CHAPTER 1 : Business Economics

Nature & scope of Business Economics - Micro and Macro economics Need Objectives and importance of Business Economics. Goals of business Economics Goals
Social Goals Strategic Goals - Profit maximisation Vs Optimisation of profits.

Learning Objectives
On the completion of this chapter, you should be able to:

Understand the distinction between micro and macro economics

Appreciate how micro economics informs business and managerial decisions

NATURE AND SCOPE OF BUSINESS ECONOMICS

When people engage in different tasks in producing different goods there must be some way
that the results of their efforts get from the hands of the producers to those who use them. This
was not a complex problem when most families produced most of what they needed, relying
little on other producers. But in a modern and global economy, different products like shirts or
flash drives, and different components of products like the collars on the shirts or
microprocessors in computers, have to end up not where they were produced but where they
are needed. There has to be a way to coordinate the division of labour.
That coordination is done by organizing different units under business organisations called
firms. Firms employ people and purchase the inputs they need to produce and market goods at
prices that more than cover the cost of production. The people making up the firmowners,
managers, and employeesare united in their common interest in the success of the firm
because all of them would suffer if it were to fail. The firm, its decision making and its
immediate environment form the scope for the study of business economics where we study
how a firms managers make decisions about production, how competitors react to business
decisions and how consumers who buy products and services the firm produces make their
decisions.
In small enterprises, the owners are typically also the managers, in charge of operational and
strategic decisions. As an example, consider a restaurant owned by a sole proprietor, who
decides on the menu, hours of operation, marketing strategies, choice of suppliers, and the size
and compensation of the workforce. In most cases the owner will try to maximise the profits of
the enterprise by providing the kinds of food and ambiance the people want at competitive
prices.
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In large corporations, there are typically many owners. Most of them play no part in
management. The owners of the firm are the individuals and institutions that own the shares
issued by the firm. By issuing shares to the general public a company can raise capital to finance
its growth, leaving strategic and operational decisions to a relatively small group of specialised
managers. These decisions include what, where and how to manufacture, or how much to pay
employees and managers. The senior management of a firm is also responsible for deciding how
much of the firms profits are distributed to shareholders in the form of dividends, and how
much is retained to finance growth. Of course the owners benefit from the firms growth
because what they own is part of the value of the firm, which increases as the firm grows. When
managers decide on the use of other peoples funds, this is referred to as the separation of
ownership and control.
SCOPE
Economics contributes a great deal towards the performance of managerial duties and
responsibilities. Managers with a working knowledge of economics can perform their functions
more efficiently than those without it. The basic function of the managers of a business firm is to
achieve the objective of the firm to the maximum possible extent with the limited resources
placed at their disposal. The emphasis here is on the maximization of the objective and
limitedness of the resources. Had the resources been unlimited, like sunshine and air, the
problem of economising on resources or resource management would have never arisen. But
resources, howsoever defined, are limited. Resources at the disposal of a firm, whether finance,
men or material, are by all means limited. Therefore, one of the basic tasks of the management is
to optimize the use of the resources in its effort to achieve the goals of the firm.
GOALS OF BUSINESS
Economics has two major branches :
(i) Microeconomics the study of behavior of individual consumers and firms when it comes to
decisions such as what to buy (for consumers) or what to produce (for firms). It is the study of
decisions of individual people and businesses and the interaction of these decisions:
Price & quantities of individual goods and services.
Effects of government regulation & taxation on prices and quantities of goods and services
produced.
and (ii) Macroeconomics the study of the collective behavior of firms and consumers when we
look at their actions as an aggregate in an economy.
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Both these branches are important to business analysis and managerial decision making
directly or indirectly. The scope of managerial economics comprises, therefore, both micro and
macroeconomic theories.
The goals managers seek to achieve for businesses through their decision making can be
classified in the following categories:

Economics Goals The primary objective of the firm (to economists) is to maximize
profits.
Strategic Goals - Other than just pure profit a firm may have some strategic goals as well
which will benefit by strengthening it in the long run. The firm may aim for market
share maximization (as measured by sales revenue or proportion of quantity sold to
total market) which would make it powerful enough a player to later maximize its
profits in that market. Other than that they may look at growth rate maximization i.e.
increasing size of the firm over time by aiming for higher rates of growth in other
variables than profit such as sales, number of employees, number of branches etc.
Social Goals Other than just caring about their own profits businesses nowadays are
becoming aware of the need to also contribute to society and the environment. Thus
managers are expected not only to focus on the economic goals of profit maximization
for the firm but also on social goals. These social goals include improving the state of
the community and environment where they operate by being environmentally
responsible as well as contributing to philanthropic causes and charity. It is also
sometimes called Corporate Social Responsibility (CSR).
Profit Maximisation vs Optimization of Profits
The traditional theory assumes that profit maximisation is the goal of a firm. Where profit
maximisation is the goal of the firm, economists have developed a set of rules to guide decision
makers to achieve it.
There is one important aspect to consider while applying the profit maximisation maxim in the
traditional economic theory. While profit is defined as the difference between revenue and costs,
in economics we consider both explicit (raw materials, labour and similar tangible costs) as well
as implicit (i.e. Costs that arent tangible but important for economic decision making) costs
such as opportunity cost of capital. That is why, in economics while talking about profit, the
focus is mainly on economic profit the money a firm makes after all explicit and implicit costs
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are taken care of. For example, if an entrepreneur invests Rs. 100,000 and makes a 3% return on
it (Rs. 3,000) at the end of the year after running a business, it can be argued that while hes
made a profit in the general sense, he hasnt made an economic profit, because perhaps if he had
let the Rs.100,000 be in savings account he could have made say a riskless 4% return. This 4%
can be considered his opportunity cost. Economic profit is made when both explicit and
opportunity (implicit) costs are covered.
In the real world though the theories do not perfectly apply. Thus managers aim for
optimization of profits. So, while profit maximization means the process of fixing the prices and
deciding the total output levels in such a way that maximum profits can be generated. But profit
optimization is about figuring out profits from managing the firms operations in the most
rational way possible under various constraints. Quite simply, a firm that has maximized profits
has no room to improve (because the profit is already the maximum possible). Optimization is
when a firm looks to improve its profits from existing levels by making decisions about its
operations, cutting costs, entering new markets and making similar strategic decisions.

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CHAPTER 2:
Consumer Behaviour: The Law of Diminishing Marginal Utility The law of equi-marginal
utility the indifference curve techniques properties of indifference curve.

Learning Objectives
On the completion of this chapter, you should be able to:

Understand the concept of utility and budget line and how consumers make decisions

based on this concept

Be able to work out rational consumer choices based on indifference curves and equi-

marginal utility
Understand one of the most important concepts in micro economics Law Of
Diminishing Marginal Utility

The Concept of Utility

Why do we buy the goods and services you do? It must be because they provide us with
satisfaction we feel better off because we have purchased them. Economists call this
satisfaction utility.
The concept of utility is a very abstract one. A person who consumes a good such as peaches
gains utility from eating the peaches. But we cannot measure this utility the same way we can
measure a peachs weight or calorie content. There is no scale we can use to determine the
quantity of utility a peach generates.
In economics we assume that consumers are rational and will always try to maximize their
utility (or satisfaction) from consuming a good. Marginal utility is the additional satisfaction
gained by acquiring each additional unit of a given good.
When we speak of maximizing utility, then, we are speaking of the maximization of something
we cannot measure. We assume, however, that each consumer acts as if he or she can measure
utility and arranges consumption so that the utility gained is as high as possible.
Total Utility
If we could measure utility, total utility would be the number of units of utility that a consumer
gains from consuming a given quantity of a good, service, or activity during a particular time
period. The higher a consumers total utility, the greater that consumers level of satisfaction.
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TOTAL UTILITY & MARGINAL UTILITY

The figure below shows the total utility Hari obtains from attending movies. In drawing his total
utility curve, we are imagining that he can measure his total utility. The total utility curve shows
that when Mr. Hari attends no movies during a month, his total utility from attending movies is
zero. As he increases the number of movies he sees, his total utility rises. When he consumes 1
movie, he obtains 36 units of utility. When he consumes 4 movies, his total utility is 101. He
achieves the maximum level of utility possible, 115, by seeing 6 movies per month. Seeing a
seventh movie adds nothing to his total utility.
Total Utility and Marginal Utility Curves

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Panel (a) shows Haris total utility curve for attending movies. It rises as the number of movies increases,
reaching a maximum of 115 units of utility at 6 movies per month. Marginal utility is shown in Panel
(b); it is the slope of the total utility curve. Because the slope of the total utility curve declines as the
number of movies increases, the marginal utility curve is downward sloping.
Haris total utility rises at a decreasing rate. The rate of increase is given by the slope of the total
utility curve. The slope of the curve between 0 movies and 1 movie is 36 because utility rises by
this amount when Hari sees his first movie in the month. It is 28 between 1 and 2 movies, 22
between 2 and 3, and so on. The slope between 6 and 7 movies is zero; the total utility curve
between these two quantities is horizontal.

Marginal Utility
The amount by which total utility rises with consumption of an additional unit of a good,
service, or activity, all other things unchanged, is marginal utility. The first movie Hari sees
increases his total utility by 36 units. Hence, the marginal utility of the first movie is 36. The
second increases his total utility by 28 units; its marginal utility is 28. The seventh movie does
not increase his total utility; its marginal utility is zero. Notice that in the table marginal utility is
listed between the columns for total utility because, similar to other marginal concepts, marginal
utility is the change in utility as we go from one quantity to the next. Haris marginal utility
curve is plotted in Panel (b) of the graph. The values for marginal utility are plotted midway
between the numbers of movies attended. The marginal utility curve is downward sloping; it
shows that Haris marginal utility for movies declines as he consumes more of them.
Haris marginal utility from movies is typical of all goods and services. Suppose that you
are really thirsty and you decide to consume a soft drink. Consuming the drink increases your
utility, probably by a lot. Suppose now you have another. That second drink probably increases
your utility by less than the first. A third would increase your utility by still less. This tendency
of marginal utility to decline beyond some level of consumption during a period is called
the law of diminishing marginal utility. This law implies that all goods and services eventually
will have downward-sloping marginal utility curves. It is the law that lies behind the negatively

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sloped marginal benefit curve for consumer choices that we examined in the chapter on
markets, maximizers, and efficiency.
One way to think about this effect is to remember the last time you ate at an all you can eat
cafeteria-style restaurant. Did you eat only one type of food? Did you consume food without
limit? No, because of the law of diminishing marginal utility. As you consumed more of one
kind of food, its marginal utility fell. You reached a point at which the marginal utility of
another dish was greater, and you switched to that. Eventually, there was no food whose
marginal utility was great enough to make it worth eating, and you stopped.
What if the law of diminishing marginal utility did not hold? That is, what would life be like in
a world of constant or increasing marginal utility? In your mind go back to the cafeteria and
imagine that you have rather unusual preferences: Your favorite food is creamed spinach. You
start with that because its marginal utility is highest of all the choices before you in the cafeteria.
As you eat more, however, its marginal utility does not fall; it remains higher than the marginal
utility of any other option. Unless eating more creamed spinach somehow increases your
marginal utility for some other food, you will eat only creamed spinach. And until you have
reached the limit of your bodys capacity (or the restaurant managers patience), you will not
stop. Failure of marginal utility to diminish would thus lead to extraordinary levels of
consumption of a single good to the exclusion of all others. Since we do not observe that
happening, it seems reasonable to assume that marginal utility falls beyond some level of
consumption.
The Law of Diminishing Marginal Utility states that the first unit of consumption of a good or
service yields more utility than the second and subsequent units. When you are hungry, even
the simplest food will satisfy you but when you are less hungry, the same food will satisfy you
less. When you have only a few items of clothing, each new item bought is gives you a lot of
satisfaction. When you already have a cupboard full of clothes, each new piece of clothing gives
you less satisfaction than the earlier one.
One of the reasons why the demand curve is downward sloping (i.e. Demand falls as price rises,
which we will see in the next unit) is because of the Law Of Diminishing Marginal Utility.
Maximizing Utility
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Economists assume that consumers behave in a manner consistent with the maximization of
utility. To see how consumers do that, we will look at a slightly different approach to utility. It is
called the indifference curve technique.
Indifference Curve Analysis: An Alternative Approach to Understanding Consumer Choice

We will begin our analysis with an algebraic and graphical presentation of the budget
constraint. We will then examine a new concept that allows us to draw a map of a consumers
preferences. Then we can draw some conclusions about the choices a utility-maximizing
consumer could be expected to make.
The Budget Constraint
The total utility curve in the graph above shows that Hari achieves the maximum total utility
possible from movies when he sees six of them each month. It is likely that his total utility
curves for other goods and services will have much the same shape, reaching a maximum at
some level of consumption. We assume that the goal of each consumer is to maximize total
utility. Does that mean a person will consume each good at a level that yields the maximum
utility possible?
The answer, in general, is no. Our consumption choices are constrained by the income available
to us and by the prices we must pay. Suppose, for example, that Mr. Hari can spend just Rs. 250
per month for entertainment and that the price of going to see a movie is Rs. 50. To achieve the
maximum total utility from movies, Mr. Hari would have to exceed his entertainment budget.
Since we assume that he cannot do that, Mr. Hari must arrange his consumption so that his total
expenditures do not exceed his budget constraint: a restriction that total spending cannot exceed
the budget available.
Suppose that in addition to movies, Mr. Hari enjoys concerts, and the average price of a concert
ticket is Rs 100. He must select the number of movies he sees and concerts he attends so that his
monthly spending on the two goods does not exceed his budget.
The Budget Line

