices a"e a++ a+most o# this natu"e2$ Conse")ati)e com!anies may decide not to inc+ude ca!ita+ ains in the cu""ent !"o#it$ At the same time& they *ou+d +ike to *"ite o## ca!ita+ +osses #"om the cu""ent !"o#its o# the yea" in *hich the +oss occu"s$ On the othe" hand& a com!any may decide to inc+ude the ca!ita+ ains in the !"o#its o# the yea"$ Re a"din ca!ita+ +osses& the com!any may decide to *"ite it o## out o# "etained ea"nin s$ Thus the amount of profit would be affected by the treatment of capital gains and losses. ood *i++ may ensu"e ce"tain decisi)e ad)anta es to the #i"m$ 7ence& a "ationa+ )ie* *ou+d be to *"ite o## the ood *i++ o)e" an

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In the case o# un"ea+i3ed ca!ita+ ains& the"e is unanimity that they shou+d not be inc+uded in the !"o#its$ I# the"e is a "e)a+uation o# !"o!e"ty& the ain "esu+tin out o# it is usua++y t"ans#e""ed to ca!ita+ "ese")e$ A++ these sho* that the"e can be disc"e!ancies in the !"o#it "e!o"ted by di##e"ent com!anies because o# the di##e"ent a!!"oaches that they adhe"e to the t"eatment o# ca!ita+ ains and +osses$

=$<$ 8"o#it 8+annin

A #i"m has to #ace many unce"tainties and "isks$ %hese unce"tainties may a"ise due to the dynamic natu"e o# the consume" needs& the natu"e o# com!etitions& continuous chan e in techno+o ica+ de)e+o!ments and uncont"o++ab+e natu"e o# cost o# !"oduction$ %he sym!toms o# a hea+thy business inc+ude makin a "easonab+e !"o#it consistent *ith the "isks it has to #ace$ %he !"o#its cannot be +e#t to chances and it has to be !+anned$ A #i"m #aces un!"edictab+e demand #o" its !"oducts$ ;a""in the basic

"e:ui"ements o# +i#e and othe" essentia+ commodities& consume" !"e#e"ences o# commodities a"e hi h+y sub4ecti)e and the #i"m may not be ab+e to !"edict the demand !"ecise+y and #i"m #aces this unce"tainty& )i3$& %he !atte"n and :uantum o# demand is unce"tain$ %his is a "isk and the #i"m has to take ste!s to #o"ecast the demand #o" its !"oducts$ %he #i"m has to #ace com!etition #"om the "i)a+ !"oduce"s$ %he

com!etition may be !"ice-com!etition o" !"oduct com!etition o" it may be both$ 8"oduct com!etition is mo"e im!o"tant ti++ it "eaches the sta e o# matu"ity$ In a !e"iod o# continuous "isin !"ices& no #i"m can be ce"tain o# its o*n

cost st"uctu"e& as it cannot ha)e cont"o+ o)e" the !"ice o# "a* mate"ia+s and *a es and t"ans!o"t cost& as *e++ as ta0es to be !aid$ %his is anothe" unce"tainty$ Im!"o)ements and chan e in techno+o ica+ de)e+o!ments may make a

#i"m(s !"oduct obso+ete and !ush the #i"m out o# business& un+ess& the #i"m ado!ts the ne* techno+o y$

,<=

A++ these c"eate a condition o# "isk and unce"tainties #o" the #i"m to su")i)e in the business and to make !"o#it in the ente"!"ise$ Un+ess the #i"m takes an e0t"a o"dina"y ca"e to study a++ the abo)e #acto"s !"one to "isks& the !"o#its *ou+d be +e#t to chance$ %he firm has to plan for the profits by having a thorough knowledge of the relationship of cost, price and volume in the enterprise $%he kno*+ed e o# mani!u+ation o# these& )i3$& cost !"ice and )o+ume *i++ ha)e a de#inite bea"in on the !"o#it makin abi+ity o# the #i"m$ I# a #i"m does this e0e"cise e+e ant+y and e##icient+y& the ta" eted !"o#it can be ensu"ed$ I# a #i"m makes tho"ou h study and e0e"cise o# COS%* V.+4)! P/.,IT #1#+?SIS and takes decisions acco"din +y to decide the :uantum o# !"o#it& then the #i"m is said to ha)e ado!ted '8"o#it 8+annin ( e##ecti)e+y$ %he most im!o"tant method o# dete"minin the cost-)o+ume-!"o#it "e+ationshi! is that o# ;"eak- e)en- ana+ysis$

=$=$ ;"eak E)en Ana+ysis

A business unit b"eaks e)en *ith its tota+ sa+es )a+ue i# it is e:ua+ to its tota+ cost$ %he ;"eak-e)en ana+ysis he+!s in unde"standin the "e+ationshi! bet*een the "e)enues and costs in "e+ation to its )o+ume o# sa+es$ It he+!s in dete"minin the )o+ume in *hich the #i"m(s cost and "e)enue a"e e:ua+$ ;"eakJe)en !oint D;E8-& "e#e"s to that +e)e+ o# sa+es )o+ume at *hich the"e is neithe" !"o#it no" +oss& costs bein e:ua+ to its sa+es )a+ue and the cont"ibution is e:ua+ to #i0ed e0!enses$ '.'.1 Differing Fiews on Area=1E en Point Accountants and Economists di##e" on b"eak-e)en !oint$ Economists assume that "e)enue and cost )a"y o)e" inc"easin )o+ume o# out!ut$ Accountants& on the othe" hand& assume that )a"iab+e cost )a"ies in di"ect !"o!o"tion to out!ut and the b"eak-e)en !oint is const"ucted assumin +inea" cost and "e)enue #unctions$ %he com!a"ison o# the t*o )ie*s is i)en in the #i u"e by de!ictin the st"uctu"e o# the b"eak-e)en cha"t acco"din to Economist and Accountants$ %he #i u"e =$, indicates the Economist(s )ie*!oint o# b"eak-e)en and the #i u"e =$. sho*s the Accountants )ie* !oint$ In the Economists #i u"e the #i"m shou+d !"oduce O>, to ma0imi3e !"o#its$ E0!ansion o# out!ut beyond O>, "esu+ts in dec+ine in !"o#its due to diminishin "etu"ns and diminishin ma" ina+ "e)enue $%he %ota+ Re)enue Cu")e

,<@

e)entua++y d"o!s do*n& as "eate" :uantities can be so+d on+y by +o*e"in the !"ices $%he %ota+ Cost Cu")e simu+taneous+y continues to inc"ease since e0t"a out!ut does not ha)e a 3e"o cost $%he #i u"e sho*s the +e)e+ o# out!ut *he"e !"o#its a"e the ma0imum$ %his situation co""es!onds to the distance bet*een %R and %C$ /i u"e =$,: %he ;"eak-e)en Cha"t Acco"din to Economist

/i u"e =$.: %he ;"eak-e)en Cha"t Acco"din to Accountants

In the #i u"e =$.& the ;E8 is const"ucted assumin #unctions$ %his )ie* su

+inea" cost and "e)enue

ests that hi he" the out!ut& hi he" is the !"o#its$ ;"eak e)en

!oint is at ; *he"e %CF%R $In the Accountants #i u"e& %R *i++ be a+*ays at a hi he"

