Economics For Managers

Yashwantrao MBA 103
Chavan
Maharashtra
kmZJJm KamoKar Open University
Economics for Managers

Unit 1 Introduction to Managerial Economics 1
Unit 2 Market Equilibrium 9
Unit 3 Demand Theory 22
Unit 4 Supply Analysis 56
Unit 5 Economics of Production 63
Unit 6 Cost Analysis 88
Unit 7 Perfect Competition 115
Unit 8 Monopoly 125
Unit 9 Monopolistic Competition 138
Unit 10 Oligopoly 144
Unit 11 Pricing under Different Structures Pricing Practices 153
Unit 12 New Theories of Firm 164
Unit 13 Project Evaluation 176
Unit 14 Risk and Uncertainty 183
Unit 15 Technological Change 193
Unit 16 Externalities and Environmental Issues 203
Unit 17 Information Asymmetry and Game Theory Applications for Managers 212
Unit 18 Measuring National Income and Concepts 224
Unit 19 Consumption, Investment and Savings 239
Unit 20 Monetary Policy 253
Unit 21 Fiscal Policy 266
Unit 22 Business Cycles 278
Yashawantrao Chavan Maharashtra Open University
Vice-Chancellor : Dr. M. M. Salunkhe
Director (I/C), School of Commerce & Management : Dr. Prakash Deshmukh
NATIONAL ADVISORY BOARD
Dr. Pandit Palande Prof. Devanath Tirupati, Dr. Surendra Patole

Hon. Vice Chancellor Dean Academics, Assistant Professor,
Dr. B. R. Ambedkar University Indian Institute of Management School of Commerce &
Muaaffarpur, Bihar (IIM-Bangalore) Bangalore. Management,
Yashwantrao Chavan Maharashtra
Prof. Sudhir K. Jain Prof. Karuna Jain, Open University, Nashik
Vice Chancellor , Director,
Shri Mata Vaishno Devi University N I T I E, Vihar Lake, Dr. Latika Ajitkumar Ajbani
(SMVDU) Katra Mumbai - 400087 Assistant Professor,
Jammu and Kashmir. School of Commerce &
Management,
Prof. Vinay .K.Nangia, D. Prakash Deshmukh Yashwantrao Chavan Maharashtra
Ex- Head, Director (I/C), School of Commerce Open University, Nashik
Department of Business Studies, & ManagementYashwantrao
Indian Institute of Technology, (IIT- Chavan Maharashtra Open
Roorkee) Roorkee. University, Nashik
Authors & Editor

Prof. Sudhir K. Jain Dr. Ruchi Sharma
Vice Chancellor , Assistant Professor,
Shri Mata Vaishno Devi University School of Humanities and Social
(SMVDU) Katra Sciences, Indin Institute of Technology
Jammu and Kashmir. (IIT), Indore- 452020
Instructional Technology Editing & Programme Co-ordinator

Dr. Latika Ajitkumar Ajbani
Assistant Professor,
School of Commerce & Management, Yashwantrao Chavan
Maharashtra Open University, Nashik
Production
Shri. Anand Yadav
Manager, Print Production Centre Y. C. M. Open University, Nashik- 422 222
Copyright Yashwantrao Chavan Maharashtra Open University, Nashik.

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First Publication : Sept. 2015
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Introduction to
UNIT 1 INTRODUCTION TO Managerial Economics
MANAGERIAL ECONOMICS
NOTES
Structure
1.0 Introduction
1.1 Unit Objectives
1.2 Economics: An Introduction
1.3 Managerial Economics
1.4 Basic Concepts
1.5 Plan for the books
1.6 Summary
1.7 Key Terms
1.8 Question & Exercises
1.9 Further Reading and References
1.0 Introduction
This is an introductory unit that focuses on the definition of economics and

managerial economics. It also discusses some basic concepts used in the study.
1.1 Unit Objectives
After studying this unit, you should be able to-