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As we have already seen, a consumers choices are limited by the budget available. Total
spending for goods and services can fall short of the budget constraint but may not exceed it.
Algebraically, we can write the budget constraint for two goods X and Y as:
Equation 2.1

PXQX+PYQYB

where PX and PY are the prices of goods X and Y and QX and QY are the quantities of goods X
and Y chosen. The total income available to spend on the two goods is B, the consumers
budget. Equation 2.1 states that total expenditures on goods X and Y (the left-hand side of the
equation) cannot exceed B.
Suppose a college student, Janet Bain, enjoys skiing and horseback riding. A day spent pursuing
either activity costs $50. Suppose she has $250 available to spend on these two activities each
semester. Ms. Bains budget constraint is illustrated in Figure 2.1 "The Budget Line".
For a consumer who buys only two goods, the budget constraint can be shown with a budget
line. A budget line shows graphically the combinations of two goods a consumer can buy with a
given budget.
The budget line shows all the combinations of skiing and horseback riding Ms. Bain can
purchase with her budget of $250. She could also spend less than $250, purchasing
combinations that lie below and to the left of the budget line in Figure 2.1 "The Budget Line".
Combinations above and to the right of the budget line are beyond the reach of her budget.
Figure 2.1The Budget Line

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The budget line shows combinations of the skiing and horseback riding Janet Bain could consume if the
price of each activity is $50 and she has $250 available for them each semester. The slope of this budget
line is 1, the negative of the price of horseback riding divided by the price of skiing.
The vertical intercept of the budget line (point D) is given by the number of days of skiing per
month that Ms. Bain could enjoy, if she devoted all of her budget to skiing and none to
horseback riding. She has $250, and the price of a day of skiing is $50. If she spent the entire
amount on skiing, she could ski 5 days per semester. She would be meeting her budget
constraint, since:
$500 + $505 = $250
The horizontal intercept of the budget line (point E) is the number of days she could spend
horseback riding if she devoted her $250 entirely to that sport. She could purchase 5 days of
either skiing or horseback riding per semester. Again, this is within her budget constraint, since:
$505 + $500 = $250
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Because the budget line is linear, we can compute its slope between any two points. Between
points D and E the vertical change is 5 days of skiing; the horizontal change is 5 days of
horseback riding. The slope is thus 5/5=1 . More generally, we find the slope of the budget
line by finding the vertical and horizontal intercepts and then computing the slope between
those two points. The vertical intercept of the budget line is found by dividing Ms. Bains
budget, B, by the price of skiing, the good on the vertical axis (PS). The horizontal intercept is
found by dividing B by the price of horseback riding, the good on the horizontal axis (PH). The
slope is thus:
Equation 2.2
Slope=B/PSB/PH
Simplifying this equation, we obtain
Equation 2.3
Slope=BPSPHB=PHPS
After canceling, Equation 2.3 shows that the slope of a budget line is the negative of the price of
the good on the horizontal axis divided by the price of the good on the vertical axis.

Indifference Curves
Suppose Ms. Bain spends 2 days skiing and 3 days horseback riding per semester. She will
derive some level of total utility from that combination of the two activities. There are other
combinations of the two activities that would yield the same level of total utility. Combinations
of two goods that yield equal levels of utility are shown on an indifference curve. Because all
points along an indifference curve generate the same level of utility, economists say that a
consumer is indifferent between them.
Figure 2.2 "An Indifference Curve" shows an indifference curve for combinations of skiing and
horseback riding that yield the same level of total utility. Point X marks Ms. Bains initial
combination of 2 days skiing and 3 days horseback riding per semester. The indifference curve
shows that she could obtain the same level of utility by moving to point W, skiing for 7 days and

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going horseback riding for 1 day. She could also get the same level of utility at point Y, skiing
just 1 day and spending 5 days horseback riding. Ms. Bain is indifferent among combinations W,
X, and Y. We assume that the two goods are divisible, so she is indifferent between any two
points along an indifference curve.
Figure 2.2 An Indifference Curve

The indifference curve A shown here gives combinations of skiing and horseback riding that produce the
same level of utility. Janet Bain is thus indifferent to which point on the curve she selects. Any point
below and to the left of the indifference curve would produce a lower level of utility; any point above and
to the right of the indifference curve would produce a higher level of utility.
Now look at point T in Figure 2.3 "An Indifference Curve". It has the same amount of skiing as
point X, but fewer days are spent horseback riding. Ms. Bain would thus prefer point X to point

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T. Similarly, she prefers X to U. What about a choice between the combinations at point W and
point T? Because combinations X and W are equally satisfactory, and because Ms. Bain prefers X
to T, she must prefer W to T. In general, any combination of two goods that lies below and to the
left of an indifference curve for those goods yields less utility than any combination on the
indifference curve. Such combinations are inferior to combinations on the indifference curve.
Point Z, with 3 days of skiing and 4 days of horseback riding, provides more of both activities
than point X; Z therefore yields a higher level of utility. It is also superior to point W. In general,
any combination that lies above and to the right of an indifference curve is preferred to any
point on the indifference curve.
We can draw an indifference curve through any combination of two goods. Figure 2.4
"Indifference Curves" shows indifference curves drawn through each of the points we have
discussed. Indifference curve A from Figure 2.4 "An Indifference Curve" is inferior to
indifference curve B. Ms. Bain prefers all the combinations on indifference curveB to those on
curve A, and she regards each of the combinations on indifference curve C as inferior to those on
curves A and B.
Although only three indifference curves are shown in Figure 2.5 "Indifference Curves", in
principle an infinite number could be drawn. The collection of indifference curves for a
consumer constitutes a kind of map illustrating a consumers preferences. Different consumers
will have different maps. We have good reason to expect the indifference curves for all
consumers to have the same basic shape as those shown here: They slope downward, and they
become less steep as we travel down and to the right along them.
Figure 2.3 Indifference Curves

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Each indifference curve suggests combinations among which the consumer is indifferent. Curves that are
higher and to the right are preferred to those that are lower and to the left. Here, indifference curve B is
preferred to curve A, which is preferred to curve C.
The slope of an indifference curve shows the rate at which two goods can be exchanged without
affecting the consumers utility. Figure 2.5 "The Marginal Rate of Substitution" shows
indifference curve C from Figure 2.4 "Indifference Curves". Suppose Ms. Bain is at point S,
consuming 4 days of skiing and 1 day of horseback riding per semester. Suppose she spends
another day horseback riding. This additional day of horseback riding does not affect her utility
if she gives up 2 days of skiing, moving to point T. She is thus willing to give up 2 days of skiing
for a second day of horseback riding. The curve shows, however, that she would be willing to
give up at most 1 day of skiing to obtain a third day of horseback riding (shown by point U).

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Figure 2.5 The Marginal Rate of Substitution

The marginal rate of substitution is equal to the absolute value of the slope of an indifference curve. It is
the maximum amount of one good a consumer is willing to give up to obtain an additional unit of
another. Here, it is the number of days of skiing Janet Bain would be willing to give up to obtain an
additional day of horseback riding. Notice that the marginal rate of substitution (MRS) declines as she
consumes more and more days of horseback riding.
The maximum amount of one good a consumer would be willing to give up in order to obtain
an additional unit of another is called the marginal rate of substitution (MRS), which is equal to
the absolute value of the slope of the indifference curve between two points. Figure 2.5 "The
Marginal Rate of Substitution" shows that as Ms. Bain devotes more and more time to horseback
riding, the rate at which she is willing to give up days of skiing for additional days of horseback
ridingher marginal rate of substitutiondiminishes.

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LAW OF EQUIMARGINAL UTILITY: The Utility-Maximizing Solution

We assume that each consumer seeks the highest indifference curve possible. The budget line
gives the combinations of two goods that the consumer can purchase with a given budget.
Utility maximization is therefore a matter of selecting a combination of two goods that satisfies
two conditions:
1.

The point at which utility is maximized must be within the attainable region defined by
the budget line.
2.
The point at which utility is maximized must be on the highest indifference curve
consistent with condition 1.
Figure 2.6 "The Utility-Maximizing Solution" combines Janet Bains budget line from Figure 2.2
"The Budget Line" with her indifference curves from Figure 2.4 "Indifference Curves". Our two
conditions for utility maximization are satisfied at point X, where she skis 2 days per semester
and spends 3 days horseback riding.
Figure 2.6 The Utility-Maximizing Solution

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Combining Janet Bains budget line and indifference curves from Figure 2.2 "The Budget
Line" and Figure 2.4 "Indifference Curves", we find a point that (1) satisfies the budget constraint and
(2) is on the highest indifference curve possible. That occurs for Ms. Bain at point X.
The highest indifference curve possible for a given budget line is tangent to the line; the
indifference curve and budget line have the same slope at that point. The absolute value of the
slope of the indifference curve shows the MRS between two goods. The absolute value of the
slope of the budget line gives the price ratio between the two goods; it is the rate at which one
good exchanges for another in the market. At the point of utility maximization, then, the rate at
which the consumer is willing to exchange one good for another equals the rate at which the

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goods can be exchanged in the market. For any two goods X and Y, with good X on the
horizontal axis and good Y on the vertical axis,
Equation 2.4
MRSX,Y=PXPY

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CHAPTER 3:
Demand and Revenue Concepts: Meaning of demand Determinants of demands - Demand
Schedule The Demand curve The Law of Demand Exceptions to the law of demand,
Demand Distinction (types of demand) - Elasticity of Demand Price elasticity Types
Measurement of Price elasticity factors influencing elasticity of demand Income elasticity of
demand Types Cross elasticity of demand, Demand Forecasting Types Techniques,
Revenue concepts Total revenue, Average revenue, Marginal revenue.
Learning Objectives
On the completion of this chapter, you should be able to:

Understand the concept demand

Understand how a demand curve is generated and learn how to state the law of demand
Appreciate the exceptions to the law of demand and their reasons
Understand the concept of elasticity of demand and be able to calculate the elasticity of
demand for various situations

Demand
In Economics, demand is the desire to consume something, the ability to pay for it, and the
willingness to pay.
Ceteris paribus (means all other things being assumed constant), demand refers to the quantity of
the goods and services that people are willing and able to buy.
Further, while the need or desire is a necessary component, it must be accompanied by financial
capability before an economic demand is created.
There are different kinds of demand.

Individual demand: Individual demand is the demand of one person/family or one

firm. It represents the quantity of a good or service that a single consumer would buy at
a specific point in time. Individual demand covers both personal demand and firm
demand.

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Market demand: Market demand is the total demand of all consumers in the market for a
good or service. It represents the total quantity of a good all buyers in the market would
buy within a specific time duration.

Assessing market demand is one of the most important ways that businesses decide what to sell
and how to go about selling the products they produce.
The factors which affect the demand of a consumer are:

Decision to buy

Budget

Competitive products

Because people will purchase different quantities of a good or service at different prices,
economists must be careful when speaking of the demand for something. They have therefore
developed some specific terms for expressing the general concept of demand.

The quantity demanded of a good or service is the quantity buyers are willing and able
to buy at a particular price during a particular period, all other things unchanged. (As
we mentioned, we can substitute the Latin phrase ceteris paribus for all other things
unchanged.) Suppose, for example, that 10,000 movie tickets are sold each month in a
particular town at a price of Rs 80 per ticket. That quantity10,000is the quantity of
movie admissions demanded per month at a price of Rs 80. If the price were Rs 120, we
would expect the quantity demanded to be less. If it were Rs 50, we would expect the
quantity demanded to be greater. The quantity demanded at each price would be
different if other things that might affect it, such as the population of the town, were to
change. That is why we add the qualifier that other things have not changed to the
definition of quantity demanded.

A demand schedule is a table that shows the quantities of a good or service demanded
at different prices during a particular period, all other things unchanged. To introduce
the concept of a demand schedule, let us consider the demand for coffee in the United
States. The table below shows quantities of coffee that will be demanded each month at

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prices ranging from $9 to $4 per pound; the table is a demand schedule. We see that the
higher the price, the lower the quantity demanded.

The graph above is what we call a demand curve.

As the price goes up, the demand comes down i.e. move from right to left.
This demand curve, which has a negative relationship, is consistent with the law of demand.
Since the relationship is represented as a straight line, it is called a linear relationship.
In general, demand curve is a non-linear downward sloping curve. For the sake of simplicity we
use demand curve as linear curve.
Introduction
There are two basic models of individual demand.
1. Direct demand
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2. Derived demand
Direct Demand
When we purchase fruits, it is for consumption. This is called direct demand. Similarly, we may
purchase rice for direct consumption as cooked rice. When a firm purchases computers, it is
used by the people i.e. the consumption is direct.
Direct demand is the theme of the Theory of Consumer Behaviour. Consumer behaviour is the
study of when, why, how, and where people do or do not buy a product. It blends elements
from psychology, sociology, social anthropology and economics. It relates to the personal
consumption of goods.
The Direct Demand model is appropriate for analysing individual demand for goods and
services that directly satisfy consumer desires.
The value or worth of a good or service is its utility and is the prime determinant of direct
demand.
Individuals are viewed attempting to maximise the total utility or satisfaction provided by the
goods and services they acquire and consume.
This optimisation process requires consumers focus on the marginal utility i.e. additional
satisfaction gained by acquiring each additional unit of a given good.
Important determinants of direct demand are:

Quality of products and services

Individual preferences (including tastes and habits)

Ability to pay

Derived Demand

When we purchase sugar, we use it to make some dish (kheer) or drink (coffee). We do
not eat sugar directly. This is called derived demand. Here purchased item is not
consumed directly but indirectly.

If we purchase rice to make Idly, the consumption is indirect and thus the demand is
derived.

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When an automobile manufacturer procures steel, it is used to make parts of the

automobile. So, the demand for cars leads to a demand for steel. This is derived demand.