,<B

+e)e+ beyond ;E8 sho*in inc"easin !"o#its *ith the inc"ease o# out!ut $%C in this #i u"e *i++ ne)e" d"o! do*n& as these a"e assumed to be +inea" $%he Economist #i u"e is "ea+istic and the Accountants #i u"e is !"actica+ '.'.2. -alculations of Area=1e en Point %he #o++o*in #o"mu+a cou+d be used to #ind out the ;"eak-e)en !oint %ota+ /i0ed Cost AEP F Se++in !"ice- A?C F %ota+ #i0ed e0!enses Se++in !"ice !e" unit - ?a"iab+e cost !e" unit

?a@ Illustration) ,ind out the AEP from the following data: ?a"iab+e cost !e" unit FRs 9GASe++in !"ice !e" unit FRs <GA/i0ed e0!enses Ans*e": Rs$,& GG&GGG AEP F Rs$<G-Rs$9G ,&GG&GGG F ,G /o" this i++ust"ation& calculate the selling price per unit i# ;E8 is b"ou ht do*n to H&GGG %ota+ #i0ed cost ,iHed cost per unit F Numbe" o# units ,&GG$GGG F H&GGG Selling price F ?a"iab+e cost O /i0ed Cost !e" unit F Rs$9G O Rs$,.$=G F Rs$<.$=G F ,.$=G F ,G&GGG Units F Rs$, +akh$

,<H

Area=1e en point in terms of sales alue ?3@ Illustration) /ind out the ;E8 in te"ms o# sa+es )a+ue on the basis o# #o++o*in data: Sa+es FRs$,G&GGG ?a"iab+e cost FRs$@&GGG /i0ed cost F Rs$9&GGG In this case& *e ha)e to ca+cu+ate the cont"ibution "atio and then *e ha)e to ca+cu+ate the ;E8: %ota+ "e)enue minus %ota+ )a"iab+e cost -ontri3ution ratio F %ota+ "e)enue Sa+es minus )a"iab+e cost F Sa+es F ,G$GGG-@&GGG ,G&GGG %ota+ #i0ed cost AEPF Cont"ibution Ratio 9&GGG .A= 9&GGG 0 = F . ;"eak- e)en ana+ysis he+!s the business #i"m in #ocusin on some im!o"tant economic +e)e"a e& *hich cou+d be o!e"ated suitab+y to enhance its !"o#itabi+ity$ It he+!s the business #i"m in Ca+cu+atin out!ut o" sa+es to ea"n a desi"ed !"o#itC Ma" in o# sa#ety Chan e in !"ice Make decisionsC and Chan e in cost and !"ice etc$ F Rs$ B=GG F . =

,<I

'.'.". -alculation in /erms of /arget Profit ?c@ Illustration) ,ind out the target sales olume& i# the desi"ed !"o#it is Rs$,.$GGG *ith the #o++o*in data: #i0ed cost Rs$.G& GGG&?a"iab+e cost Rs$< !e" unitC and se++in !"ice Rs$ H !e" unit$ Acco"din to ;"eak e)en Ana+ysis the #o"mu+a #o" /i0ed cost O %a" et !"o#it /arget Sales olume F Cont"ibution ma" in !e" unit Substitutin the )a+ues to the #o"mu+a& *e et: .G&GGGO,.&GGG /arget sales olumeF H-< 9.&GGG F < /arget sales olume F H&GGG unites

'.'.#. -alculation in /erms of Safet. Margin ?d@ Illustration) I# the !"esent sa+es o# a #i"m is Rs$<G +akhs and ;"eak-e)en sa+es a"e Rs$9G+akhs& #ind out !e"centa e o# ma" in o# sa#ety6 %he #o"mu+a #o" Sa#ety ma" in is as #o++o*: DSa+es-;E8Safet. marginF Sa+es <G&GG&GGG - 9G&GG&GGG Safet. margin F <G&GG&GGG F .=Vo# !"esent sa+es$ '.'.'. -alculation in /erms of -hange in Price and New Sales Folume) ?e"y #"e:uent+y& the #i"m *i++ be #aced *ith !"ob+ems o# takin decisions #o" "educin the !"ice o" not$ A "eduction o# !"ice *i++ "esu+t in the "eduction o# cont"ibution R ,GG R,GG

,=G

ma" in$ Reduction in !"ice need not necessa"i+y "esu+t in the inc"eased sa+es& as it de!ends on the e+asticity o# demand o# the commodity !"oduced by the #i"m$ Assumin that it "emains constant& the mana ement has to take decision "e a"din the inc"ease o# )o+ume o# out!ut in o"de" to maintain the same !"o#it +e)e+ in the conte0t o# "eduction in !"ice$ %he #o"mu+a #o" dete"minin the ne* )o+ume o# sa+es *ith i)en "eduction in !"ice *i++ be as #o++o*s: %ota+ /i0ed cost O %ota+ !"o#it New sales olume F Ne* se++in !"ice- A)e"a e )a"iab+e cost ?e@ Illustration) A #i"m se++s <&GGG unites !e" month at a !"ice o# Rs$<G!e" unit$ /i0ed cost *o"ks out to Rs$,G&GGG !e" month and )a"iab+e cost comes to Rs$.< !e" unit the"e is a !"o!osa+ to "educe the !"ice o# the commodity by .G !e" cent$ 7o* many units shou+d the #i"m se++ to maintain the !"esent +e)e+ o# !"o#it6 Sa+es )a+ue o# <&GGG units at Rs$<G Less )a"iab+e cost o# <&GGG units at Rs$ .< Cont"ibution Less #i0ed e0!enses 8"esent 8"o#it F,&@G&GGG F I@&GGG F @<&GGG F ,G&GGG Rs$ =<&GGG

O+d !"ice is Rs$<G Reduction o# !"ice is .G !e" cent& i$e$& Rs$H$ hence& the ne* sa+es !"ice is Rs$9.$ Sa+es needed to maintain the !"esent !"o#it o# Rs$=<& GGG at ne* !"ice o# Rs$9. !e" unit a"e: Rs$,G&GGGO=&<GGG Ne* sa+es )o+ume F 9.-.< %he #i"m has to inc"ease the sa+es #"om <GG units to HGGG units$ 8"ice "eduction o# .GV is 4usti#ied i# the mana ement is con#ident o# "aisin the sa+es to HGGG units$ ;"eak-e)en ana+ysis a+so he+!s to decide *hethe" com!onents& *hich a"e !a"t o# thei" #inished !"oducts& shou+d be manu#actu"ed by them o" b"ou ht #"om out side #i"ms$ Illustration: A manu#actu"e" o# bicyc+es buys a ce"tain !a"t at Rs$<G each$ I# he decides to F @<&GGGAH F H&GGG units$