* To define economics
* Managerial economics
* Understand basic concepts of economics
1.2 Economics: An Introduction

Before understanding managerial economics and its intricacies, it is essential to
ponder upon the elements of economics. Economics is derived from the Greek word,
Oikonomos i.e. one who manages household. Suppose you have two hours and you
have to study for mathematic examination or economics paper. Thus time is an important
resource or means that you have to spend in such a way that it satisfies your want to
clear exams. Such resources are many like land, capital, mineral resources that are
limited with unlimited needs that can be fulfilled using these resources. It is important
to ensure that these resources are devoted to fulfilling wants in such a way that their
allocation is optimal and efficient. This is what we do in economics we allocate scarce
resources to unlimited wants or needs in such a way so as to derive maximum satisfaction Economics for
out of it. For instance, a country may have limited land that it may decide to allocate Managers : 1
Introduction to either for building houses or for agricultural purposes.
Managerial Economics
Economics is about the allocation of scarce resources/means to unlimited wants/
ends to get maximum satisfaction. The level of the allocation can be individual,
NOTES household, firm, industry, national or international. An economy at every level faces
the problem of scarcity of resources. For instance, land that is limited in supply for a
country can be either allocated for agricultural production or constructing houses. This
discussion is based on the definition of economics as given by Prof. Lionel Robbins in
his book Nature and significance of Economic Science in 1932. He defined economics
as, Economics is a science which studies human behaviour as ends and scarce means
which have alternative uses. Robbins definition is based on multiplicity of wants and
scarcity of means. Prof. Samuelson added another dimension to the disciple when he
said, Economics is the study of how society use scarce resources to produce valuable
commodities and distribute them among different people. As evident this dimension
is about the distribution of the final goods that was missing from earlier definition.
Economic problems
Every economy whether developed, developing or underdeveloped, faces three
common economic problems of (i) what to produce, (ii) how to produce and (iii) for
whom to produce. As explained earlier, through our example of allocation of resources
i.e. decision of using land for food production or building houses, it is important to
decide what should be produced. The issue of how to produce is related to the problem
of choice of production method. Every economic organization has to decide, what
method of production it need to adopt - capital intensive or labor intensive? Choice of
a factor will depend upon the associated cost, which is turn depends upon the supply
and demand forces. If a factor is in abundant supply then price of that factor will be
relatively lower and vice-versa. In a country like USA, as labor is relatively costly, it is
cheaper for them to adopt capital intensive method of production than labor intensive
techniques. While in a country like India, where abundant working force is available,
labour intensive technology may be preferable. The decision about for whom to produce
is the problem of distribution of national resources. It involves taking decisions like
who are going to take the fruits of economic activity or how national income is to be
distributed to people of different category.
Economics as a science
When we say economics is a science, it may sound odd as after all economists do
not work with test-tubes, telescope in the laboratories. But just as scientists, economists
also develop theory about how the world works. It is a systematized body of knowledge,
which involves observation and experiments to describe any natural phenomenon and
to establish cause and effect relationship and to develop theories which are universally
applicable. Besides that, one important thing with science is that it works with
Economics for assumptions. An economist also observes the situations and circumstances arising in
Managers : 2 an economy and does experiments to find out the reason behind them. For example, an
economist observing continuous price rise in the economy may be motivated to find Introduction to
out the reason behind this by conducting study to develop the theory of inflation. Just Managerial Economics
as science establishes cause and effect relationship, in economics also such relationships
are studied through various theories like theory of demand establishes the relationship NOTES
between price and demand of a commodity, inflation theory establishes relationship
between quantity and value of money.
Positive vs normative
An economist plays the dual role of an analyst and a policy advisor. As an analyst,
economists identify what the situation is and what is its cause and effect. They do not
give any recommendations or suggestions to improve them. On the other hand, they
understand the situation and give recommendation and suggestions to improve upon
them as a policy advisor. Note that these two aspects go hand in hand. Consider the
following statements: (i) food inflation in India has increased sharply at the rate of 10-
12% in last week. (ii) Government should put restriction on the export of essential
commodities in India so as to provide supply to the domestic market and curb inflation.
First statement is giving us simply the actual situation i.e. WHAT IS. It is an
objective statement giving us the facts and data which can be justified by collecting
prices of all essential items in the last months and comparing them with the relative
data in this month. It is a positive statement which is not coming up with any
recommendations. The second statement is a normative statement that gives us the
recommendation as to WHAT SHOULD BE DONE. When we start analysing the
situation and start making prescriptions and recommendations about the situation, it
becomes normative analysis.
1.3 Managerial Economics
As discussed earlier, every economic organisation faces three basic problems i.e.
what to produce, how to produced and for whom to produce. Managerial economics
has been developed so that different tool and techniques of economics can be used to
deal with these three basic problems. According to Prof. Mansfield, managerial
economics is concerned with the application of economic concepts and economics to
the problem of formulating rational decision making. In the similar vein, Prof. Spencer
and Seigelman wrote, managerial economics is the integration of economic theories
with business practices for the purpose of facilitating decision making and forward
planning.
As given in Figure 1.1, managerial economics is a field of study which leads to