Derived demand relates to demand for goods and services which are acquired, because
they are inputs in the manufacturing and distribution of other goods. For instance,
picture tube is an intermediate good to manufacture television sets. Thus demand for
picture tube is a derived demand as it depends upon the demand for television sets.

Shift versus Movement along a Demand Curve

Introduction
Shift
The demand curve shifts when consumers change their perceptions about the worth of a
product. If consumers decide they are willing to pay higher prices for a product or want to
purchase more of it, the demand curve shifts to the right. The less consumers are willing to pay
for a product, the more the demand curve shifts to the left. In other words, heightened
perceived worth of a product shifts the demand curve right, while decreased perceived worth
shifts the demand curve to the left. Factors that can shift the demand curve either way include
changes in consumer expectations for a certain product, changes in discretionary income and
changes in trends and what is fashionable.
A shift in demand, or switch from one demand curve to another, reflects a change in one or
more non-price variables in the demand function of a good. Some of these are listed below.

Customer preference

Price of related goods i.e. Substitutes and Complements

Income

Number of potential buyers

Expectations of price change

Movement
Unlike shifts in demand curves that are dictated by consumer interest, movement in the
demand curve occurs when the price of a product changes. For example, movement can occur if
a candy manufacturer raises or lowers the price of a certain type of candy. Altering candy prices

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could cause consumers to buy more candy or less candy, depending on where the new price is
set. The demand curve itself does not move; rather, there is movement along the curve.
We will study the following:
1. Shift in Linear Demand Curve
2. Shift in Non-Linear demand curve
3. Factors causing Increase and Decrease in Demand
Shift in Linear Demand Curve
Consider the situation that a new person has been added to a household and the demand for
milk has changed.

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Demand

Demand

in 4 person

in 5 persons

household

household

18

30

38

20

26

33

22

22

28

24

18

23

26

14

18

28

10

13

Price of milk
(Rs./litre)

Shift in Linear Demand Curve

This is an example of shift of a linear demand curve due to addition to the number of family
members.
Shift of non-Linear demand Curve
Consider the situation that a new person has been added to a household and the demand for
apples has changed.
Price of

Demand

Demand

in 4 person

in 5 persons

(Rs./kg)

household

household

65

30

36

80

22

26

Elasticity

100

16

20

Introduction

130

11

14

We have seen that increase (decrease) in price

180

apple

Shift in Non-Linear Demand Curve

This is an example of shift of a non-linear
demand curve due to increase in the number of
persons in the family.

leads to decrease (increase) in demand.

A firm is interested in knowing what will be the

impact of a proposed price increase on revenue and on profit.

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Consider a hypothetical situation of a movie theatre. The ticket price is raised by Rs.25. to
Rs.225. The number of seats sold comes down from 200 to 190. What is the revenue?
Original revenue = Rs.200 x 200 = Rs.40,000.
New Revenue = Rs.225 x 190 = Rs.42,750.
So, this is a gain.
What if 160 seats were sold after he price increase.
New revenue = Rs.225 x 160 = Rs.36,000.
This is a loss.
You consider another situation where the ticket price is reduced from Rs.200 to Rs.180. You
would expect an increase in the number of seats sold. If the seats sold are 215 and 230 at the
reduced price, the corresponding revenues will be Rs.38,700 and Rs.41,400. Again we find that
there may be a gain or a loss as far as revenue is concerned.
Your objective is not to increase or decrease the price but to generate more revenue.
For decision making purposes, it is not enough to know that demand will expand when price is
reduced, we want to know by how much the demand will expand for a certain decrease in price.
In other words, we need to quantify the expansion of demand against reduction of price. We
want to know how sensitive is the demand for seats to its price? If price of ticket increases by
Rs.20 i.e. 10%, how much will demand change? How much will demand change if price is
reduced by 10%?
We use elasticity to answer these questions.
Definition
Elasticity is a measure of the responsiveness of one variable to another. It is a number that tells
us the percentage change that will occur in one variable in response to a 1 percent change in
another variable.
Price Elasticity
The price elasticity of demand, measures the responsiveness of quantity demanded to price
changes. The price elasticity of demand is the percentage change in the quantity demanded
against 1% change in the price.
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Micro Economics

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Ep

Q P

P Q

Price elasticity of demand is given by

where,
Ep = Price elasticity of demand
P = Original price
Q = Original quantity demanded
Q = Change in quantity demanded
P = Change in the price
For normal goods the demand decreases as price increases and demand increases and price
decreases. Thus Ep is negative.
Let us understand the significance of different values price elasticity of demand.
Consider the household demand for salt against price.
Price (Rs./kg)

Demand (kg)

10

11

12

13

14

15

16

17

18

19

Ep

Q P

P Q

We find that there is no change in demand for salt as the price changes.

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Here, since Q = 0, Ep = 0. This is called Perfectly Inelastic.

This is generally true for absolutely essential commodities.

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Now consider the demand for flour at a bakery.

Price

Demand

Rs./kg

kg

25

180

30

175

35

170

40

165

45

160

The requirement does not change much with change in the price. Against 80% increase in price,
from Rs.25 to Rs.45, the demand decreases from 180 to 160 kgs i.e. by 11% only.

(175 170) 30
Q P
5 30

Ep

0.171429
(30 35) 175
P Q
5 175

We compute elasticity for

price change from 30 to 35 when demand falls from 175 to 170.

This value is between 0 and -1. This is called Relatively Inelastic.

In real life, this kind of inelasticity is observed for essential commodities like wheat or rice.
Now consider domestic demand for juice.
Price

Demand

Rs./kg

kg

65

24

70

20

80

16

100

12

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120

10

150

(16 12) 80
4 80
Q P

Ep

1.0
(80 100) 16
P Q
20 16

We compute elasticity for price change

from 80 to 100 when demand falls from 16 to 12.

This value is = -1. This is called Unitary Elasticity.

This is the border line between Elastic and Inelastic item.
A 10% quantity change divided by 10% price change is one. This means that a one percent
change in quantity occurs for every one percent change in price.
Now consider domestic demand for biscuit. Many varieties of biscuits are available.
Price

Demand

Rs./100 gms

gms

20

2000

21

1200

22

700

23

400

24

150

25

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(700 400) 22
300 22
Q P

9.4286
Ep

(22 23) 700

P Q
1 700

We compute elasticity for price

change from 22 to 23 when demand falls from 700 to 400 gms.

This value is = - 9.4286. When the price increases by 4.5%, the demand decreases by 42.86%. This
is called Relatively Elastic.

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Now consider demand for gold at a jeweler. The price of gold at every jeweler is same as it is
governed by international and national pricing mechanism.
Price

Demand

Rs./10 gms

gms

2622

1900

2622

1500

2622

1100

2622

750

2622

300

(1500 1100
) 2622
400 2622
Q P

Ep

(2622 2622
) 1500
P Q
0 1500

We compute elasticity as price

remains steady at Rs.2622 and demand falls from 1500 to 1100 gms.

This value is - . When the demand changes even if there is no change in price, the elasticity
approaches infinity. This is called Perfectly Elastic.
Demand changes significantly even for no change in price.
Let us look at the summary of the different values of elasticity.
Meaning

Value

Example

Perfectly inelastic

Ep = 0

Necessary Goods (Salt)

Relatively inelastic

1 < Ep < 0

Complementary Goods (Bread or Rice)

Unit (or unitary) elastic

Ep = 1

Borderline (Juice)

Relatively elastic

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< Ep <
1

Substitute Goods (Biscuit)

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Perfectly elastic

Ep =

Luxury Goods (Gold)

Meaning of Terms used in Elasticity

Price elasticity of demand has negative sign in front of it; because as price rises demand falls
and vice-versa. It shows the inverse relationship between price and demand.
The different values of elasticity we computed are called Point Elasticity. Point elasticity is
computed with the actual values of P and Q.
This method of computation leads to an interesting situation. For the same pairs of values,
elasticity is different depending which value is considered to be the original value and which is
the changed value. To remove this anomaly, we use Arc Elasticity.
Point Elasticity and Arc Elasticity
Consider the relationship between price and monthly demand of a cement producer.

Price and Demand

(24000
22000
) 1050
Q P 2000 1050
105

Ep

1.09375

(1130 1050
) 24000
P Q
96
80 24000

Let us

computer the Point Elasticity of demand when price increases from Rs.1050 to Rs.1130 per bag
and demand goes down from 24,000 to 22,000 bags.
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22000
) 1130
Q P (24000
113
2 1130

Ep

1.2841
(1130 1050
) 22000
P Q
88
80 22

Now reverse the

original and changed values. As price falls from Rs.1130 to Rs.1050, demand increases from
22,000 to 24,000 bags.

Starting at a lower price, we got Point Elasticity = 1.09375.

Starting at a higher price, we got the Point Elasticity = 1.2841.
This is not very convenient!
So, we use Arc Elasticity.

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Point Elasticity and Arc Elasticity

The formula for arc price elasticity is expressed in equations below.

DQ P1 P2

DP Q1 Q2

Symbolically the arc price elasticity is defined as:

Where
DQ is the change in demand
DP is the change in price
P1 and P2 are the two values of price
Q1 and Q2 are the two values of demand

109
2000 2180 2000 1050 1130 DQ P1 P2

D Q Q

1.1848

24000
P 1
2
92
80 46000 80 22000

In our

example, arc price elasticity is given by:

We note that this value is somewhere in between the two values

(1.09375) and (1.2841) we had got earlier.
Arc elasticity computes the percentage change between two points in relation to the average of
the two prices and the average of the two quantities, rather than the change from one point to
the next. This provides the average elasticity for the arc of the curve between the two points.
Hence, the term arc elasticity.
Income Elasticity

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Income elasticity of the demand measures the relationship between the changes in consumption
of a good following an increase or decrease in the income.
Definition

EDy

Q Y

Y Q

Income elasticity of demand is defined as the ratio of the percentage change in

quantity demanded and the percentage change in income.

Income elasticity of demand is given by
where,
EDy = Income elasticity of demand
Q = Change in quantity demanded
Y = Change in income
Q

= Original quantity demanded

= Original income

Different types of goods are impacted differently by increasing income.

Consider three types of goods Normal, Luxury and Inferior.
Both Normal and Luxury goods have positive income elasticity of demand i.e. as income rises,
demand for the goods expand at each price level.
However, as income rises, the expansion of demand is faster for Luxury goods than for Normal
goods. Consumers, having satisfied their need of necessities, use the increased income to
purchase luxury goods and services. The quantity demanded for luxury goods is very sensitive
to changes in income.
Inferior goods have a negative income elasticity of demand - the quantity demanded for inferior
goods falls as incomes rise. For example, the quantity demanded for generic food items tends to
decrease during periods of increased incomes.
Income elasticity of demand can be either positive or negative. For a normal good the income
elasticity of demand is expected to be positive, while for an inferior good it is expected to be
negative.
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Income Elasticity >1, is considered High

Income Elasticity <1, is considered Low

Example

(3 1)
70000
Q Y

EDy

(80000
70000
)
1
Y Q

Anand had a salary of Rs. 70,000/- per month

and receives an increment of Rs. 10,000/- a month. With this increase he is able to fly to his
home town thrice a month as against once a month earlier. Compute Income elasticity of
demand for Anands air travel.

14

This indicates high elasticity.

The variations in demand due to positive and negative income elasticities that are greater than
1 and lesser than 1. Are given below.

Variation of Demand with respect to Positive and Negative Income Elasticities

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Firms would prefer to produce goods that have Income Elasticity > 1. As the income of people
grows, there will be growth in demand for its output.
With Income Elasticity > 1, even if the firm is losing market share, it can still expect demand
growth.
For goods with Income Elasticity < 1, positive or negative, increasing sales is possible only by
gaining market share. This is possible only if the firm has a competitive edge in terms of better
product or lower price.
Advertising Elasticity
Definition

Q A

A Q

Advertising elasticity of demand is the measure of how advertising affects the demand

of a certain good. It is the percentage change in the sales of the advertised good as opposed to
the percentage change in its advertising expenses.
Advertising Elasticity. Is given by EDA =
where,
Q = Quantity sold
A= Advertising expenditure
Q = Change in quantity sold
A = Change in advertising expenditure
Example
Assume that the management of the Innovative Multiplex is interested in analysing the
responsiveness of movie ticket demand to changes in advertising.
The firms advertising expenditure is Rs.50,000 month. The movie tickets sold are 20,000 tickets
per month .

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10,000 50,000Q A

0.833 30,000 20,000 A Q

The firm increases its advertisement expenditure to

Rs.80,000 per month and ticket sale increases to 30,000 per month. The Advertisement Elasticity
is computed as
EDA =
So, the advertising elasticity of demand for movie tickets is 0.833.
Since this is < 1, we may conclude that advertising is low i.e. not very effective.
You can compute that if the sale of tickets is 35,000, the Advertising Elasticity is 1.25. This is
considered High i.e. the advertising is effective.
Cross-Price Elasticity
Let us consider related good and the impact change in price in one has on the demand of the
other. Demand for diesel cars may go down if the price of diesel increases.
Cross-price elasticity of demand measures the change in demand for one good in response to
the change in price of a related good.
It is measured as the percentage change in demand for the first good that occurs in response to a
percentage change in price of the second good. It can range from negative infinity to positive
infinity.
Say the price of diesel goes up by 10% and demand of new diesel cars contracts by 20%.
The cross-price elasticity of demand is given by
EDCP = -20%/10% = -2.
Cross-Price Elasticity is negative for complementary goods.
As the price of one good increases, the demand for it falls, with a corresponding fall in the
demand in the complementary good.

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Cross-Price Elasticity is positive for substitute goods.