,=,

manu#actu"e it himse+#& his cost *ou+d be as #o++o*s: /i0ed costs Rs <HGGGC ?a"iab+e cost Rs$,@ !e" unit$ /ind out i# it is !"o#itab+e #o" him to manu#actu"e the !a"ts instead o# buyin $ /$C ;"eak-E)en 8oint F 8u"chase !"ice- ?a"iab+e cost <HGGG F <G- ,@ %his sho*s that the manu#actu"e" can !"oduce the !a"ts !"o#itab+y& i# he needs mo"e than .GGG com!onents !e" yea"$ I# his "e:ui"ement is +ess than .GGG units& it is bette" to buy #"om outside #i"ms$ %hus the ;"eak-E)en ana+ysis is use#u+ to the mana ement in dete"minin !"o#it !o+icies and !"o#it !+annin $ '.+. :inear Programming %he"e a"e many )a"ieties o# ana+ytica+ techni:ues to so+)e const"ained o!timi3ation !"ob+em$ Le ha)e +inea" !"o "ammin & Inte e" 8"o "ammin & >uad"atic 8"o "ammin & and Non-Linea" 8"o "ammin $ 7o*e)e"& +inea" !"o "ammin techni:ue has been de)e+o!ed mo"e and used #"e:uent+y$ %he o"i in o# +inea" !"o "ammin dates back to ,I.Gs *hen L$ Leontie# de)e+o!ed this #o" in!ut-out!ut ana+ysis$ %he !"esent )e"sion is the *o"k o# mathematician Geo" e ;$ Dent3i in ,I<B$ O"i ina++y& this techni:ue *as used in !+annin the di)e"si#ied o!e"ation o# US Ai"-/o"ce$ Economists +ike 5oo!mans& Coo!e"& Do"#man and Samue+son ha)e made si ni#icant cont"ibutions$ '.+.1 Meaning of :inear Programming Linea" !"o "ammin is a mathematica+ techni:ue by *hich "ationa+ decisions a"e taken in !"oduction to o!timi3e out!ut *ith the const"aints o# +imited in!ut& i$e$& "esou"ces$ %o !ut it in a sim!+e" *ay& it is use#u+ in a++ocatin the +imited "esou"ces in an o!tima+ manne" in !"oduction$ Le kno* that "esou"ces a"e )e"y +imited and the"e a"e const"aints in ettin ade:uate "esou"ces and a+so in the !"ocess o# !"oduction$ A !"oduce" has to take decisions to make use o# the +itt+e "esou"ces in o"de" to et ma0imum out!ut& o" to make a unit out!ut *ith minimum cost$ %he !"ob+em be#o"e the mana ement is the a++ocation o# #i"m(s "esou"ces& )i3& money& mate"ia+& s!ace& time& +abou" etc$& so as <HGGGA.< F .GGG

,=.

to et ma0imum !"o#it$ %he +inea" !"o "ammin techni:ue he+!s in "ea+i3in the ob4ecti)e o# o!tima+ uti+i3ation o# "esou"ces #o" ettin ma0imum "etu"ns o" !"o#its$ 7ence& this is an im!o"tant too+ in decision-makin and it is com!a"ati)e+y a ne* too+ in decisionmakin $ Linea" 8"o "ammin is de#ined as 1a mathematica+ techni:ue o# study *he"e in *e conside" the ma0imi3ation Do" minimi3ation- o# a +inea" e0!"ession Dca++ed the ob4ecti)e #unction- sub4ect to a numbe" o# a +inea" e:ua+ities and ine:ua+ities Dca++ed +inea" "est"aints-2$ %he te"m '+inea"( denotes that it is mathematica++y in)o+)in +inea" #unction& and the *o"d '!"o "ammin ( denotes mathematica+ !"ocedu"es to et the best so+ution to a !"ob+em uti+i3in +imited "esou"ces$ '.+.2 Need for :inear Programming /echni0ue In economics& *e ha)e studied about Ma" ina+ Ana+ysis and Least Cost Combination %echni:ues& etc$ in the !"oduction ana+ysis$ Lhen *e ha)e these methods& *he"e is the need #o" the +inea" !"o "ammin techni:ue6 Ma" ina+ ana+ysis and ca+cu+us and othe" usua+ methods cannot be used in a situation& *he"e the !"ob+em is to obtain an o!timum so+ution *ith const"aints$ %he usua+ methods a"e use#u+ on+y in the conte0t o# "esou"ce a++ocation to achie)e a !a"ticu+a" oa+& "athe" than *ith the e##iciency *ith *hich the "esou"ces a"e to be em!+oyed$ Rea+i3in a !a"ticu+a" ob4ecti)e in !"oduction is di##e"ent #"om uti+i3in the "esou"ces most e##icient+y sub4ect to ce"tain const"aints$ /o" e0am!+e& i# it is a !"ob+em o# suitab+e choice o# combination o# out!uts so as to ma0imi3e Nationa+ income& *ith the const"aints that no mo"e than a i)en amount o# "esou"ces shou+d be used& then& it is a !"ob+em o# not on+y o!timi3ation$ %his means that *e can use on+y a i)en amount o# "esou"ces and that the out!ut +e)e+ o# each !"oduct has to be nonne ati)e$ %his& connotes& that *e a"e "e:ui"ed to choose amon st a host o# !ossib+e combinations o# di##e"ent out!uts& that combination *hich does not )io+et the i)en const"aint conditions& and at the same time& it shou+d ma0imi3e Nationa+ Income$ Mo"eo)e"& the const"aints may be !"ecise o" s!eci#icC instead they may im!ose on+y u!!e" o" +o*e" +imits on the decision-make"$ /o" instance& the i)en +imitations may state on+y the ma0imum amounts o# the in!uts that a"e a)ai+ab+e o" it may be on+y ce"tain

,=9

minimum "e:ui"ements that must be met$ Such const"aints can be e0!"essed on+y as ine:ua+ity "e+ationshi!s$ %hese !"ob+ems cannot be so+)ed by means o# ma" ina+ ana+ysis$ Le ha)e to necessa"i+y de!end on a ne* techni:ue o# ana+ysis& *hich has been !"o)ided by +inea" !"o "ammin $ '.+." *ssumptions of :inear Programming /echni0ue %he +inea" !"o "ammin techni:ue is based on ce"tain assum!tions in the !"ocess o# obtainin be+o*: #ssumption of +inearity& %he main assum!tion in the techni:ue is the +inea" "e+ationshi! o# the )a"iab+e used in it$ %he )a"ious "e+ationshi!s shou+d be e0!"essed in the #o"m o# e:uations o" ine:ua+ities and they must be +inea"$ %his means a !"o!o"tiona+ "e+ationshi!& i$e$& the e0!onents o# a++ )a"iab+e must be one$ /o" e0am!+e& the "a* mate"ia+s used& the numbe" o# hou"s o# *o"k and the units o# !"oducts a"e !"o!o"tiona+$ ;y assumin +inea"ity& *e mean that a .GV chan e in the !"oducti)ity hou"s o# *o"k *i++ +ead to .GV chan e in "a* mate"ia+s and .GV chan e in out!ut$ Simi+a"+y& the basic "e+ationshi! bet*een cost #unctions& "e)enue #unction and thei" com!osite& i$e$& !"o#it #unction a"e di"ect+y !"o!o"tiona+& i$e$& +inea"$ %his assum!tion o# +inea"ity im!+ies the constancy of product prices. I# costs& out!ut and !"ices ha)e to "ise +inea"+y& necessa"i+y the"e must be constant returns to scale, i$e$& the !"oduction #unction must be +inea"& i$e$& homogeneous production function of first degree. %his #u"the" +eads to the assum!tion o# constancy of factor prices "emain constant& such a situation can be obtained on+y unde" !e"#ect com!etition$ So& the enti"e ana+ysis "ests on a condition o# perfect competition$ %hus the techni:ue assumes +inea"ity "e+ationshi!s& *hich +eads to the assum!tion o# Constancy o# !"oduct !"ices Constant "etu"ns to Sca+e Constancy o# #acto" !"ices 8e"#ect com!etition the o!tima+ so+ution$ Some o# the im!o"tant assum!tions a"e discussed

'.+.#. -haracteristic ,eatures of :inear Programming Pro3lems A++ !"ob+ems *he"e +inea" !"o "ammin cha"acte"istic #eatu"esC is a!!+icab+e ha)e the #o++o*in