the application of economic theories along with the logic of mathematics and statistics
in business management to arrive at the solution to various decision making problems
and to assist management in forward planning. Economics for
Managers : 3
Introduction to Figure 1.1: Economics, Decision Sciences and Managerial Economics
Decision making problem
NOTES
ECONOMIC THEORY DECISION SCIENCE
Microeconomic Game theory

Macroeconomic Linear programming

Optimum solution
Nature of managerial economics

Managerial economics is microeconomic in nature as it studies the behaviour of
an individual firm and applies various economic tools to solve various economic
problems. Managerial economics is normative in nature as it not only studies the actual
situation but also help in analysing the current business problem and give
recommendations as to what should be done to improve upon the situations. It is
prescriptive in nature as it prescribes suggestion or course of action for solving problems.
Managerial economics is a science as well as an art as it not only involves theory
principles and facts which are universally acceptable but also involve practical
implications for them. Lastly, managerial economics is interdisciplinary in nature as it
involves the use of other disciplines like statistics, mathematics, business management
and human sciences.
Scope of managerial economics

Following are the important areas where managerial economics finds its application :
Demand analysis
The very first step before starting any business is to find out consumers demand
and preferences. To know which characteristics of the product consumer will prefer,
why consumer stop buying a product, what kind of products consumers have been
buying earlier and what are the factors that influence buying decisions. On the basis of
this analysis producers estimate the future sales and make the production schedule and
employ productive resources. In this analysis, demand theory plays a very important
part. It studies the impact of change in the price of the product, income of consumer,
price of related product on the total demand of concerned commodity.
Production Theory and Input-Output Analysis

A business manager has to take decision regarding how to make use of minimum
Economics for resources or input to gain maximum advantage/output out of it. Theory of production
Managers : 4
helps in finding out: (i) input-output relations, (ii) the changes in the cost of production Introduction to
changes with the change in output, (iii) finding profit maximising output, and (iv) the Managerial Economics
response of output to the changes in factors of production.
NOTES
Pricing Theory
Once production is complete manager has to take decision regarding price of that
product before launching it in the market. Price should be logical and justifiable. It
forms the important source of revenue so the pricing decision has to be taken in very
cautious manner. In managerial economics, we study market structure or theory of
exchange, in which we study price determination, market situation and interaction
between different firms for pricing decisions.
1.4 Basic Concepts
Microeconomics and Macroeconomics Check Your Progress