As the price of one good increases, the demand for it contracts with a corresponding expansion
of demand of the substitute good.
Typical substitute goods could be two different brands of soft drinks (Coke and Pepsi), modes of
travel (train vs bus) etc.

The importance of cross elasticity of demand is that it enables a firm to identify those goods that
consumers view as substitutes for its own goods.
Demand Estimation
Introduction
In an increasingly uncertain business environment decision-making becomes difficult.
The uncertainty in business environment is due to the complex behaviour of market related
variables like demand, market share, peoples perception and factors affecting demand.

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This behaviour can be attributed to the result of policy changes and market forces. The manager
should know the behaviour of the market related variables, their interrelationship and future
movement.
The most important aspects for a manager in the present day are to know the usage of below
mentioned of scientific tools.

Process of estimation of demand

Demand forecasting techniques

Factors affecting demand

Identification of target groups

Demand estimation is commonly done for short-run sales forecasting, marketing, pricing, and
market placement analysis. Three common methods used for demand estimation are the
following.
1. Consumer interview
2. Market experiment
3. Regression analysis
1.

Consumer Interviews

Surveying consumers, or potential consumers, to know their anticipated responses regarding

how their purchase decision may be influenced by many factors. Some of these factors are

Variation in the good's price

Price of rival (substitute) goods

Complementary goods

Their own incomes

Such surveys can also be designed to determine the effectiveness of advertising campaigns.
Survey methods are highly developed in terms of the statistics of a representative sample, and
in terms of the way questions are asked.
2.

Market Experiments

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Test markets may be actual, such as 'representative' cities like Hyderabad or 'laboratory' markets
in which representative consumers are brought in under simulated market conditions. An
advantage of market experiments is that, actual votes are measured. Market experiments can be
expensive, and the results may not generalise for situations outside the test market.
3.

Regression Analysis

One begins by constructing the estimating equation, such as a demand function, then gathers
data and estimates the coefficients of the equation that tell us the marginal effects of each
individual variable on sales quantity. Regression analysis can be used in conjunction with datagathering market experiments.
Demand Forecasting Techniques
Introduction
Some forecasting techniques are basically quantitative and others are largely qualitative.
The most commonly applied forecasting techniques are listed below.

Qualitative analyses

Trend analysis and projection

Exponential smoothing

Econometric methods

The best forecast methodology for a particular task depends on the nature of the forecasting
problem.
When making a choice among forecast methodologies, a number of important factors must be
considered:

Distance into the future that one must forecast

Lead time available for making decisions

Level of accuracy required

Quality of data available for analysis

Stochastic or deterministic nature of forecast relations

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Cost and benefits associated with the forecasting problem

Trend analysis, market experiments, consumer surveys, and the leading indicator approach to
forecasting are well suited for short-term projections.
Forecasting with complex econometric models and systems of simultaneous equations has
proven somewhat more useful for long run forecasting.
Typically, it is observed that greater the level of sophistication, higher is the cost. If the required
level of accuracy is low, less sophisticated methods can provide adequate results at minimal
cost.
Three techniques
Three demand forecasting techniques are briefly explained below.
1.

Qualitative analysis

Qualitative analysis is an intuitive judgmental approach for forecasting, can be useful if it allows
for the systematic collection and organisation of data derived from unbiased, informed opinion.
However, qualitative methods can produce biased results when specific individuals dominate
the forecasting process through reputation, force of personality, or strategic position within the
organisation.
2.

Market Studies

Market studies and experiments are generally more expensive and difficult. They manifest itself
in the form of a controlled market study or experiment. It incorporates displaying the goods in
several different stores, generally in areas with different characteristics, over a period of time
and further changing parameters while holding other things constant. This enables analysing
and understanding the consumer preferences and how they change following a change in any
one parameter. An instance of changing the price, holding everything else constant.
3.

Trend Analysis

Trend analysis is based on the premise that economic performance follows an established
pattern and that historical data can be used to predict future business activity. Trend analysis
techniques involve characterising the historical pattern of an economic variable and then
projecting its future path based on past experience.
Trends of time series

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All time series, regardless of the nature of the economic variable involved, can be described in
terms of a few important underlying characteristics. Four of these are described below.
1.

Secular Trend
A secular trend is the long-run pattern of increase or decrease in a series of economic data.

2.

Cyclical fluctuation
Cyclic fluctuation describes the rhythmic variation in economic series that is due to a pattern
of expansion or contraction in the overall economy.

3.

Seasonal variation
Seasonal variation or seasonality is a rhythmic annual pattern in sales or profits caused by
weather, habit, or social custom, for example, seasonal vegetables and fruits.

4.

Irregular or random influences

Irregular or random influences are unpredictable shocks to the economic system and the
pace of economic activity caused by wars, strikes, natural catastrophes, and so on.

Regression Model
A frequently used statistical technique in demand estimation is the regression model.
Definition
It estimates the quantitative relationship between the dependent variable and independent
variable(s), the quantity demanded being the dependent variable. If only one independent
variable (predictor) used, we term it as simple regression and if several independent variables
used we term it as multiple regression.

CHAPTER 4:
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Production: Introduction Production Functions Law of Variable Proportions Production

functions with two variable inputs (isoquants & iso costs). Equilibrium through Iso quants and
Iso cost curves.
Learning Objectives
On the completion of this chapter, you should be able to:

Understand the concept of production as defined in economics and appreciate the

relationship between production and factors of production

Be able to work out a firms choices of production based on its production function and

costs
Distinguish between short run and long run production decisions
Understand how equilibrium in level of production is reached in the long run and the
short run

PRODUCTION
Our analysis of production and cost begins with a period economists call the short run.
The short run in this microeconomic context is a planning period over which the managers of a
firm must consider one or more of their factors of production as fixed in quantity. For example,
a restaurant may regard its building as a fixed factor over a period of at least the next year. It
would take at least that much time to find a new building or to expand or reduce the size of its
present facility. Decisions concerning the operation of the restaurant during the next year must
assume the building will remain unchanged. Other factors of production could be changed
during the year, but the size of the building must be regarded as a constant.
When the quantity of a factor of production cannot be changed during a particular period, it is
called a fixed factor of production. For the restaurant, its building is a fixed factor of production
for at least a year. A factor of production whose quantity can be changed during a particular
period is called avariable factor of production; factors such as labor and food are examples.
While the managers of the restaurant are making choices concerning its operation over the next
year, they are also planning for longer periods. Over those periods, managers may contemplate
alternatives such as modifying the building, building a new facility, or selling the building and

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leaving the restaurant business. The planning period over which a firm can consider all factors
of production as variable is called the long run.
Production Function
The relation between the amount of inputs used in production and the resulting amount of
output is called the Production Function.
The production function indicates the maximum output Q that a firm will produce for every
specified combination of inputs.
Assuming that there are only two inputs, labor L and capital K, the production function can
be represented as Q = f(K,L).
For instance, Tata Motors employs some workers (L) and certain amount of machinery (K) to
produce Tata NANO. The production function gives the maximum output (Q) of Tata NANO
that can be produced for any given combination of the inputs.
Production functions depict what is technically feasible when the firm operates efficiently.
We are not assuming that there are only two inputs in the production process. We will consider
situations with one and two variable inputs to understand the relationships. This understanding
can then be extended to multiple input situations.
Production functions are related to the technology deployed for production. As technology
improves, the production function will change to indicate higher level of output obtained with
the same inputs.
We are looking at two inputs, Capital and Labour. In the short run, the amount of capital or
equipment are fixed and hence do not affect the production. Only the variable inputs appear in
the production function. But in the long run all the inputs are considered variable.
The production method is said to be efficient if there is no other way for the firm to produce a
larger amount of output using the same amounts of inputs. Owners and managers of firms
should try to produce outputs efficiently.
Consider the output quantity of a firm for a fixed capital input and different Labour inputs.
Units of Capital

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Units of Labour Employed

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Employed - 10

Output

1
10

2
30

60

80

5
95

108

112

112

108

This is a representation of the production function.

The Short-Run Production Function

A firm uses factors of production to produce a product. The relationship between factors of
production and the output of a firm is called a production function. Our first task is to explore
the nature of the production function.
Consider a hypothetical firm, Acme Clothing, a shop that produces jackets. Suppose that Acme
has a lease on its building and equipment. During the period of the lease, Acmes capital is its
fixed factor of production. Acmes variable factors of production include things such as labor,
cloth, and electricity. In the analysis that follows, we shall simplify by assuming that labor is
Acmes only variable factor of production.
Total, Marginal, and Average Products
Acme Clothings Total Product Curve shows the number of jackets Acme can obtain with
varying amounts of labor (in this case, tailors) and its given level of capital.
A total product curve shows the quantities of output that can be obtained from different
amounts of a variable factor of production, assuming other factors of production are fixed.
Figure 8.1 Acme Clothings Total Product Curve

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10
100

The table gives output levels per day for Acme Clothing Company at various quantities of labor per day,
assuming the firms capital is fixed. These values are then plotted graphically as a total product curve.
Notice what happens to the slope of the total product curve in Figure 8.1 "Acme Clothings Total
Product Curve". Between 0 and 3 units of labor per day, the curve becomes steeper. Between 3
and 7 workers, the curve continues to slope upward, but its slope diminishes. Beyond the
seventh tailor, production begins to decline and the curve slopes downward.
We measure the slope of any curve as the vertical change between two points divided by the
horizontal change between the same two points. The slope of the total product curve for labor
equals the change in output (Q) divided by the change in units of labor (L):
Slope of the total product curve = Q/L
The slope of a total product curve for any variable factor is a measure of the change in output
associated with a change in the amount of the variable factor, with the quantities of all other
factors held constant. The amount by which output rises with an additional unit of a variable
factor is the marginal product of the variable factor. Mathematically, marginal product is the

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ratio of the change in output to the change in the amount of a variable factor.
The marginal product of labor(MPL), for example, is the amount by which output rises with an
additional unit of labor. It is thus the ratio of the change in output to the change in the quantity
of labor (Q/L), all other things unchanged. It is measured as the slope of the total product
curve for labor.
Equation 8.1

MPL= Q/L

In addition we can define the average product of a variable factor. It is the output per unit of
variable factor. Theaverage product of labor (APL), for example, is the ratio of output to the
number of units of labor (Q/L).
Equation 8.2

APL=Q/L

The concept of average product is often used for comparing productivity levels over time or in
comparing productivity levels among nations. When you read in the newspaper that
productivity is rising or falling, or that productivity in the United States is nine times greater
than productivity in China, the report is probably referring to some measure of the average
product of labor.
The total product curve in Panel (a) of Figure 8.2 "From Total Product to the Average and
Marginal Product of Labor" is repeated from Figure 8.1 "Acme Clothings Total Product Curve".
Panel (b) shows the marginal product and average product curves. Notice that marginal product
is the slope of the total product curve, and that marginal product rises as the slope of the total
product curve increases, falls as the slope of the total product curve declines, reaches zero when
the total product curve achieves its maximum value, and becomes negative as the total product
curve slopes downward. As in other parts of this text, marginal values are plotted at the
midpoint of each interval. The marginal product of the fifth unit of labor, for example, is plotted
between 4 and 5 units of labor. Also notice that the marginal product curve intersects the
average product curve at the maximum point on the average product curve. When marginal

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product is above average product, average product is rising. When marginal product is below
average product, average product is falling.
Figure 8.2 From Total Product to the Average and Marginal Product of Labor

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The first two rows of the table give the values for quantities of labor and total product from Figure 8.1
"Acme Clothings Total Product Curve". Marginal product, given in the third row, is the change in
output resulting from a one-unit increase in labor. Average product, given in the fourth row, is output per
unit of labor. Panel (a) shows the total product curve. The slope of the total product curve is marginal
product, which is plotted in Panel (b). Values for marginal product are plotted at the midpoints of the
intervals. Average product rises and falls. Where marginal product is above average product, average
product rises. Where marginal product is below average product, average product falls. The marginal
product curve intersects the average product curve at the maximum point on the average product curve.
The total and the marginal product curves demonstrate the property known as the Law of
Diminishing Returns.
Law of Diminishing Returns states that there is a general tendency for the marginal product
of an input to eventually decline as its use is increased holding all other inputs fixed.
Production Function with Two Variable Inputs
IsoQuant Analysis
We have looked at the Production Function and its behaviour with only one variable input i.e.
labour. That was the scenario in the short run where usually one factor of production is fixed.
Let us now look at a production function with two variables i.e. Labour (L) and Capital (K). This
is basically the long run where all factors of production are variable. To deal with a simplified
model we are only considering a production function that employs just two factors L and K.
Consider the data giving combinations of K & L to produce the same output of 500.
L

12

18

180

120

90

60

45

40

30

20

This data may be plotted as shown.

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IsoQuant

Capital (K)

200
180
160
140
120
100
80
60
40
20
0
0

8 10 12 14 16 18 20

Labour (L)

This line is called a IsoQuant.