,=<

/he (34ecti e ,unction) %his c+ea"+y de#ines the ob4ecti)e o# the !"o "amme in :uantitati)e te"ms$ %his te++s about the dete"minants o# the :uantity o!timi3ed$ Gene"a++y& in business& the ob4ecti)e *i++ be ma0imi3ation o# !"o#it o" minimi3ation o# cost$ I# it is !+annin at the nationa+ +e)e+& the ob4ecti)e may be ma0imi3ation o# nationa+ income as the sum o# out!uts o# di##e"ent !"oducts$ %he ob4ecti)e sou ht a#te" is kno*n as the 'ob4ecti)e #unction($ /o" e0am!+e& su!!ose a manu#actu"e" !"oduces th"ee commodities& R& S& and %$ %he :uantities !"oduced a"e >R& >S& >% "es!ecti)e+y$ Let the !"o#it !e" unit in case o# these commodities be 8R& 8S& 8% "es!ecti)e+y$ %he !"oduce" *ants to ma0imi3e !"o#it '8( #o" them$ %he ob4ecti)e #unction *ou+d then be stated as #o++o*s: >R8R O >S8S O >%8% F Ma0imum

-onstraints) %his is an a+ eb"aic statement o# the +imits o# a "esou"ce o" in!ut$ %his e0!"ession is usua++y in the #o"m o# ine:ua+ities& *hich state the thin s that a"e !ossib+e o" not !ossib+e to be done$ I# a #i"m is t"yin to ma0imi3e !"o#its& then it has to take account o# the #act that they a"e +imited by numbe" o# machines it has& the *a"ehousin ca!acity and the amount o# "a* mate"ia+ a)ai+ab+e& etc$ su!!ose the commodities R& S& and %& each "e:ui"e !e" unit o# !"oduct E&M and ` hou"s o# machine time and on+y '7( hou"s o# machine time is a)ai+ab+e$ %he const"aints on the !"oduction o# R& S and %& then *i++ be as #o++o*s: E>R O M>S O `>% a h %he const"aints +ike and ob4ecti)e #unction must be ca!ab+e o# a"ithmetica+ o" a+ eb"aic e0!"ession$ /o" e0am!+e& a "e:ui"ement that any so+ution sha++ not +o*e" the :ua+ity o# the !"oduct is not a const"aint in the +inea" !"o "ammin sense& as this cannot be e0!"essed nume"ica++y$

Non1Negati it. condition) Linea" 8"o "ammin techni:ue is a mathematica+ too+ #o" so+)in const"ained o!timi3ation !"ob+ems$ 7ence *e *ou+d et any ans*e" *ith any a+ eb"aic si n attached *ith it$ Some ans*e"s may be e)en ne ati)e and as such absu"d$ Lhen *e et such a ne ati)e so+ution& +ike ne ati)e :uantity& it *i++ be a !"actica+ im!ossibi+ity$ /o" e0am!+e& in dist"ibution !"ob+ems& the o!tima+ so+ution a""i)ed at by the techni:ue may be 'ne ati)e shi!ments( #"om ,==

one !+ace to anothe"$ O# cou"se& this is an im!ossib+e so+ution$ In o"de" to e+iminate such im!ossib+e and non-sensua+ "esu+ts& it is necessa"y to inc+ude the non-ne ati)ity conditions$ %hus in any !"oduction !"ob+em& *e *ou+d be "e:ui"ed to inc+ude conditions that any #acto"-in!ut o" the :uantity !"oduced cannot be ne ati)e$ %hus& the non-ne ati)ity condition me"e+y states the #act that a++ )a"iab+e in the !"ob+ems must be e:ua+ to& o" "eate" than 3e"o$ In ou" e0am!+e& i# the #i"m makes th"ee !"oducts& R& S and %& the :uantity o# !"oduction shou+d be eithe" 3e"o o" !ositi)e$ %he"e *ou+d be no ne ati)e !"oduction& *hich means that the commodity is '"e!"oduced( o" 'dismant+ed( *hich is absu"d$ So& in the i++ust"ation& the non-ne ati)ity conditions *ou+d be: >R b G >S b G >% b G :inear relationship) As has been indicated a+"eady& the )a"ious "e+ationshi!s to be e0!"essed in the #o"m o# e:uations o" ine:ua+ities must be +inea"& i$e$& !"o!o"tiona+ "e+ationshi!$ '.+.'. Methods of :inear Programming A !"ob+em "e+ated to +inea" !"o "ammin can be so+)ed by t*o methods$ %he #i"st one is ca++ed the ' "a!hica+ method( and the second one is kno*n as 'sim!+e0 method($ %he +atte" "e:ui"es ad)anced mathematica+ techni:ues in)o+)in e0tensi)e use o# a+ eb"aic e:uations and mani!u+ations$ /u"the"& the com!utationa+ !"ocedu"e is )e"y *ea"isome& and *ithout e+ect"onic com!ute"& it *i++ be di##icu+t to co!e *ith the )o+ume o# data and ca+cu+ations to #ind so+utions to actua+ business !"ob+ems$ ;ut the Graphical )ethod is a sim!+e" one ha)in a c+ose "esemb+ance to indi##e"ence cu")e ana+ysis$ %his method can be used )e"y e+e ant+y *he"e the"e a"e a #e* decision )a"iab+es$

=$@$@$ G"a!hica+ method

Problem& Su!!ose the ob4ecti)e o# a #i"m is to ma0imi3e !"o#it in the !"oduction o# !"oduct 'R( andAo" !"oduct 'S($ ;oth these !"oducts "e:ui"e t*o machines& name+y& machine 'a( and machine 'b( #o" !u"!oses o# !"ocessin $ 8"oduct 'R( "e:ui"es < hou"s on both the machines 'a( and 'b(& *hi+e !"oduct 'S( "e:ui"es @ hou"s on machine 'a(& but on+y . hou"s on machine 'b($ %he"e a"e on+y .< and ,@ hou"s a)ai+ab+e on machine 'a( and 'b( ,=@

"es!ecti)e+y$ %he !"o#it !e" unit is estimated at Rs$,.A- and Rs$,<A- in the case o# 'R( and 'S( "es!ecti)e+y$ No*& *e ha)e de!endent )a"iab+e& )i3& !"o#it *hich is to be ma0imi3ed and this is the #unction o# t*o inde!endent )a"iab+es 'R( and 'S( the !"oduction o# *hich is "est"icted by the time a)ai+ab+e in the machines$ ,irst Step) ?,ormulation of pro3lem@ %he abo)e stated in#o"mation has to be #o"mu+ated in mathematica+ #o"m$ Le ha)e the ob4ecti)e #unction$ %his is an e:uation sho*in "e+ationshi! bet*een out!ut and !"o#it$ 8 F Rs$ ,.R O Rs$,<S I# 8 F 8"o#itC Rs$,.R F %ota+ !"o#it #"om sa+e o# !"oduct 'R( Rs$,<S F %ota+ !"o#it #"om sa+e o# !"oduct 'S( %he time taken in !"ocessin the !"oducts in the machines must not e0ceed the tota+ time a)ai+ab+e on each$ It may be +ess o" e:ua+ to the time a)ai+ab+e on the machine$ %hese a"e the const"aints and the const"aints can be e0!"essed mathematica++y as #o++o*s: A: ;: <R O @S a .< <R O .S a ,@