Every subject is studied at different levels: just like in biology we have molecular 1. What is economics?
Relate it with the three
biologist, cellular biologist, and evolutionary biologist. In engineering as well we have
problems that every
software engineering, electronic engineering and chemical engineering. Similarly,
economy deals with.
economics can also be studied at different levels: at individual level and at the country
2. How is economics like
level. At individual level, we study behaviour and economic decision of an individual
a science? Why do
person, household or any firm and how do these individual entities interact with each
economists make
other and make decisions regarding production and price. This particular branch of
assumptions?
economics in which we study individual entity is called Microeconomics. 3. What is the positive
When we talk about Macroeconomic then it is the study of nationwide and normative
phenomenon like study of national income, GDP, aggregate employment, total statement? Give an
investment in the country. Two branches of economics and various theories related to example of each.
them are shown in Figure 1.1. 4. What are two subfields
into which economics
Real and nominal is divided? Explain
what each subfield
In day to day conversation you may have heard you elders day that during our
studies?
time in 1 Rs we use to get one liter of milk. Is it meaningful to make such a comparison
5. What do you
since one should measure the price of one good with respect to other goods? If the
understand by
price of a commodity has risen with respect to prices of the entire commodities only
Managerial
then one can say it has become costly. Thus, in economics we draw a distinction between
Economics? Explain
real and nominal prices. The concept of real and nominal is extended to various variables
its contribution in
like, interest rate, exchange rate, gross domestic products. In case of nominal prices we business management.
do not make adjustment for inflation and take the absolute prices. However, real prices
are those for which inflation adjustment is made.
Economics for
Managers : 5
Introduction to Firm and industry
Managerial Economics In economics analysis, we move from an individual firm to the industry. The
distinction between two is very important as the unit of analysis is different. An industry
NOTES comprises of firms producing substitutable or similar products. The number of firms in
an industry determines the nature of the market that is very important for the determining
the forces of demand and supply in an industry for both the final goods and raw material.
For example, if the information technology firms in the industry increases the demand
for skilled labor raise immensely as well the salaries. It will also lead to competition in
the final goods market and determination of the equilibrium price and quantity. The
firms in an industry appear and disappear in response to profitability. Thus, there is a
need to draw a distinction between a firm and an industry.
Opportunity cost
The key concern for economist is the utilization of resources that are limited in
availability and can be put to various uses. For example, a piece of land can be used for
constructing a building or for agricultural purpose. There is a need to calculate the cost
of resources in terms of the opportunity forgone while it was put into particular use.
The opportunity cost of input is the next best alternative (choices) sacrificed or foregone
that could have been employed. Further details are given in unit VI.
1.5 Plan for the books
All the topics in the series of Economics for Managers are divided into five
books. Each book compromises of independent units. In the present book, after this
introductory unit, we will focus on markets, markets equilibrium and its demand and
supply side. Later, we discuss about the demand and supply in detail separately focusing
on elasticity and determining factors.
The second book covers production, cost and the economics behind them. Unit V
focuses on factors of production, short-run and long-run production and economies of
scale and scope. The cost analysis is also divided into short and long run.
The third book is about market structure and pricing. The units are organized to
study different market structure including perfect competition, monopoly, monopolistic
competition, and oligopoly.
The fourth book concentrates on some of the recent developments in the economic
theory and its application for the managers. The units in this book cover recent topics
like project evaluation, risk and uncertainty, technological change, externalities and
environmental issues and information asymmetry and game theory. As the objective of
the authors is to sensitize the future managers to recent developments in the discipline,
Economics for most of these topics are introductory in nature and interested readers are guided to
Managers : 6
further readings. Introduction to
The last book covers macroeconomic analysis focusing on national income
concepts, investment and savings, central banking, monetary and fiscal policy and
business cycles. These units form the base for studying some of the topics in business NOTES
environment.
How to study the units?