(Iso stands for same and Quant represents quantity of production).
This line represents the same quantity of output with two variable inputs.
For each output quantity, we get a different IsoQuant i.e. we get a family of IsoQuants.
The graph shows three levels of output, namely, Q1, Q2 and Q3 where Q1 < Q2 < Q3

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There are three points R, S, and T on isoquants Q1, Q2 and Q3 respectively showing increasing
output.
Properties of Isoquants
The properties of isoquants are listed below:
1. There is a different Isoquant for every output level the firm could possibly produce, with
isoquants farther from the origin indicating higher levels of output.
2. Along a given Isoquant, the quantity of labour employed is inversely related to the
quantity of capital employed. This implies that isoquants have negative slopes, that is,
downward sloping.
3. Isoquants do not intersect. Since each Isoquant refers to a specific level of output, an
intersection would indicate that the same combination of resources could, with equal
efficiency, produce two different amounts of output.
4. Isoquants are usually convex to the origin. Any Isoquant gets flatter as we move down
along the curve.
5. Marginal Rate of Technical Substitution (MRTS) is the additional amount of capital
required to maintain production at a certain level after a unit of labour is taken away.
L

12

18

180

120

90

60

45

40

30

20

At Input of 6, the MRTS = (60-45) / (8 6) = 7.5. This indicates that for each unit of
labour removed, an additional capital of 7.5 will have to be deployed to produce the
same output.
6. MRTS between capital and labour is the negative of the slope of the Isoquant curve at a
particular point.
7. Production Process of the firm is embodied in the Isoquant curve.
Law of variable proportions: Returns to Scale

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The law of variable proportions tells us what happens when a firm changes the inputs in a
production function by a certain proportion. If a firm increases the amount of all its inputs by
same proportions, there are three possibilities:
1. Constant Returns to Scale
2. Increasing Returns to Scale
3. Decreasing Returns to Scale
Let us understand the three possibilities of returns to scale.
Returns to Scale is related to the change in output when both inputs are changed in the same
ratio. Suppose 40 units of labour and 35 units of capital is used to produce 100 units of output.
Now, you double both the inputs i.e. 80 units of labour and 70 units of capital. Observe what
happens to the output. There are three possibilities.
1. Output = 200 i.e. double Constant Returns to Scale Output changes in the same
proportion as the inputs.
2. Output > 200 i.e. more than double Increasing Returns to Scale Output changes in
the a proportion higher than the inputs.
3. Output < 200 i.e. less than double Decreasing Returns to Scale Output changes in
the a proportion lower than the inputs.
These concepts can be graphically represented.

Constant Returns to Scale

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Increasing Returns to Scale

Decreasing Returns to Scale

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Isocost Curve
An isocost line can be formed with taking all the input combinations with the corresponding
costs with total cost remaining the same.
The isocost curve is derived from the firms total variable costs (TVC), the costs which change
with output. As the firm hires inputs, it pays interest, r, for capital (K), and wages, w, for labour
(L).
The firms total variable cost is the sum of its capital and labour costs, which is represented as
TVC = wL + rK

We can rewrite the equation as

TVC r
K
w w

This Isocost line can be plotted with labour on the vertical axis and capital on the horizontal axis
as shown.
Where, the slope, -r/w is the relative price of capital to labour.
For different values of TVC, we will get different IsoCost lines, all parallel to each other. This is
because the slope r/w remains the same as TVC changes.
These represent different combinations of labour and capital costs for the same total cost.

Slope = -r/w

If the firm decides to expand production, the isocost curve will shift right, leading to more
possible combinations of capital and labour requirement.
On the other hand, if the firm decides to reduce production, the isocost curve shifts left leading
to fewer combinations of capital and labour requirement.
If the price of capital falls, i.e. r falls, the isocost curve will shift out along the horizontal axis
only, making the isocost curve flatter.
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If the price of labour falls, i.e. w falls, the isocost curve will shift up along the vertical axis only,
making the isocost curve steeper.
1. As the price of an input falls, it makes more combinations of capital and labour feasible.
2. As the price of an input increases, it makes fewer combinations of capital and labour
infeasible.
EQUILIBRIUM: Optimal Input Combinations
A firm would like to minimise cost of production for a given output quantity by choosing a
particular combination of K & L values on the isoquant line.
A cost-minimizing input bundle is a point on the isoquant for the given output that is also on the
lowest possible isocost line. Put differently, a cost-minimizing input bundle must satisfy two
conditions:
a. it is on the isoquant
b. no other point on the isoquant is on a lower isocost line.

b
a
X
d

In other words, the IsoCost line is tangential to the IsoQuant line.

You find that IsoCost line b meets the conditions.
The point X gives the lowest cost combination of the inputs capital and labour for producing the
output quantity as given by the IsoQuant line shown.
Expansion Path
For each level of production i.e. an Isoquant line, there will be a an Isocost curve tangential to it
that gives the optimal input combination. The line created by joining these points of tangency is
called the Expansion Path for the firm.

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CHAPTER 5:
Cost Analysis: Introduction Cost Classification - Real Cost Opportunity Cost Money Cost
Explicit and Implicit Cost Accounting and Economic Cost Fixed and Variable Cost Total
Cost Marginal Cost Short Run Total Cost Schedule of a Firm TFC, TVC & TC Curves The
behaviour of short run average cost curve Marginal Cost Curve The Long Run Average Cost
Curve Cost and Output Relations. (Simple Problems)

Learning Objectives
On the completion of this chapter, you should be able to:

Understand the relationship between production level and costs

Be able to differentiate between different types of costs and their relationship to

production in the short and the long run

Be able to generate and calculate different costs curves Total Cost, Average Cost &
Marginal Cost and understand the relationship between cost cruves in the short run
and the long run

COSTS
Our analysis of production and cost begins with a period economists call the short run.
The short run in this microeconomic context is a planning period over which the managers of a
firm must consider one or more of their factors of production as fixed in quantity. For example,
a restaurant may regard its building as a fixed factor over a period of at least the next year. It
would take at least that much time to find a new building or to expand or reduce the size of its
present facility. Decisions concerning the operation of the restaurant during the next year must
assume the building will remain unchanged. Other factors of production could be changed
during the year, but the size of the building must be regarded as a constant.
When the quantity of a factor of production cannot be changed during a particular period, it is
called a fixed factor of production. For the restaurant, its building is a fixed factor of production
for at least a year. A factor of production whose quantity can be changed during a particular
period is called a variable factor of production; factors such as labor and food are examples.
While the managers of the restaurant are making choices concerning its operation over the next
year, they are also planning for longer periods. Over those periods, managers may contemplate
alternatives such as modifying the building, building a new facility, or selling the building and

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leaving the restaurant business. The planning period over which a firm can consider all factors
of production as variable is called the long run.
At any one time, a firm will be making both short-run and long-run choices. The managers may
be planning what to do for the next few weeks and for the next few years. Their decisions over
the next few weeks are likely to be short-run choices. Decisions that will affect operations over
the next few years may be long-run choices, in which managers can consider changing every
aspect of their operations. Our analysis in this section focuses on the short run. We examine
long-run choices later in this chapter.
Estimating and controlling cost is an essential part of the production process. If a firm does not
know how much it costs to produce an item, it will not be able to decide the selling price. While
in a monopolistic know the cost is adequate to fix the selling price, in a competitive
environment, the firm also need to control cost so that it remains profitable at the market price.
Cost analysis is made difficult by the effects of unforeseen inflation, unpredictable changes in
technology, and the dynamic nature of input and output markets.
You may consider the principles and practices of Cost Accounting to be appropriate for
analysing cost. However, there is a concept of Economic Cost which is different from the
concept of Accounting Cost. The difference is in the perspective of looking at the cost. While the
Accountants look at past cost and its treatment, the Economists look at future cost. Some of the
areas of difference are handling of Sunk Cost and Opportunity Cost.
Sunk Cost
Sunk Cost is the cost that has been incurred and cannot be recovered. There are many ways a
firm can incur sunk cost. Costs incurred for company formation, interior decoration in a rented
premise, procurement of an equipment that cannot be disposed off, cost of development of
internal road are some examples of sunk cost.
Accountants deals with sunk cost over several accounting periods. Depreciation is charged as
cost during the period and the balance (cost depreciation for the period), is passed on to the
next year as asset. Economists ignore it since it has no relevance in the decision that one has to
make for the future.
Note:

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Expired cost Cost whose economic benefit has been received during the period of
consideration.

Unexpired cost Cost whose economic benefit will be received in future period (as well).

Opportunity Cost
Opportunity Cost is one which is not incurred actually but notionally. Consider a firm that
operates out of a property it owns. It does not pay any rent to itself. So, for Accountants, there is
no cost involved. But, if the property was rented out to someone else, the firm would earn rental
income. This possible income, when not earned, is the opportunity cost of occupying the
building.
Accountants ignore it as there is no financial transaction associated with opportunity cost. But
Economists will take this into account while computing cost.
1. Cost Categories
Cost can be categorised as:
A. Actual cost
B. Opportunity cost
C. Discretionary cost
D. Fixed cost
E. Quasi-fixed cost
F. Variable cost
G. Investment
H. Sunk Cost
I.

Direct Cost

J.

Indirect Cost

A. Actual cost
Actual costs are the expenses incurred for the factors of production. These include salary,
raw , rent, power etc.
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B. Opportunity Costs
Opportunity cost is the value of benefits foregone. If you are run a workshop you may not take a
salary. If you had worked in some other organisation, you would have got a salary. This salary
that you are not getting is a benefit that you are foregoing. This is an opportunity cost incurred
by your workshop.
C. Discretionary Costs
Discretionary costs are those which are not strictly necessary for current production and can be
avoided/postponed without disrupting a firms operations in the short run.
It corresponds to medium/long term objectives of the firm.
Consider a firm that develops accounting software. The firm is running a promotion of the
product at several B-Schools. The objective is to get mindshare of the students so that when they
join the work-force, they remember the product. It is expected that this will boost sales in the
medium to long term.
This is an example of discretionary cost.
D. Fixed Costs
Fixed costs are those costs that remain constant irrespective of the volume of output.
Some examples of fixed costs are rent, interest, salaries of permanent employees etc.
These are costs that cannot be reduced even if you reduce output in the short term.

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E. Quasi-Fixed Costs
Quasi-fixed costs are those costs that are incurred if the firm produces, but are not dependent
upon the level of output. Typically they are non-labour costs.
Consider a firm that produces products that have seasonal demand. It has set up multiple
productions facilities in different parts of the country such that during peak demand, all of the
units put together can satisfy the demand. During non-peak season, the firm shuts down some
of the units keeping only skeleton staff for security purposes. Every time one of the production
units is started there is a certain cost associated with making the unit operational. This cost is
not dependent upon the output that will be generated by that unit. This cost that is incurred to
make the unit operational is an example of quasi-fixed cost.
Please note that the cost of the skeleton staff when the unit is not producing is neither variable
nor quasi-fixed, it is fixed.
On a smaller scale, there are machines that have to be started-up time after they have been shutdown. There is a cost associated to this start-up operation. This is also an example of quasi-fixed
cost.
Suppose you are a lucky person to own a residence in a location where you do not normally
reside. You only go there once or twice a year. Every time you go, you have to get the place
cleaned up and make it habitable. This is also an example of quasi-fixed cost in the sense that
you incur the cost only if you go there (and not otherwise) and this cost is not dependent upon
how many days you stay there.
Some examples of quasi-fixed costs related to labour are given below.

Cost of hiring new workers

Cost of training new workers

Social insurance programs, such as, social security, workers compensation insurance,
unemployment insurance

F. Variable Costs
Variable costs are the costs which vary with the volume of production. Variable costs have
positive relationship with the volume of output. Variable costs increases with higher volume of
production and vice versa (proportionally or not).

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If there are only variable costs, at zero production the total costs will be zero. Generally, variable
costs are measured on the basis of per unit of output produced.
If there are only variable costs the total costs will follow the pattern as shown. At zero output,
the total variable cost will also be zero.

Variable cost
400
300

Rupees '000

200
100
0
0

10

12

Production Quantity

Pattern of Total Costs when only Variable Costs are Present

G. Investment
In most cases, a firm has first to sustain certain costs (investment) before any production takes
place (e.g. R&D, machinery investment). These costs are called investment costs.
These costs should be recovered within a reasonable period of operative activity (production).
In certain cases, after the full exploitation of production opportunities there may be a further
one-time revenue for asset sale.
For instance, when a firm buys an office, it invests a certain amount of money. It will use it for a

certain period, say 10 years, during which it saves the rent it would have paid if it didn't own
the office, thus (totally or partially) recovering the initial cost. At the end of the 10-years period,
it can decide to shut down operations and it will be able to sell the office getting a one-time
revenue. There could also be a manufacturing unit that is in use for a period of time and then
sold off or say a trucking company buying a fleet of trucks and selling them off after a few years
of use. Such costs are typically investments.
Source: http://www.economicswebinstitute.org/glossary/costs.htm#temp

H. Sunk cost
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Sunk costs are investment costs incurred before a certain activity takes place which cannot be
recovered by the possible sale of the asset they produced.
In other words, sunk costs are unrecoverable past expenditures. Highly specific investment
(Research and Development (R&D) is usually an example of sunk costs). Sunk costs represent
barriers to exit. A firm which has incurred in high sunk costs will have difficulties in deciding to
exit the market even if it views good opportunities outside.
When a firm is deciding whether to enter into a certain business will have to consider sunk costs
and the risk associated with it that during the operations period sunk costs might not be
recovered. Thus, sunk costs represent barriers to entry. In the case of an exporter, an example of
sunk costs could be the costs of analysing the market and of exploring opportunities and
seeking commercial partners.
I.

Direct cost1

Direct costs are those for activities or services that benefit specific projects, e.g., salaries for
project staff and materials required for a particular project. Because these activities are easily
traced to projects, their costs are usually charged to projects on an item-by-item basis.
Costs usually charged directly

Project staff

Consultants

Project supplies

Publications

Travel

J. Indirect Cost1
Indirect costs are costs that are not directly accountable to a cost object (such as a particular
function or product). Indirect costs may be either fixed or variable. Indirect costs include
administration, personnel and security costs, and are also known as overhead. These are those
cost which are not related to production.
There are two types of indirect costs. One are the fixed indirect costs which contains activities or
costs that are fixed for a particular project or company like transportation of labour to working
site, building temporary roads etc. The other are recurring indirect costs which contains
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activities that repeat for a particular company like Maintenance of Records or payment of
Salaries.
Some examples of indirect costs

Utilities

Rent

Audit and legal

Administrative staff

Equipment rental

Fuel%

Maintenance

Generator

Security

Telephone

Bill expense

2. Total and Average Costs

Total cost (TC) are the sum of all costs. A firms total cost of producing a given level of output is
the total expenditure incurred to produce that output.
Average cost (AC) is obtained by dividing the TC with the quantity produced (Q). Average cost
is the cost per unit of output produced.