%his means& the #i"st ine:ua+ity states that the hou"s "e:ui"ed to !"oduce one unit o# 'R( D< hou"s- mu+ti!+ied by the numbe" o# units o# 'R( !"oduced !+us the hou"s "e:ui"ed to !"oduce one unit o# 'S( D@ hou"s- mu+ti!+ied by the numbe" o# units o# 'S( !"oduced must be e:ua+ to o" +ess than .<hou"s a)ai+ab+e on machine 'a($ A simi+a" e0!+anation ho+ds ood #o" the second ine:ua+ity$ ;oth these ine:ua+ities "e!"esent ca!acity "est"ictions on out!ut and hence on !"o#it$ /ina++y& to et meanin #u+ ans*e"s& the )a+ues o# R and S must be !ositi)e i$e$& !"oducin ne ati)e :uantities o# R and S may not con)ey any meanin $ %hus so+utions #o" R and S must be eithe" 3e"o o" "eate" than 3e"o& i$e$& R b GC S b G$ %o sum u! *e et: Ma0imi3e sub4ects to const"aints 8 F ,.R O ,<S ,=B

<R O @S a .< <R O .S a ,@ R b GC S b G$ Second Step )?Plot the constraints on &raph@ %he ne0t ste! is to !+ot the "est"aints o# the +inea" !"o "ammin !"ob+em on a "a!h !a!e"C !"oducts 'R( to be sho*n on 'E( a0is and !"oduct 'S( on 'M( a0is D/i u"e =$9-$ %he ine:ua+ity <R O @S I .< may be d"a*n on the "a!h #i"st +ocatin its t*o te"mina+ !oints& and then 4oinin these t*o !oints by a st"ai ht +ine$ %his is done in the #o++o*in manne"$ I# *e assume that a++ the time a)ai+ab+e on machine 'a( is used #o" makin !"oduct 'R(& then it *ou+d mean that the !"oduction o# !"oduct 'S( is 3e"o$ %hen @ units o# !"oduct 'R( *ou+d be made$ %hus& i# S F G& then R a @$ I# *e !"oduce the ma0imum numbe" o# !"oduct 'R(& then R F @$ so the #i"st !oint is D@&G- to be !+otted in the "a!h& i$e$& 3e"o !"oduct o# S and @ units o# R$ In o"de" to #ind the second !oint& *e assume that a++ the time a)ai+ab+e on machine 'a( is used in makin 'S(C i$e$$& !"oduction o# 'R( is 3e"o$ Unde" this assum!tion& *e et < units o# 'S($ %hus& i# 'R( is 3e"o& then S F ,<$ %he ma0imum numbe" o# 'S( *ou+d be <$ So& the second !oint is DG&<-$ %his denotes < units o# 'S( and 3e"o unit o# 'R($ Locatin these !oints& )i3$& DG&<- and 4oinin them& *e et a st"ai ht +ine A; as sho*n in #i u"e J=$,$ %his +ine sho*s the ma0imum :uantities o# !"oduct R and S that can be !"oduced on machine 'a($ %he a"ea AO; is the "a!hic "e!"esentation o# ine:ua+ity <R O @S a .< It can be d"a*n "a!hica++y as sho*n in the #i u"e$ Simi+a"+y i# the out!ut o# 'S( is 3e"o& the ma0imum out!ut o# 'R( on machine 'b( *i++ be <& i$e$& D<&G-. I# the out!ut o# 'R( is 3e"o& the ma0imum out!ut o# 'S( on the machine 'b( *i++ be H$ i$e$& DG&H-$ Locatin these t*o !oints and 4oinin them& *e et st"ai ht +ine CD& as sho*n in the #i u"e$ %his +ine a ain "e!"esents the ma0imum :uantities o# !"oducts R and S that can be !"oduced on machine 'b($ %he a"ea COD the "a!hic "e!"esentation o# ine:ua+ity <R O .Sa ,@

/i u"e =$9 G"a!hica+ Re!"esentation o# Linea" !"o "ammin 8"ob+em

,=H

/hird Step) ,inding out ,easi3ilit. Region and -o1ordinates of its -orner Points. %he thi"d ste! is to identi#y the c"oss-shaded !o"tion a"e OAED in the #i u"e$ %his is ene"a++y kno*n as #easibi+ity "e ion$ %his is #o"med *ith the #o++o*in bounda"iesC E a0isC M-a0isC AED bounda"y is #o"med by the inte"section o# +ines A; and CD at !oint 'E($ I# a !oint is to satis#y both the const"aints and the non-ne ati)ity conditions& it must #a++ inside the c"oss-shaded a"ea o" on its bounda"ies$ A++ !oints outside the #easibi+ity "e ion a"e inadmissib+e$ /o" e0am!+e& i# *e be in at the o"i in O& *e cannot t"a)e+ beyond !oint 'D($ I# *e *e"e to !"oceed #u"the"& the ca!acity "est"iction o# machine 'b( *i++ be )io+ated$ Simi+a"+y on the M-a0is& *e cannot !"oceed beyond 'A($ Mo)in beyond 'O( +e#t*a"d o" do*n*a"d *ou+d not satis#y non-ne ati)ity conditions In this #easibi+ity "e ion& *e ha)e to study the co"ne" !oints& as the o!timum so+ution in)a"iab+y must +ie in one o# the co"ne" !oints$ Le kno* the co-o"dinates o# th"ee co"ne" !oints& )i3$& Co"ne" !oint O A D R DG& DG& D<& S G<G-

,=I

%he co-o"dinates o# !oint 'E( ho*e)e"& a"e yet to be asce"tained$ One method is to "ead the co-o"dinates in the #i u"e itse+#& i# it is d"a*n accu"ate+y and to the sca+e in the "a!h sheet$ Anothe" method is to so+)e simu+taneous+y the e:uations o# the t*o +ines& *hich inte"sects to #o"m !oint 'E($ %he e:uations to be so+)ed a"e: <R O @S F .< <R O .S F ,@ So+)in these t*o e:uations *e et the )a+ue o# R o" S <R O @S F .< <R O .S F ,@ - <S F H SF. No*& substitute the )a+ue o# S in the e:uation <R O @S F .<$ Le et )a+ue o# R F 9$ So& the co-o"dinates o# !oint 'E( a"e DRF9: SF.,ourth Step) ,ind Most Profita3le -orner Point %he #ina+ ste! is to test the #ou" co"ne"-!oints& )i3$& O& A& DC E$ O# the #easib+e "e ion OAED and to see *hich co"ne"- !oint yie+ds the ma0imum !"o#it$ Co"ne"-!oint Co"ne"-!oint Co"ne"-!oint Co"ne"-!oint OC AC DC EC DG&GDG&<D<&GD9&.F ,.DGF ,.DGF ,.D<F ,.D9O ,<DGO ,<D<O ,<DGO ,<D.F G F =@ F <H F @<

%he co"ne"-!oint *hich yie+ds the ma0imum !"o#it is 'E( and the ma0imum !"o#it is Rs$@<A- %hus& the "a!hica+ method o# +inea" !"o "ammin consists o# #o"mu+atin the !"ob+em& !+ottin the ca!acity "est"aints on the "a!hC identi#yin the #easibi+ity "e ion and its co"ne"-!oints and #ina++y testin *hich co"ne" !oint i)es the ma0imum !"o#it$ '.+.2. SimpleH Method Anothe" method o# +ine" !"o "ammin is the Sim!+e0 method$ %he sim!+e0 method o##e"s a means o# so+)in the mo"e com!+icated !"o "ammin !"ob+ems$ %he sim!+e0 method& ho*e)e"& is mo"e com!+e0 than sim!+e( and in)o+)es some*hat unso!histicated& com!+e0 mathematics$ %he com!+e0ity +ies in the mani!u+ation o# numbe"s$ %he sim!+e0 method #o" so+)in +inea" !"o "ammin !"ob+ems *as de)e+o!ed by G$;$ Dent3i $ ,@G