It is suggested to the readers that units 2-17 should be studied in the same order as
various concepts are interrelated. It would be beneficial and convenient for the reader
to follow the order. However, units 18-22 can be studied independently.
1.6 Summary
We learn in this unit that economics is about the allocation of scarce resources/
means to unlimited wants/ends to get maximum satisfaction. Managerial economics is
about the application of economic concepts to the problem of managers for rational
decision making.
1.7 Key Terms
Economics : is about the allocation of scarce resources/means to unlimited wants/

ends to get maximum satisfaction.
Industry : comprises of firms producing substitutable or similar products.
Opportunity cost of input : is the next best alternative (choices) sacrificed or

foregone that could have been employed.
1.8 Questions and Excercises
1. What is economics? Relate it with the three problems that every economy
deals with.
2. How is economics like a science?
3. What is the positive and normative statement? Give an example of each.
4. What are two subfields into which economics is divided? Explain what each
subfield studies?
5. What do you understand by Managerial Economics? Explain

itscontribution in business management.
6. Distinguish between firm and industry, real and nominal. Economics for
Managers : 7
Introduction to
1. R. S. Pindyck and D. L. Rubinfeld, Microeconomics (7th Edition), Person
NOTES Prentice Hall, New Jersey, 2009.
2. Dominick Salvator, Managerial Economics, Sixth Edition, Oxford: New
Delhi
3. Craig H. Peterson, W. Cris Lewis, and Sudhir K Jain, Managerial
Economics, Fourth Edition, Pearson Education: New Delhi.
Economics for
Managers : 8
Market Equilibrium
UNIT 2 MARKET EQUILIBRIUM
Structure NOTES
2.0 Introduction
2.1 Unit Objectives
2.2 Supply and Demand
2.3 Market Equilibrium
2.4 Market Mechanism and the Role of Government
2.5 Summary
2.6 Key Terms
2.0 Introduction
In the previous unit, we discussed basic concepts like - definition of economics,
positive and normative aspects of economics, relevance of economics for managers,
managerial economics as a subset of economic theories and scope of managerial
economics. Now we will advance our discussion towards the most fundamental aspect
of economics theory including market, market equilibrium and its determining factors.
The demand and supply side of the market are used and applied to a wide variety of
real life problems to discover the price of the commodity. To name a few: evaluating
the impact of government price controls, minimum wages, price supports, and production
incentives. In this chapter, we will discuss the mechanism of market, demand and supply
forces and we will see the determination of prices of goods and services in a free
market economy. We will also lay the foundation to understand the mechanism of
demand and supply that we have covered in the subsequent unit.
The understanding of the market mechanism is extremely important for a manager
of a firm as a firm operates in different types of markets. A firm is a seller in a final
goods market and a buyer of factors of production. This analysis is therefore pertinent
and a good first point to begin the economic analysis for mangers.
This unit is organized as follows: Section 2.2 discusses about the market, its
definition and extent. Section 2.3 elaborates on the basics of supply and demand and
Section 2.4 deals with the concept of market equilibrium. There are certain situations
when the market mechanism does not work leading to market failure and such instances
are presented in Section 2.5.
Economics for
Managers : 9
Market Equilibrium
2.1 Unit Objectives