AC

TC
Q

Average cost (AC) can be represented mathematically as represented in equation.

where,

AC = Average costs

TC = Total costs

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Q = Number of units produced

AC

FC VC
Q

Since TC is sum of fixed costs (FC) and variable costs (VC), replacing TC in

equation above, we get

where

VC = Variable costs

FC = Fixed costs

Consider the short run cost structure of a hypothetical firm.

(Amount Rs. in000)
Quantity Fixed Cost

Variable Cost Total Cost

Average

Average

Fixed Cost

Variable Cost

(Q)

(FC)

(VC)

(TC = FC + VC) (AFC)

50

50

50

55

105

50

78

50

Average Cost

(AVC)

(AC = AFC + AVC)

50.0

55.0

105.0

128

25.0

39.0

64.0

98

148

16.7

32.7

49.3

50

112

162

12.5

28.0

40.5

50

130

180

10.0

26.0

36.0

50

150

200

8.3

25.0

33.3

50

175

225

7.1

25.0

32.1

50

204

254

6.3

25.5

31.8

50

242

292

5.6

26.9

32.4

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10

50

300

350

5.0

30.0

35.0

11

50

385

435

4.5

35.0

39.5

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Let us look at the graphs of the data.

Since the fixed costs remain independent of the output, at higher output levels, the costs gets
apportioned over a larger amount of output. Therefore, we find that higher the production level
(Q), fixed costs decreases systematically.
At low production levels, these reductions are quantitatively relevant whereas, for a high Q it
is not. In fact, for high Q, the average cost is practically equal to variable cost VC.
For low levels of production, fixed costs are major determinants of average costs whereas for
high levels of production, variable costs dominate.
Average costs can be directly compared with price to compute profitability. If the price is higher
than average cost, the production is profitable.
3. Economies of Scale
Let us consider a hypothetical furniture making firm. It was started by Ramesh when he had to
move to city as his small plot of agricultural land was acquired for a road widening project. He
Worked as an apprentice with someone for some time. Once he received the compensation from
the government, he invested the money to set up a small workshop. He was diligent and did
well. He built up a set of clientele.
One of the customers gave him a design of a bed that could be converted to a sofa or packed and
stored away easily. He made it well and the customer was very happy. He started getting more
orders for the same.

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Fast forward five years. Ramesh was making only the special foldable bed. He had set up a large
workshop where a number of people, mostly from his village, work. To improve productivity, he
had trained each person to do only one activity. Some cut the legs, some cut other parts, some
joined the pieces, some polished and so on. His production was streamlined and profitable.
Fast forward now. Ramesh is exporting the beds to a large multinational furniture company. He
has set up machines, with guidance from his customer, to make different parts of the bed,
polished and finished. People only do the joining and packing. His profits are even more. He
has set up a school in his village. Boys and girls study there and then come to city to attend
college. He has set up hostels for them.
He still makes only beds and of one design only.
Ramesh is getting the benefits of Economies of Scale.
Let us see what it means.
Initially Ramesh was making the beds alone.
Then he got others to join him and they were making more beds. People who joined him took
time to learnt the job. Their productivity was initially low and then went up.
Later, Ramesh installed a machine that cost a lot of money. He got more output per day from
one machine, located in one part of the workshop, that many people, taking up half the
workshop, were making. His wastage has come down.
He also ensured that he got the raw material pre-cut to his size and shape requirements without
any extra cost. In fact he got a lot of discount from the vendors who gave him wood, glue,
polish, tools etc. Thus, as his output increased, his average cost per bed came down due to
several reasons.

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We can put is in a different way.

As level of production increases, the costs rise less proportionally than the volume of output.
This situation is called the Economies of Scale.
A firm experiences economies of scale when its average cost falls as its quantity produced
increases. The average falls to a certain extent (of course, it cant practically fall to zero!) and
stabilizes for sometime (the yellow portion in the graph). There the firm enjoys constant returns
to scale.
Now consider a different turn in the story of Ramesh making beds.

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Fast forward five years. Ramesh was making only the special foldable bed. He had set up a large
workshop where a number of people, mostly from his village, work. He had trained each person
to do only one activity. Some cut the legs, some cut other parts, some joined the pieces, some
polished and so on. Many of his people had some dispute or the other running down
generations. These started getting manifested in ill-will in the workshop. Ramesh had to spend
time to resolve these disputes. His was getting distracted but his business still continued to
grow.
Fast forward now. Ramesh is still making those beds as his order book is full due to his
commitment to quality. He has started employing people not related or known to each other to
avoid relationship issues. Now there are several layers of people in the workshop, some working
in small teams, some supervising these small teams and yet some others managing schedules
and production flow.
His costs have risen but it is still profitable and growing. Ramesh is getting hurt by
Diseconomies of Scale. As level of production increases, the costs rise more proportionally than
the volume of output. This situation is called the Diseconomies of Scale. A firm experiences
diseconomies of scale when its average cost rises as its quantity produced increases.
Economies of scale are divided into Real Economies and Pecuniary Economies.
Pecuniary Economies
Pecuniary economies are comprehended from paying lower prices to factors of production and
it does not imply a reduction in the quantity used by the factors of production.
Bulk buying of raw material gives a firm bargaining power and hence lower prices. But paying
lower wages is rare unless the firm has monopolistic advantages.
Real Economies
Real economies are realised from a reduction in the physical quantity of factors of production
used as the firm expands. There are four types of real economies. They are:

Production economies

Selling and marketing economies

Managerial economies

Transport and storage economies

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The real economies are important when discussing inter-plant economies of scale, rather than
intra-plant scale economies. Thus, the concept of multi-plants is an important element in
understanding efficient production. Multi-Plants arise where markets are located in different
geographic places and high transport costs exist because of weight - value problems. Transport
costs can affect the optimal scale of the single plant to a large extent and so may give rise to
multi-plants.
The other reason for multi-plants is that of pooling risks. If risks are not systematically related,
then there are options available to hold less slack capacity or inventories, to guard against
contingencies than a single plant would. This in turn will lower the costs of raising capital.
However, there may be diseconomies from operating multiple plants because of co-ordination
and communication problems.
4. Marginal Costs
Marginal Cost is the change in total cost when the quantity produced changes by one unit.

Rupees
Average Variable Cost (AVC)

Average Total Cost (ATC)

Marginal Cost (MC)

Production Quantity

MC

VC TC

Q
Q
If there is neither any fixed cost nor any quasi-fixed cost, the total cost is

equal to the variable cost. In such a situation, Marginal Cost = Additional Variable Cost for
producing one more unit of output.
Marginal cost is given by
where MC = Marginal Cost, VC = Change in variable cost, Q = 1 i.e. one unit change in
production quantity and TC = Change in total cost.
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There are several cost-related terms like total cost, total variable cost, average total cost and
average variable cost. However, marginal cost is the most important. Marginal cost is critical in
understanding the short-run production cost.

The marginal cost (MC) curve intersects both the AVC and ATC curves at their minimum points,
that is, at these points both the AVC and the ATC are minimum.
Declining average total costs are result of economies of scale where the fixed costs are spread
over the larger quantities of output and, at low quantities of output it is the result of the
increasing marginal Product. Increasing average costs occur when the effect of declining
marginal Product is more than the effect of spreading the fixed costs.
Relationship between Marginal Cost and Average Cost
The relationship between marginal costs (MC) and average costs (AC) is useful in understanding
whether a firm has economies of scale, diseconomies of scale or constant costs.
MC < AC

Economies of Scale

MC = AC

Constant Costs

MC > AC

Diseconomies of Scale

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Average cost decreases with increase in quantity

Average cost remains constant with increase in
quantity
Average cost increases with increase in quantity
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Short Run Cost Curves

In general, short-run cost curves are based on a production function with one variable input of
production.
The short-run curves of marginal Product initially increases and then decreases.

The average variable cost (AVC) curve is nothing but the per unit variable cost of variable
input used in the production.

The average fixed cost (AFC) curve is the cost of the fixed factor of production divided
by the number of unit produced.

The average total cost (ATC) curve is U-shaped and can be derived by adding the average
fixed and variable costs (AFC, AVC).

Short Run Average Total Cost curves (indicated as ATC above) are generally denoted as SRAC.

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Long Run Cost Curves

In the long run, all factors of production are variable and firms can enter or exit any industry or
market. Consequently, a firm's output and costs are unlimited in the sense that the firm can
produce any output level it chooses by employing the necessary quantities of factors of
production (such as labour and capital) and incurring the total costs of producing that output
level.

The Long Run Average Cost is generally referred to as LRAC. The LRAC curve of a firm shows
the minimum or lowest average total cost at which a firm can produce any given level of output
in the long run (when all inputs are variable).
Given that LRAC is an average quantity, one must not confuse it with the long-run marginal cost
curve, which is the cost of producing one extra unit.
The LRAC curve is created as an envelope of an infinite number of short-run average total cost
curves. The typical LRAC curve is U-shaped, reflecting economies of scale when negativelysloped and diseconomies of scale when positively sloped.
In the long-run perfectly competitive environment, the equilibrium level of output corresponds
to the minimum efficient scale, marked as Q2 in the figure. This is due to the zero-profit
requirement of a perfectly competitive equilibrium. This implies production is at a level
corresponding to the lowest possible average cost. However it is not to say that other production
levels are not efficient. While all the points along the LRAC are productively efficient, they are
not equilibrium points in a long-run perfectly competitive environment.
In some industries, the LRAC is always declining (economies of scale exist indefinitely). This
means that the largest firm tends to have a cost advantage, and the industry tends naturally to
become a monopoly. Hence, it is called a natural monopoly. Natural monopolies tend to exist in

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industries with high capital costs in relation to variable costs, such as water supply and
electricity supply.

Long Run Average Cost Curve

In the long run, a firm will use the level of capital or other inputs that are fixed in the short run
that can produce a given level of output at the lowest possible average cost. Consequently, the
LRAC curve contains the short run average total cost (SRAC) curves, where each SRAC curve is
defined by a specific quantity of capital (or other fixed input).

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CHAPTER 6:
Analysis of Market situations and Pricing - Kinds of competitive situations features of perfect
competition, monopoly, duopoly, oligopoly and monopolistic competition.
Pricing: Meaning, Types of pricing, Pricing under different market situation: Perfect competition
Price determination under monopoly price discrimination monopolistic competition and
Price determination.

Learning Objectives
On the completion of this chapter, you should be able to:

Understand the different kinds of market structures that exist

Be able to understand how firms make pricing and profit maximizations decisions under
different market structures such as perfect competition and monopolistic competition

MARKET STRUCTURE
If your bank is the only one having a branch in a residential locality, your market position is
different from another branch, say, in an industrial estate having branches of five other banks.
If your locality has a number of grocery stores, your will have a better chance of finding
competitive prices and products of better quality and more variety. In other words, you will get
a better deal.
When you set up home, you will take electricity connection from the only provider as we do not
have a choice of multiple electricity vendors in any location in India.
The above are different example of market structures, the subject matter of our study in this
Unit.
Market Structure is central to both economics and marketing. Both disciplines are concerned
with strategic decision making. Market structure has an important role as it impacts the
decision-making parameters. The extent and characteristics of competition in the market affect
choice of behaviour.

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In economics, markets are classified based on the structure of the industry serving that
particular market. Industry structure is categorised on the basis of market structure variables
which are believed to determine the extent and characteristics of competition.
Features of Market Structure
Some important variables of market structure listed below.
1. Number of firms
2. Market share of the largest firms
3. Nature of costs
4. Degree of vertical integration of the industry
5. Product differentiation / substitutability
6. Structure of buyers
7. Turnover of customers and/or sellers
8. Barriers to entry and/or exit
9. Extent of mutual interdependence
1.

Number of firms

The number of firms participating in the market includes the scale and extent of foreign
competition.
2. Market Share of the Largest Firms
The market share of the largest firms is measured by the concentration ratio, which measures
the relative size of the firms when compared to the industry as a whole.
3.

Nature of Costs

The nature of costs includes the potential for firms to exploit economies of scale and also the
presence of sunk costs which affects market contestability in the long term.
4.

Degree to which the Industry is Vertically Integrated

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The degree to which the industry is vertically integrated (whether a firm produces all the things
that it sells or if a firm also owns the distribution channel for its products) is another important
feature of market structure.
5.

Product Differentiation

The extent of product differentiation which affects cross-price elasticity of demand, that is, to
what extent a company can differentiate its products in the eyes of consumers than rival
company.
6.

Structure of Buyers

The structure of buyers in the industry that includes the possibility of monopsony power.
7. Turnover of Customers
Turnover of customers is also known as Market Churn.
How many customers are switching the supplier over a given time period when market
conditions change. The factors affecting the turnover are brand loyalty and the influence of
persuasive advertising and marketing.
8.

Barriers to Entry

Barriers to entry depend on how difficult it is for companies to enter a particular market. The
factors making it difficult for a new company to enter the market are (i) control of the necessary
resources or inputs, (ii) government regulations, (iii) economies of scale, (iv) network
externalities, (v) technological superiority, (vi) investment required etc.
9.

Extent of mutual interdependence

Mutual interdependence means that no one firm can take decisions independent of the
decisions taken by the competing firms. Mutually Interdependent firms have the following
characteristics.

All firms are price takers.

Each firm sets its own price based on its anticipated reaction by its competitors.

All firms are free to enter or leave the market.