'.+.2.1 -haracteristic features Sim!+e0 method !ossesses t*o *o"th mentionin cha"acte"istic #eatu"es$ /i"st& in the sim!+e0 method& the com!utationa+ "outine is an ite"ati)e !"ocess$ %o ite"ate means to "e!eatC hence in *o"kin to*a"ds the o!timum so+ution& the com!utationa+ "outine is "e!eated o)e" and o)e"& #o++o*in a standa"d !atte"n$ Successi)e so+utions a"e de)e+o!ed in a system at !atte"n unti+ the best so+ution is "eached$ Second+y& each ne* so+ution *i++ yie+d a !"o#it as +a" e as o" +a" e" than the !"e)ious so+ution$ %his im!o"tant cha"acte"istic assu"es us that *e a"e a+*ays mo)in c+ose" to the o!timum so+ution$ '.+.2.2. :inear programming pro3lem Let us take +inea" !"o "ammin !"ob+em$ A manu#actu"e" makes t*o !"oducts& tab+es and chai"s& *hich must be !"ocessed th"ou h t*o machines$ On machine,& 9G hou"s a"e a)ai+ab+e and on machine .& .< hou"s a"e a)ai+ab+e$ Each tab+e cE ,d needs . hou"s on machine , and , hou" on machine .$ Each chai" cE.d "e:ui"es , hou" on machine , and . hou"s on machine .$ %he !"o#it is Rs$ < !e" tab+e cE,d and Rs$ 9 !e" chai" cE.d$ %he !"ob+em is to dete"mine the best !ossib+e combination o# tab+es and chai"s to !"oduce and se++ in o"de" to ea"n the ma0imum !"o#it$ Statin mathematica++y& the +inea" !"o "ammin !"ob+em is: Ma0imi3e !"o#it FRs$<E,ORs$9E. Sub4ect to .E,OE. a 9G hou"s E,O .E.a .< hou"s So+)in a !"ob+em by the sim!+e0 method "e:ui"es D,- a""an in the !"ob+em e:uations and ine:ua+ities in a s!ecia+ *ay and then D.- /o++o*in systematic !"ocedu"es and "u+es in ca+cu+atin a so+ution$ I Step) De elop E0uations from the Ine0ualities ?*dding S:*-D Faria3les@ %he #i"st ste! is to chan e the ine:ua+ities #o" the t*o const"ains in ou" !"ob+em into e:uations$ Le cannot use the sim!+e0 method un+ess a++ the ine:ua+ities a"e con)e"ted into e:uations by addin s+ack )a"iab+es$ Let us e0!+ain *hat a s+ack )a"iab+e is$ A s+ack )a"iab+e "e!"esents cost+ess !"ocess *hose #unction is to 'use u!( othe"*ise unem!+oyed ca!acity& say machine time o" *a"ehouse ca!acity$ In e##ect& the s+ack

,@,

)a"iab+e "e!"esents unused ca!acity and it *i++ be `e"o on+y i# !"oduction #aci+ities a"e #u++y used$ %he s+ack )a"iab+e makes the "i ht-hand side o# an ine:ua+ity and u! the +e#thand side$ %o take an e0am!+e: Let S,FS+ack )a"iab+e Dunused time- on Machine ,$ S.F S+ack )a"iab+e Dunused time- on Machine .$ S, is e:ua+ to the tota+ time a)ai+ab+e on machine ,Di$e$& 9G hou"s- +ess any hou"s used the"e in !"ocessin tab+es and chai"s$ Simi+a"+y& S. is e:ua+ to the tota+ time a)ai+ab+e on machine . Di$e$& .< hou"s- +ess any hou"s used the"e in !"ocessin tab+es and chai"s$ Mathematica++y& *e can "estate the e:uations #o" the s+ack )a"iab+e S,and S. as unde": S,F9G-.E,-E.Qmachine , S.F.<-E,-.E.Q$ machine. Le may a+so see that by addin the s+ack )a"iab+es& *e cou+d chan e the const"aint ine:ua+ities in ou" !"ob+em into e:uations$ %hus& by addin the s+ack )a"iab+e S,& the ine:ua+ity .E,OE. a 9G hou"s is chan ed into the e:uation .E,OE.OS,F9G hou"s Like*ise by addin the s+ack )a"iab+e S.& the ine:ua+ity E,O.E. a .< hou"s is chan ed into the e:uation E,O.E.OS.F.< hou"s In othe" *o"ds& the s+ack )a"iab+e on each machine takes on *hate)e" )a+ue is "e:ui"ed to make the e:uation "e+ationshi! ho+d$ %*o e0am!+es *i++ make this !oint c+ea"$ EHample1. Su!!ose that on machine ,& *e !"ocess 9 tab+es DE,- and . chai"s DE.-$ S,F9G hou"s J .D9--,D.9G-@-.F.. EHample 2. Su!!ose that on machine .& *e !"ocess 9 tab+es DE,- and = chai"s DE.-$ S.F.<-,D9- -.D=F .<-9-,GF,,

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Le can no* "estate ou" +inea" !"o "ammin !"ob+em in the #"om in *hich it *i++ be used in the sim!+e0 method$ It is: Ma0imi3e 8"o#it D8-FRs$<E,ORs$9E.$ Sub4ect to .E,OE.OS,F9G hou"s E,O.E.OS.F.< hou"s %he abo)e #o"m is "e#e""ed to as the e:ua+ity #o"m o# the !"o "amme the on+y chan es *e ha)e made a"e the int"oduction o# s+ack )a"iab+e into the const"ains$ It may be !ointed out that *he"eas S, and S. a"e the s+ack )a"iab+es& E, and E.& in cont"ast& a"e ca++ed st"uctu"a+ o" o"dina"y )a"iab+es$ /u"the"& the s+ack )a"iab+es must be non-ne ati)e$ In the sim!+e0 method& any unkno*n that a!!ea"s in one e:uation must a!!ea" in a++ e:uations$ %he unkno*n that do not a##ect an e:uation a"e *"itten *ith a `e"o coe##icient$ /o" e0am!+e& since S,and S. "e!"esents unused time& *hich yie+ds no !"o#it& these )a"iab+es a"e added to the !"o#it #unction *ith `e"o coe##icient$ /u"the"mo"e& since S, "e!"esents unused time on machine , on+y& it is added to the e:uation-"e!"esentin machine . *ith `e"o coe##icient$ /o" the same "easons& S. is added to the e:uation "e!"esentin the time const"aint on machine ,$ %hus *e et the #o++o*in e:uation: Ma0imi3e 8"o#it FRs$<E,ORs$9E. OGS,OGS. Sub4ect to .E,OE.OS,OGS.F9G hou"s E,O.E.OGS,OS.F.< hou"s II Step) De elop Initial SimpleH /a3leau Le can no* set out *ho+e !"ob+em in *hat is kno*n as a sim!+e0 tab+eau$ %he sim!+e0 tab+eau is a tab+e consistin o# "o*s and co+umns o# #i u"es and is a+so kno*n as sim!+e0 mat"i0$ It *i++ be he+!#u+ he"e to desc"ibe the sim!+e0 tab+eau and to identi#y its )a"ious !a"ts$ Le i++ust"ate be+o* the #o"m o# sim!+e0 tab+eau o" mat"i0 and e0!+ain its )a"ious !a"ts D%ab+e =$.-$ D,- -4 row) In the sim!+e0 tab+eau& the #i"st "o* is the C4 "o*& a+so kno*n as ob4ecti)e "o*$ In this "o*& *e inse"t the coe##icients in the ob4ecti)e e:uation$ %hus& the C4 "o* a!!ea"s as #o++o*s in the initia+ sim!+e0 %ab+eau D%ab+e =$.-:

,@9

Rs$< E,

Rs$9 E.