Types of Market Structure

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One way of describing Market Structure is based on the number of firms producing identical or
substitution products.
Types of Market Structures Based On Supply

Market Structure
(Supply Side)
Monopoly Oligopolistic Market
Monopolistic
Perfectly
MarketCompetitive Market
Many sellers of Many sellers of
A few sellers of a
f a product for which there is no close substitute
diferentiated a standardised
Product with similar features
product
products
Market structure affects the market outcomes by impacting the motivations, opportunities and
decisions of economic actors participating in the market. Market structure is best defined as the
organisational and other characteristics of a market.
But, in general, we focus mainly on those characteristics which affect the nature of competition
and pricing. It is important not to place too much emphasis simply on the market share of the
existing firms in an industry.
Market structure may b described based on the demand side as well. Two special cases of
demand side based market structure are as follows.
1. Oligopsony
2. Monopsony

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Market Structure
(Demand Side)
Monopsony

Oligopsony

A few buyers of a
A single buyer of a product
Product
Consider a large vegetable market and a product, say, cucumber. If there are sufficiently large
number of vendors selling cucumber of same quality, the price of cucumber will be uniform in
the market across all vendors. On the other hand, if there is only one vendor selling cucumber,
he will decide the price. The situation where there are a large number of vendors of an identical
product, the market is said to have a structure called Perfectly Competitive Market.
It does not cost much to become a vegetable vendor i.e. the entry barrier is low. At the same time
it also does not cost much to stop being a vegetable vendor i.e. the exit barrier is also low.
Consider share brokers. There are a large number of share brokers in each city. If one broker
charges more commission than the other, customers will leave him and go to the cone who
provides the same service at a lower rate. This is also a perfectly competitive market.
Perfectly Competitive Market is a market structure that features no barriers to entry, a large
number of producers and consumers, and facing a perfectly elastic demand curve.
Each market participant is too small to influence market prices. Individual buyers and sellers are
price takers. Firms take market prices as given and devise their production strategies
accordingly. Free and complete demand and supply information is available in a perfectly
competitive market, and there are no barriers to entry and exit. As a result, vigorous price
competition prevails. Only a normal rate of return on investment is possible in the long run.
Economic profits are possible only during periods of short-run disequilibrium before rivals
mount an effective competitive response.
In perfect competitive markets, the following hold true.

Many buyers and sellers, where individual firms have little effect on the price

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Goods offered are very similar and the demand is very elastic for individual firms

Firms can freely enter or exit the industry i.e. there are no barriers to entry or exit

Many competing firms, hence no individual firm can influence the market (price or
share)

Homogenous products, not branded

Perfect knowledge of the market

Perfect mobility of factors of production

Absence of transport cost

No government intervention i.e. no regulation and no subsidy

Profit Maximisation
For maximization of profit, a firm has to adjust the quantity of production such that it achieves
the greatest level of economic profit given existing market conditions and production cost. A
firm in a perfectly competitive market will adjust the production in response to the market price.
There are three different ways to identify the quantity that will maximize profit.
1. Economic profit curve
2. Comparison of total revenue and total cost curves
3. Comparison of marginal revenue and marginal cost curves

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For maximization of profit, a firm has to adjust the quantity of production such that it achieves
the greatest level of economic profit given existing market conditions and production cost. A
firm in a perfectly competitive market will adjust the production in response to the market price.
Let us look at it graphically.

Marginal Revenue: In a perfectly competitive market, the firm is a price taker i.e. marginal
revenue curve is a horizontal line of the market price.
2.

Marginal Cost: The marginal cost curve has a negative slope for smaller quantity and a
positive slope for larger quantities.

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3.

Profit Maximization: The maximum profit is generated at the intersection of the MR and
MC curves.

Consider what results if marginal revenue is not equal to marginal cost:

MR > MC: When the production quantity is small, the firm can increase profit by increasing
production as additional production adds more to revenue than to cost.
MR < MC: When the production quantity is large, the firm can increase profit by decreasing
production as additional production reduces revenue less than it reduces cost.
MR = MC: When the production quantity is such that the marginal revenue (which is same as
price here) is equal to marginal cost, the firm profit is maximum.

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Introduction
Monopoly is a firm that is the sole producer of a good or service. We can also state that a
monopoly is a single producer of a product which does not have close substitute. For example,
railroad transportation in India is provided only by the Indian Railways, although it can be
argued that rail travel does have close substitutes. About two decades back BSNL had the
monopoly over providing telephone services in most of the country.
A monopoly is characterised by barriers to entry.
Features

Single seller in the market

No close substitutes

No competition

Price maker

Difficult entry of new firms

Can fix both price and output by himself (but crucially, does not have control over both
he has to set one which determines the other)

Characteristics of monopoly:

A monopoly sets price to maximize profit.

Most monopolies are created by government intervention.

In many cases government may decide the price.

A monopoly is not necessarily more profitable than competing firms. This may be due
the market being small or other factors like government fixed price.

Without government intervention a profitable monopoly will encourage others to enter

the market and the monopolistic market structure will not last.

Sources
Sources of a monopoly include:
1. Ownership/Control of a Key Resource
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2. Barrier to Entry Economies of Scale

3. Technological Superiority
4. Network Externalities
5. Government-Created Barriers

Pricing and Production Decisions

A monopoly, being in a position to influence its own price as well as production quantity,
functions as a price setter rather than a price taker.
Monopolists are constrained by the negative relationship between price and quantity demanded
but the freedom to set the price is quite high compared to the Perfectly Competitive Market.

Monopoly Profit
These issues are discussed in detail.
Revenue for a Monopoly
An organisation having monopoly may raise its price, but as a result it will lose sales. In order to
sell more, it must lower its price.
There are two effects on total revenue:
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1. Output effect: More revenue generated due to selling more units

2. Price effect: Less revenue because it earns less from each unit sold due to the lower price

Monopoly Profit
4. Profit Maximisation in Monopoly
As we know, profit maximisation is the most important objective of a firm. So, the firm would
produce that level of output where profit is maximised.

MCtotal
< MR
nit will increase
revenue (TR) more than increase in total cost (TC), so the monopo

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g one extra unit

increase TC more than increase in TR, so the monopolist should dec
MC will
> MR

MR = MC

Profit is maximised.

A monopolist generally produces less output than a socially efficient level of output, and
charges a very high price. Are the above normal profits of monopoly a social cost? Not usually,
since profit is still a part of surplus but has been transferred from consumers to producers.
Social cost arises from inefficiently low output which leads to the dead weight loss.
However, if the monopolist uses some of its normal profits to lobby in order to maintain a
monopoly then this can be a welfare cost to society. This phenomenon is called Rent Seeking and
is not discussed in detail here.
Social Costs of Monopoly Power

There is a loss of consumer surplus and a deadweight loss from monopoly pricing

Government Regulation of Monopolies

Public ownership of natural monopolies like Post Office, electric power and wireless

internet service in some areas. This is typically viewed as a bad idea. But the wireless internet
service seems to be a success.

Price regulation.
Unlike in the perfectly competitive market case, imposing a price ceiling on a monopolist

is not necessarily a bad thing.

Monopolistic Competition
Consider packaged food grain, say, Moong Dal. There are many players offering it, but the price
of each brand is not the same. This is because some people prefer a particular brand and they
are ready to pay more for that brand. This is in spite of the fact that any one brand can be
substituted by any other brand as the products are not highly differentiated.
This is called Monopolistic Competition.

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Monopolistic Market differs from Perfectly Competitive Market in that production does not take
place at the lowest possible cost.
This is also called Competitive Market.
Monopolistic Market as a market structure was first identified in the 1930s by American
economist Edward Chamberlin, and English economist Joan Robinson.
Many small businesses operate under conditions of monopolistic Market, including
independently owned and operated stores and restaurants. In the case of restaurants, each one
offers something different and possesses an element of uniqueness, but all are essentially
competing for the same customers.
Monopolistically competitive markets exhibit the following characteristics:

Price and output is fixed by each firm based on its product, its market, and its costs of
production.

While there is widespread knowledge between participants, it is generally imperfect.

There are no major barriers to entry or exit.

Products are differentiated as follows.

Physical product differentiation - size, design, colour, shape, performance, and features consumer electronics can easily be physically differentiated.

Marketing differentiation - distinctive packaging and other promotional techniques breakfast cereals.

Human capital differentiation - skill & training of employees, uniforms.

Differentiation through distribution - mail order (Readers Dsigest) , internet shopping

(Amazon.com, eBay.com).

Advertising - fierce competition with other firms

Profit maximizers

Advantages of monopolistic Market:

No significant barriers to entry markets are relatively contestable

Diversity, choice and utility created by differentiation - restaurants, clothing.

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More efficient than monopoly but less efficient than Perfectly Competitive Market.

Disadvantages of monopolistic Market:

Some differentiation generates waste, not utility - excess packaging, persuasive

advertising.

In Monopolistic Market the demand curve denoted by AR or Average Revenue curve is

downward sloping. The MR or Marginal Revenue curve is lower than the AR curve and is also
downward sloping.
In the Short Run, profit is maximized at MC = MR i.e. at output Q and price P. We can see that
the AR is above ATC at Q. So, it is possible to have Supernormal Profit as given by area PABC.
In the long run, both entry and exit of new forms are possible. If profit > 0, businesses will enter
and if profit < 0, businesses will exit.
As businesses enter the market, the firms market share falls and its AR and MR curves shift to
the left.

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The shifted MR curve intersects with the same MC curve giving a new quantity Q for profit
maximization. Note that this Q is lower than the Q in the Short Run curve. With lesser
production, the profit is also less.
When long-run equilibrium has been reached, the ATC curve will be tangential to the AR curve
for this value of Q. The firm will have zero profit.
If profit = 0, there will be no entry into or exit for the industry.
In the long run, all the companies' economic profits must be zero.
Monopolistic Competition and Perfectly Competitive Market
Let us look at two main differences (capacity & mark-up) between companies in monopolistic
Market and Perfectly Competitive Market (both in a long-run equilibrium i.e. profit equal to
zero).
Differences

Monopolistic Competition

Perfectly Competitive Market

Excess

Less than efficient scale of

Efficient scale of production i.e. Average

Capacity

production i.e. production quantity

Total Cost is minimum

is such that the Average Total Cost is

higher than minimum.
Mark-up

Price > Marginal Cost

Price = Marginal Revenue = Marginal

Cost

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Price Discrimination
Price discrimination refers to selling the same good or service to different customers or different
markets at different prices. Movie/airline tickets are sold at different prices depending upon the
date and/or time.
Price discrimination can be practiced, where it is easy to separate customers or markets into
groups. These groups are determined based on their elasticities to demand. The company needs
to be in a position to prevent resale between groups and also arbitrage activities.
In a theoretical market with perfect information, perfect substitutes, and no transaction costs or
prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can
only be a feature of monopolistic and oligopolistic markets, where market power can be
exercised. Otherwise, the moment the seller tries to sell the same good at different prices, the
buyer at the lower price can arbitrage by selling to the consumer buying at the higher price but
with a tiny discount.
Price discrimination is a favourable situation for monopolies. A monopolist can charge a higher
price to the segment with less elastic demand and a lower price to the segment with more elastic
demand. In this manner, a business does not have to lower prices to all buyers in order to sell
more goods.
pricing strategy that charges customers different prices for the same product or service. In pure
price discrimination, the seller will charge each customer the maximum price that he or she is
willing to pay. In more common forms of price discrimination, the seller places customers in
groups based on certain attributes and charges each group a different price.
Price discrimination allows a company to earn higher profits than standard pricing because
it allows firms to capture every last dollar of revenue available from each of its customers. While
perfect price discrimination is illegal, when the optimal price is set for every customer, imperfect
price discrimination exists. For example, movie theaters usually charge three different prices for
a show. The prices target various age groups, including youth, adults and seniors. The prices
fluctuate with the expected income of each age bracket, with the highest charge going to the
adult population.
Economists classified price discrimination into three types. These are listed below.
1. First Degree Price Discrimination
2. Second Degree Price Discrimination

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3. Third Degree Price Discrimination

First Degree Price Discrimination
First degree price discrimination occurs where a firm charges a different price for each unit sold.
Thus, the price paid is the marginal revenue to the firm of each extra unit sold. All available
consumers surplus is now translated into monopoly profit, to the benefit of the seller. The
mechanisms to achieve this end are difficult to find.
The usual examples of perfect price discrimination relate to the supply of personal services,
where the supplier is able to charge each customer according to his willingness or ability to pay.
Other examples relate to the use of auctions.
Second Degree Price Discrimination
Second degree price discrimination occurs where the monopolist charges different prices for
different quantities, or blocks, of the same product. The consumer benefits from larger output
and retains some consumer surplus.
Examples of block tariffs are to be found in the utility industries, such as gas and electricity. The
consumer is charged a price that varies with consumption in which initial units incur a higher
price than later units. This is a similar practice to quantity discounts where the more one buys,
the cheaper the product becomes.
Third Degree Price Discrimination
Third degree price discrimination occurs where the monopolist is able to separate the market
demand into two or more groups of customers. Each group is charged a different price for the
same product. In addition, the price elasticity of demand must be different for each group of
customers, so that market separation is profitable.
To be able to achieve such market separation, there must be some barriers to prevent:
1. Consumers moving from the expensive to the cheaper market
2. Consumers in the cheaper market selling to consumers in the more expensive one
Third degree price discrimination tends to be found in many industries, but particularly
transport. Railway companies offer a variety of prices for a given journey in terms of class of
travel, day of travel, season of travel, time of travel and how many weeks in advance the journey
was booked. Low-cost airlines also offer low prices for journeys booked in advance with prices
increasing the closer the date of the actual journey and the proportion of seats unfilled. Those
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wanting to travel closer to the time of the journey are willing to pay higher prices and their
elasticity of demand is lower.

CHAPTER 7:
National Income : Meaning, Methods & difficulties of Measuring Meaning of GNP, GDP, NNP,
PI, DPI. Business cycles: Meaning Features Phases of a trade cycle Adjusting business plans
to cyclical situations.

Learning Objectives
On the completion of this chapter, you should be able to:

Understand the concept of National Income and how it is measured

Be able to understand how different approaches to measurement of national income are

used and calculated

Understand the concept of the trade or business cycle in an economy

THE ECONOMY
An economy produces a mind-boggling array of goods and services. From pizzas to steel to cars
to computers to different kinds of services such as cellphone services, beauty salons, software
programming, stock broking, healthcare and transportation to name a few. A list of all the
goods and services produced in any year would be virtually endless.
So how do we figure out all the goods and services produced in an economy (say, India) in
agiven year? It is helpful to have instead a single number that measures total output in the
economy; that number is is usually called National Income.
National Income is defined as the sum total of all the goods and services produced in a country,
in a particular period of time. Normally this period consists of one year duration, as a year is
neither too short nor long a period. National product is usually used synonymous with National
income.
There are different concepts of National Income, namely; GNP, GDP, NNP, Personal Income and
Disposable Income. Lets begin with the most popular Gross Domestic Product, or GDP.
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We can divide the goods and services produced during any period into four broad components,
based on who buys them. These components of GDP are personal consumption (C), gross
private domestic investment (I), government purchases (G), and net exports, which is the
difference between the value of exports (X) and imports (M) i.e. (X-M). Thus
GDP = consumption (C) + private investment (I) + government purchases (G) + net exports (XM)
Personal Consumption
Personal consumption is a flow variable that measures the value of goods and services
purchased by households during a time period. Purchases by households of groceries, healthcare services, clothing, and automobilesall are counted as consumption. Personal
consumption represents a demand for goods and services placed on firms by households.
Private Investment
Gross private domestic investment is the value of all goods produced during a period for use in
the production of other goods and services. It is often simply referred to as private
investment. A computer produced for a software company is private investment. A printing
press produced for a magazine publisher is private investment, as is a conveyor-belt system
produced for a manufacturing firm. Private investment represents a demand placed on firms for
the production of capital goods. The production of goods and services for consumption
generates factor incomes to households; the production of capital goods for investment
generates income to households as well.

Government Purchases
Government agencies at all levels purchase goods and services from firms. They purchase office
equipment, vehicles, buildings, janitorial services, and so on. Many government agencies also
produce goods and services. Police departments produce police protection. Public schools
produce education. Indian Space Research Organization (ISRO) produces space exploration
through projects such as the latest Mangalyaan which cost about $75 million.
Government purchases are the sum of purchases of goods and services from firms by
government agencies plus the total value of output produced by government agencies
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themselves during a time period. Government purchases are not the same thing as government
spending. Much government spending takes the form of subsidies, and other types of assistance
to needy people, welfare payments to poor people, and unemployment compensation to people
who have lost their jobs. But this spending do not count in a nations GDP, because they do not
reflect the production of a good or service. Government purchases represent a demand placed
on firms.

Net Exports
Sales of a countrys goods and services to buyers in the rest of the world during a particular
time period represent its exports. A purchase by a European buyer of a car produced in India is
a Indian export. Exports also include such transactions as the purchase of programming
services from a Bangalore software firm by a company based in say New York or the purchase of
a ticket to the Taj Mahal by a tourist from Argentina. Imports are purchases of foreign-produced
goods and services by a countrys residents during a period. Indias imports include such
transactions as the purchase by Indians of watches produced in Switzerland or tomatoes grown
in Mexico or a stay in a French hotel by a tourist from India. Subtracting imports from exports
yields net exports.
Exports (X)imports (M)=net exports (X-M)
The difference between exports and imports yields either a trade surplus or deficit. If we have
more imports and less exports, we get negative net exports which constitute a trade deficit.
When exports exceed imports there is a trade surplus. The magnitude of the surplus is the
amount by which exports exceed imports.
So, to summarize Gross Domestic Product is the market value of the final goods and services
produced within the domestic territory of a country during one year inclusive of depreciation.
Components of GDP
In GDP we find different components of income namely (1) Wages and salaries (2) Rent (3)
Interest (4) Dividends
(5) Undistributed Profit (6) Mixed income (7) Direct taxes.
GDP at market price

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GDP at Market Price is estimated by deducting the value of intermediate consumption from the
value of output produced by all the producers within the domestic territory of a country. In
other words, it is estimated as the sum total of gross value added at the market price.
Another way of measuring national income is Gross National Product or GNP.
Gross National Product (GNP)
GNP at market price is sum total of all the goods and services produced in a country during a
year and net income from abroad. GNP is the sum of Gross Domestic Product at Market Price
and Net Factor Income from abroad.
While calculating GNP, the final goods and services of the following are considered:
(a) Consumer goods and services.
(b) Gross private domestic income.
(c) Goods and services produced by Government.
(d) Net income from abroad.
.
There are three different approaches to GNP, namely income approach, expenditure approach
and product
approach.
1. Income approach
In income approach, we find the different categories of Income namely; (1) Wages and salaries
(2) Rents
(3) Interest (4) Dividends (5) Undistributed corporate profits (6) Mixed incomes (7) Direct taxes
(8) Indirect
taxes (9) Depreciation (10) Net income from abroad.
2. Expenditure approach
In expenditure approach, we find the different categories of expenditure namely, (1) Private
consumption
expenditure (2) Gross domestic private income (3) Net foreign income (4) Government
expenditure on goods
and services.
3. Product approach
In product approach, we find the following categories of output. (1) Final market value of goods
and services
(2) Less cost of intermediate goods.
The following factors are to be considered while calculating the GNP:
1. Only those goods and services which can be measured by Money.
2. Market price of final goods and services alone will be considered.
3. Services which are done free of cost are not considered.
4. Productions done in current year alone are considered.
5. Illegal activities are not included.
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GNP at Market Price

If we multiply the total output produced in one year by their Market Prices, we get GNP at
market price.
Gross National Product at Factor Cost or Gross National Income
The gross national product at factor cost is the difference between gross national product and
net indirect
taxes. It is also called gross national income. Gross national income is the sum total of
compensation of
employees, operating surplus, mixed income, depreciation and net factor income from abroad.
GNP at factor cost refers to income which the factors of production receive in return for their
service alone.
GNP at FC = GNP at Market Price Net Indirect Taxes + Subsidies
Subsidies
Subsidies refer to difference between the Market Price and Cost of Production.
Difference between GDP and GNP
GDP/I = NI Net income from abroad. The major difference between GNP and GDP is that the
former includes
net income from abroad whereas the latter includes only that income which has been produced
within the
political boundary of the nation.
Gross Domestic Product at factor cost or gross domestic income.
Gross Domestic Product at factor cost or gross domestic income is the sum total of the
compensation of
employees, operating surplus and mixed income earned by the factors of production in an
accounting year plus
depreciation or consumption of fixed capital.
Gross Domestic Product at factor cost can also be estimated by deducting net indirect taxes from
gross
domestic product at market price.
Net National Product (NNP)
In the process of production of goods and services, there will be some depreciation of fixed
capital also called
as consumption of fixed capital, if the value of depreciation is deducted from the value of gross
national
product in a year, we obtain the value of net national product.
Thus, NNP at market price is gross national product at market price minus depreciation.
GNP Depreciation = NNP
NNP at market price
GNP at Market Price Depreciation = NNP at Market Price
NNP at Factor Cost

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Net National Product at factor cost is also called as national income. Net National Product at
factor cost is equal
to sum total of value added at factor cost or net domestic product at factor cost and net factor
income from
abroad.
NNP at Factor Cost = NNP at Market Price Net Indirect tax
Income earned by factors of production though participation in the production process such as
wages,
salaries, rents and profits is also termed as National Income.
Net Domestic Product at Market Price
Net Domestic Product at market price is the market value of final goods and services produced
by all the
producers in the domestic territory of a country during an accounting year exclusive of
consumption of fixed
capital. It is equal to the net value added at market price.
Net Domestic Income or Net Domestic Product at Factor Cost
NDI is the income generated in the form of wages, rent, interest and profit in the domestic territory of a
country by all the producers (normal residents and non-residents) in an accounting year(Hanson).
NDP at Factor Cost = NDP at Market Price Indirect Tax + Subsidies
Private Income
Central Statistical Organization defines Private Income as the total of factor income from all sources
and
current transfers from the government and rest of the world accruing to private sector or in other words
the
private income refers to the income from socially accepted source including retained income of
corporation.
NI Transfer Interest on Social Profit and Surplus
+++
Payments Public Debt Security Public Enterprises
Personal Income
Prof. Peterson defines Personal Income as the income actually received by persons from all sources in
the
form of current transfer payments and factor income.
Total income received by the citizens of a country from all sources before direct taxes in a year.
PI = Private Income + Undistributed Corporate Profits Direct Taxes
Disposable Income
Prof. Peterson defined Disposable Income as the income remaining with individuals after deduction
of all
taxes levied against their income and their property by the government.
Disposable Income refers to the income actually received by the households from all sources.
The individual
can dispose this income according to his wish, as it is derived after deducting direct taxes.
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Miscellaneous
DI = Personal Income Direct Taxes receipts of
the Government
Real Income
Goods and services produced in terms of money at current prices will not express/indicate real
state often.
Hence, real income is the national income expressed in terms of a general level of prices of a
particular year,
considered as the base year.
Percapita Income
Percapita Income is derived from dividing national income from the total population of the
country.
PCI = NI / Population
BUSINESS CYCLE
Economies usually go through periods of increasing and decreasing real GDP, but that over time
they generally move in the direction of increasing levels of real GDP. A sustained period in
which real GDP is rising is an expansion; a sustained period in which real GDP is falling is a
recession. Typically, an economy is said to be in a recession when real GDP drops for two
consecutive quarters. This whole cyclical nature of expansions and contractions in real GDP
levels in an economy constitute the business cycle.
Put another way, the business cycle is a series of expansions and contractions in real GDP. The
cycle begins at a peak and continues through a recession, a trough, and an expansion. A new
cycle begins at the next peak.
Economists have sought for centuries to explain the forces at work in a business cycle. Not only
are the currents that move the economy up or down intellectually fascinating but also an
understanding of them is of tremendous practical importance. A business cycle is not just a
movement along a curve in a textbook. It is new jobs for people, or the loss of them. It is new
income, or the loss of it. It is the funds to build new schools or to provide better health careor
the lack of funds to do all those things. The story of the business cycle is the story of progress
and plenty (during the expansions), of failure and sacrifice (during the recessions).
The effects of recessions extend beyond the purely economic realm and influence the social
fabric of society as well. Suicide rates and property crimesburglary, larceny, and motor vehicle
theft tend to rise during recessions. Recent research has even suggested that recessions make us
sadder than expansions make us happier. This could be due to the fact that people go through a
lot of financial and economic pain during a recession. Usually governments try to act through
public policies to make recessions less severe and, perhaps, to prolong expansions.

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PHASES OF BUSINESS CYCLE

A business cycle is typically characterized by four phasesrecession, recovery, growth, and
declinethat repeat themselves over time. Economists note, however, that complete business
cycles vary in length. The duration of business cycles can be anywhere from about two to twelve
years, with most cycles averaging six years in length.

Recession
A recessionalso sometimes referred to as a troughis a period of reduced economic activity
in which levels of buying, selling, production, and employment typically diminish. This is the
most unwelcome stage of the business cycle for business owners and consumers alike. A
particularly severe recession is known as a depression.
Recovery
Also known as an upturn, the recovery stage of the business cycle is the point at which the
economy "troughs" out and starts working its way up to better financial footing.
Growth
Economic growth is in essence a period of sustained expansion. Hallmarks of this part of the
business cycle include increased consumer confidence, which translates into higher levels of
business activity. Because the economy tends to operate at or near full capacity during periods
of prosperity, growth periods are generally accompanied by inflationary pressures.
Decline
Also referred to as a contraction or downturn, a decline basically marks the end of the period of
growth in the business cycle. Declines are characterized by decreased levels of consumer
purchases (especially of durable goods) and, subsequently, reduced production by businesses.
ADJUSTING THE BUSINESS PLAN TO CYCLICAL SITUATION
Business owners and entrepreneurs can take several steps to help ensure that their
establishments weather business cycles with a minimum of uncertainty and damage. While
there is no definitive formula for every company, the approaches generally emphasize a longterm view focused on a company's core strengths and stressing the need to plan with greater
discretion at all times. Essentially, efforts are made to adjust a company's operations in such a
manner that it maintains an even keel through the ups and downs of a business cycle.

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Specific tips for managing business cycle downturns include the following:
FlexibilityHaving a flexible business plan allows for development times that span the entire
cycle and includes various recession-resistant funding structures. For example, you can vary
levels of production more during expansion, less during recessions by having extra
manufacturing capacity and hiring temporary staff.
Long-term PlanningConsultants encourage businesses to adopt a moderate stance in their
long-range forecasting which means they should not always be too optimistic of the future and
make big projections.
ObjectivitySmall business owners need to maintain a high level of objectivity when riding
business cycles. Operational decisions based on hopes and desires rather than a sober
examination of the facts can devastate a business, especially in economic down periods.
StudyTiming any action for an upturn is tricky. The consequences of getting the timing
wrong, of being early or late, can be serious. How, then, does a company strike the right balance
between being early or late? Listening to economists, politicians, and media to get a sense of
what is happening is useful. The best route, however, is to avoid trying to predict the upturn.
Instead, listen to your customers and know your own response-time requirements.

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