Rs$G S,

Rs$G S.

C4 "o* ?a"iab+e "o*

Note that the coe##icients in the ob4ecti)e e:uation a"e +isted abo)e the co""es!ondin )a"iab+es& i$e$& < abo)e E,& 9 abo)e E.& G abo)e S, and G abo)e S.$ %he C4 "o* sho*s the !"o#it made !e" unit o# each )a"iab+eC Rs$ < !e" unit o# E,& Rs$ 9 !e" unit o# E.& Rs$ G !e" unit o# S, and Rs$ G !e" unit o# S.$ %hus& the C4 "o* o" the ob4ecti)e "o* is !ut abo)e the )a"iab+es "o* to "emind us o# ho* much !"o#it *e make #o" each item !"oduced$ /a3le '.2 5Parts of Initial simpleH /a3leau
C4 8"o#it !e" unity 8"oduct mi0 co+umn Constant co+umn Di$e$& :uantities o# !"oduct in the mi0?a"iab+e co+umns

C4 Rs$G Rs$G

8"oduct mi0 S, S.

>uantity 9G .<

Rs$< E, . ,

Rs$9 E. , .

Rs$G S, , G

Rs$G S. G ,

D.- Restraint E0uations) %he t*o "est"aint e:uations a"e sho*n in the sim!+e0 tab+eau as #o++o*s: >uantity 9G .< E, . , E. , . S, , G S. G ,

Note that on the to! *e ha)e #i"st +isted the !"oducts *hose out!uts *e a"e dete"minin & )i3$& E,& *e *"ite a++ the coe##icients o# this )a"iab+eC #o" e0am!+e& unde" E, *e *"ite a++ the coe##icients o# this )a"iab+eC #o" e0am!+e& unde" E, *e *"ite .A,$ Simi+a"+y& unde" E. *e *"ite , and .C unde" S, *e *"ite , and G& and unde" S. *e *"ite G and ,$ At the e0t"eme +e#t-hand& *e *"ite that constant 9G in the #i"st "o* and constant .< in the second "o* co""es!ondin to the t*o "est"aint e:uations$ %hus& the #i"st "o* "e!"esents the coe##icients o# ou" #i"st e:uation and the second "o* "e!"esents the coe##icients o# ou"

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second e:uation$ Le ha)e in this *ay sim!+y "ea""an ed the te"ms in the const"aint e:uations to #o"m the sim!+e0 tab+eau$ ?"@ Product1miH column) Unde" the "a!hica+ method& *e ha)e a+"eady seen that a++ so+utions to +inea" !"o "ammin !"ob+ems *i++ be #ound amon st the co"ne"s o# the #easib+e "e ion$ One such co"ne" and in #act the most easi+y #ound co"ne" is the o"i in$ Unde" the sim!+e0 method& this o"i in Do" co"ne" !oint O- !"o)ides the sta"tin !oint so+ution$ At this !oint& note that no tab+es o" chai"s *i++ be !"oduced and a++ the ca!acity *i++ be unused$ /ina++y& *ith no !"oduction and a++ unused ca!acity& the"e *i++ be no !"o#it$ In othe" *o"ds& the sta"tin so+ution *i++ be the 3e"o-!"o#it so+ution$ %his so+ution is the *o"st !ossib+e and is a+so kno*n as t"i)ia+ so+ution$ Le can see that i# no tab+es o" chai"s a"e !"oduced& i$e$& i# E,FG and E.FG& then the #i"st so+ution *ou+d be: E,FG S,F9G$ E.FG S.F.<

%he #i"st #easib+e so+ution then is sho*n in the initia+ sim!+e0 tab+eau =$.$ It may be noted that the !"oduct-mi0 co+umn sho*s the )a"iab+es in the so+utions$ %he )a"iab+es in the #i"st so+ution a"e S, and S. Dthe s+ack )a"iab+es "e!"esentin unused ca!acity-$ In the :uantity co+umn *e #ind the :uantities o# the )a"iab+es that a"e in the so+ution: S,F9G hou"s a)ai+ab+e on Machine , S.F.< hou"s a)ai+ab+e on Machine . As the )a"iab+es E, and E. do not a!!ea"C in the !"oduct-mi0& they a"e e:ua+ to 3e"o$ ?#@ -4 column) Le may no* add C4 co+umn at the +e#t end$ %his sho*s the !"o#it !e" unit #o" the )a"iab+es S, and S.$ /o" e0am!+e& the 3e"o a!!ea"in to the +e#t o# theS, "o* means that !"o#it !e" unit o# S, is 3e"o$ Like*ise& the 3e"o to the +e#t o# S. "o* means that !"o#it !e" unit o# S. is 3e"o$ ?'@ J4 row ) %he `4 may be de#ined as: 1%he `4 is the C4 #o" a "o* times the coe##icient #o" that "o* *ithin the tab+eau& summed by co+umn$2 In othe" *o"ds& to a""i)e at the `4 )a+ue #o" a !a"ticu+a" co+umn *e #i"st mu+ti!+y each coe##icient in the co+umn by the C4 a ainst the coe##icient& and then add u! the !"oducts so obtained$ %his may bette" be unde"stood by actua++y com!utin `4 "o*$

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Let us take the )a+ue in the `4 "o* unde" the >uantity co+umn$ %he #i u"es unde" this co+umn a"e 9G and .<$ %he C4 a ainst co-e##icient 9G is G$ So they a"e to be mu+ti!+ied: G E 9G F G A ain& the C4 a ainst co-e##icient .< is G$ So they a"e a+so to be mu+ti!+ied: G E .< F G No*& the !"oducts a"e to be added& i$e$& GOGFG %his is the )a+ue o# `4 unde" the >uantity co+umn$ It may be noted that this "e!"esents the tota+ !"o#it #"om this !a"ticu+a" so+ution& 3e"o in this case$ %he `4 )a+ue #o" the di##e"ent )a"iab+es )i3 E,& E.& S, and S. cou+d be obtained th"ou h this method$ %he `4 )a+ues "e!"esent the amounts by *hich !"o#it *ou+d be "educed i# one unit o# the "es!ecti)e added to the !"oduct mi0$ ?+@ -41J4 Row No* C4-`4 is the net !"o#it that *i++ occu" #"om int"oducin J#"om addin -one unit o# a )a"iab+e to the !"oduction schedu+e o" so+ution$ /o" e0am!+e& i# , unit o# E, adds Rs$< o# !"o#it to the so+ution and i# its int"oduction causes no +oss& then C4-`4 #o" E,FRs$<$ Net income #"om the int"oduction o# any )a"iab+e cou+d be obtained by #o++o*in tab+e$ '." -ompleted Initial SimpleH /a3leau C4 Rs$ < Rs$ 9 Rs$ G Rs$ G this !"ocedu"e$ %he )a+ues obtained #o" di##e"ent )a"iab+e sho*n in C4-`4 "o* in initia+ sim!+e

8"oduct Mi0 Rs$ G Rs$ G S, S. `4 C4 J `4

>uantity 9G .< G <

E, . , Rs$ G 9

E. , . Rs$ G G

S, , G Rs$ G G

S. G , Rs$ G

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;y e0aminin the initia+ numbe"s in the C4 J `4 "o* o# the initia+ sim!+e0 tab+eau& *e cou+d #ind that tota+ !"o#it can be inc"eased by Rs$ < #o" each unit o# E, added to the mi0 o" by Rs$ 9 #o" each unit o# E. added to the mi0$ %his C4 J `4 )a+ue #o" any !a"ticu+a" )a"iab+e indicate the e0tent to *hich !"o#it cou+d be inc"eased by addin , unit o# that !a"ticu+a" )a"iab+e to the !"oduct mi0$ On the othe" hand& a ne ati)e numbe" in the C4 J `4 "o* *ou+d indicate the amount by *hich !"o#it *ou+d dec"ease i# one unit o# the )a"iab+e headin that co+umn *e"e added to the so+ution$ 7ence& o!timum so+ution is "eached *hen no !ositi)e numbe" "emain in the C4 J `4 "o*$ %hus& +ookin at this "o* one cou+d dete"mine *hethe" any im!"o)ed so+ution is !ossib+e$ III De eloping Impro ed Solutions D,'hose the !ntering Variable) Lhiche)e" )a"iab+e "e!+aces S, o" S. *i++ be kno*n as the ente"in )a"iab+e$ %he numbe" in C4 J `4 "o* te++ e0act+y *hich !"oduct *i++ inc"ease the !"o#its most$ %hus& Ente"in ?a"iab+e is one #o" *hich C4 J `4 )a+ue is the hi hest$ As is seen in the tab+e =$. addin one unit o# E , *i++ add !"o#it o# Rs <$ %he"e#o"e& E, co+umn is ca++ed o!timum co+umn o" !i)ot co+umn$ D.- 'hose the $eparting Variable: In o"de" to dete"mine *hich )a"iab+e to be "e!+aced #o++o*in !"ocedu"e has to #o++o*$ /i"st+y& di)ide each numbe" in the :uantity co+umn that is 9G and .< by the co""es!ondin numbe" in the !i)ot co+umn$ S, "o* S. "o* 9G hou"sA.hou"s !e" unit .< hou"sA , hou" !e" unit F ,= units o# E, F .< units o# E.

Second+y& se+ect the "o* *ith the sma++est "atio as the "o* to be "e!+aced$ As the S, "o* has the sma++est !ositi)e "atio it is ca++ed the "e!+aced "o*$ %his "o* *i++ be "e!+aced in the ne0t so+ution by ,= units o# E,$ %his "o* is a+so kno*n as the !i)ot "o*$ D9- $eveloping Second Simple" Tableau& A#te" choosin the ente"in and de!a"tin

)a"iab+e& a second sim!+e0 tab+eau can be de)e+o!ed& !"o)idin an im!"o)ed so+ution$ %he #i"st !a"t o# the ne* tab+eau to be de)e+o!ed is the E, "o*$ %he E, "o* o# the ne* tab+eau is com!uted as #o++o*s$ A- Di)ide each numbe" in the "e!+aced "o* DS, "o*- by the inte"sectiona+ e+ement D.- o# the "e!+aced "o* i$e$ !i)ot numbe" 9GA. F ,=& .A.F,& eFe eFe GA.FG

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%hus& the ne* E, "o* *ou+d be: D,=& ,& e& e& G-$ %hese )a+ues a!!ea" in the second sim!+e0 tab+eau Dtab+e =$=-$ <- 1ew Values for rows other than pivot row: %o com!ute the second tab+eau& *e com!ute ne* )a+ues #o" the "emainin "o* by usin the #o"mu+a sho*n in the < th co+umn o# the tab+e=$<$ %ab+e =$<: Com!utation o# Ne* ?a+ues #o" the Ro*s othe" than 8i)ot Ro*$
E+ement in o+d S. "o* D,Inte"sectiona+ e+ement o# S. "o* D.Co""es!ondin e+ement in "e!+acin "o* D9Ne* S. F DCo+umn , J DCo+umn .RCo+umn9D<-

.< , ,= I , , , G . , e ,e G , e -,A. , , G , %hus& the ne* S. "o* *i++ be DI& G& , e& -,A.& ,-$ %hese )a+ues a!!ea"ed in the second "o* o# the tab+e =$=$ %ab+e =$=: Second Sim!+e0 %ab+e C4 Rs$ < Rs$ 9 Rs$ G Rs$ G

8"oduct Mi0 Rs$ < Rs$ G E, S. `4 C4 J `4

>uantity ,= I @G

E, , G Rs$ < G

E.
,A.

S,
,A.

S. G , Rs$ G G

, ,A. Rs$ . ,

-,A. Rs$ . -.

`4 )a+ue unde" :uantity co+umn *as estimated to be Rs$@G$ %hus& the !"oduce" cou+d ea"n tota+ !"o#it o# Rs$ @G #"om this so+ution o" !"oduct mi0$ %he e0istence o# !ositi)e numbe" in the C4-`4 "o* o# tab+e =$= indicates the e0istence o# #u"the" im!"o)ed so+ution$ %hi"d sim!+e0 tab+e has to de)e+o! by "e!eatin the !"ocedu"e discussed abo)e DIII De)e+o!in Im!"o)ed So+utions-$ %his !"ocedu"e has to continue as +on as the"e a"eAis !ositi)e numbe"As in the C4-`4 "o*$

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'.2. Self Re iew 8uestions

,$ .$ 9$ <$ =$ @$ Sa+es ?a"iab+e Cost /i0ed Cost De#ine the conce!t o# !"o#it Lhat is s+ack )a"iab+e6 E0!+ain the conce!t o# b"eak e)en !oint Distin uish bet*een '8"o#itee"in ( and '8"o#it-ea"nin ( E0!+ain the im!o"tant ste!s in)o+)ed in the sim!+e0 method o# %he #o++o*in in#o"mation is i)en by the cost accountant o# E co$ ,GGGGG @GGGG 9GGGG

+inea" !"o "ammin !"ob+em Ltd$ ;an a+o"e #o" .GG=

i- Ca+cu+ate ;E8 and Ma" in o# Sa#ety ii- %he E##ect o# ,GV inc"ease in se++in !"ice B$ A #i"m !"oducin eithe" 8 o" >$ It can !"oduce one unit 8 by usin . units o# chemica+s and , unit o# com!ound$ Simi+a"+y it cou+d !"oduce one unit o# > by usin , unit o# chemica+s and . units o# com!ound$ On+y HGG units o# chemica+s and .GG units o# com!ound a"e a)ai+ab+e in the #i"m$ %he !"o#it !e" unit a)ai+ab+e to the #i"m is Rs$ 9G and Rs$ .G "es!ecti)e+y$ Gi)en this in#o"mation estimate the o!timum combination o# 8 and > to be !"oduced by usin the "a!hica+ method in o"de" to !"oduce and ea"n ma0imum !"o#it$

=$H Re#e"encesA Su
Sin a!o"e

ested Readin s

,$ Dominick Sa+)ato"e: 1Mana e"ia+ Economics2& McG"a*-7i++ Inte"nationa+ Editions&

.$ ?a"shney RL& and Mahesh*a"i 5$L: 1Mana e"ia+ Economics2& Su+tan Chand N Sons& Ne* De+hi-,,GGG.

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9$ Sanka"an: 1 Mana e"ia+ Economics2& Ma" ham 8ub+ications& Mad"as 9$ D*i)edi& D$ N$: 1Mana e"ia+ Economics2& ?ikas 8ub+ishin 7ouse 8)t$ Ltd$& Gha3iabad$ =$ D$M$Mithani : 1Mana e"ia+ Economics: %heo"y and A!!+ications2& 7ima+aya 8ub+ishin 7ouse& Mumbai-<GG GG<

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