NOTES
* Discuss about the market, its definition and extent. \
* Understand the basics of supply, demand and market equilibrium. There are
certain situations when the market mechanism does not work leading to
market failure necessitating the role of government.
2.2 Supply and Demand
Market in a very general sense is the gathering of people for the purchase and sale
of goods, services and other commodities. Market is a place where buyers and sellers
come together for economic transactions. The sellers offer their goods and services in
exchange for money from buyers. Buyers and sellers create two most important economic
forces of demand and supply in the market which leads to price determination. In the
following sections, we are giving an introductory brief of demand and supply to explain
market equilibrium and later on we will advance our study with more detailed discussion
of the concepts. To begin with we will discuss the concept of market.
Market
Economists use the word economic agent for a rational individual who looks
after the maximization of his/her benefit. Such an economic agent as a consumer wants
to maximize the utility that he/she obtains by consuming different goods and as a
manager intends to maximize profits. It is possible to divide all agents into two broad
groups of buyers and sellers. Buyers include consumers who purchase goods; firms
that buy labor, capital and raw material. Sellers are firms that sell final good; workers
that sell their labor services, owner of capital and natural resources that sell land, capital,
and different minerals. It is evident that most of the economic agents are buyers for
some and sellers for another.
Market is the centre of economic activity where buyers and sellers interact with
each other, and through the collective interaction of buyers and sellers the price of
commodity is determined. Note that such interactions need not be actual because in the
current context the potential to enter into transaction in future also plays a considerable
role in price determination. One can look into the markets of futures and options for
different commodities whereby buyers and sellers agree to transact in future. In the
modern context, it is also a platform where buyers and sellers can transact with each
other without coming into physical contact with each other. The web portals like ebay,
cleartrip, make my trip bring together different sellers and buyers for different products
are in a way expanding the market for such goods.
Economics for From a firm's perspective it is very important to define the limits of the market for
Managers : 10 its product. It may appear to be an extremely easy task however a slight introspection
will reveal the complexities involved. Take a case of a manager of a car company who Market Equilibrium
wants to know the market conditions for his firm. Where should she begin? Should she
look at "all" types of cars in the "domestic" market? Note two important terms in the
earlier sentence "all" and "domestic". Should she take into account only small cars, NOTES
large or mid-sized cars? Should she take into account international players working in
the domestic market? Therefore, for determining the limit to the product market a
manager should consider: (i) geography (ii) substitutes goods available and (iii)
competition.
In a few cases, geographic conditions are enough to limit the market. Consider a
barber in Chandni Chowk in Delhi. He need not bother about any other barber who
may be located in South Delhi as his market is very limited as it is very unlikely that
people will travel that far for hair cut. In some cases, using product substitutability as
well a manager can define the market. Consider the producer of BMW who is very well
aware of the close substitute of their product in the Sedan class cars.
Along with the information of geography and substitutable goods a firm also gets
benefitted from knowing the competition in the industry. The competition may be actual
or potential and is closely related to the number of the firms in the market. Suppose that
number of firms is very large such that each firm acts and takes decisions independent
of any other firm in the market. Alternatively, number of firms may be very limited and
each firm gets affected by the decision of the other firm. One example could be farmers
in the developing countries where farm plot is small in size and there is a large number
of producers involved in agricultural production. They take decision independently.
On the other hand, with large plot size, farmers are few in developed countries and they
may come together and take collective decision. By defining the limits of market a firm
can determine the price, advertising budget and capital investment for the firm.
In the analysis of market equilibrium, the behavior of consumers and firms has
been studied with an assumption that they are unable to affect the price at which they
buy and sell. The consumers and producers confront a given price and accordingly
decide the quantity to be bought and sold to maximize their utility and profit respectively.
To clarify, the consumers buy to maximize utility and producers sell to maximize profit.
This assumption may appear very restrictive because a student may believe that each
consumer has the power to influence the price of the commodity and same goes for the
producer. We are not denying the power of producers and consumers however, if one
introspects a little, he/she may find that for most of the commodities such a power is
limited. For instance, if you go to buy milk packet in the morning and the retailer tells
you that Amul has increased the price of half a liter by one rupee, one may not be able
to argue with him about increasing the price. It doesn't imply that producers have all
the power to change the price. Similarly, if many foreign firms enter into the dairy
products market in no time, Amul may be forced to reduce the price. While these forces
are part of the discussion for the topics covered later. For the time being, we will Economics for
Managers : 11
Market Equilibrium assume that producers and consumers alone can not influence the price. However,
market demand and supply curves that are representing collective demand and supply
are used to determine the price in the market. This aspect will become clear as we will
NOTES move further in the discussion.
Demand and Supply Side of the Market

Demand
On the demand side of the market, consumers buy product from firms. A demand
curve is the graphical representation of the relationship between the quantity of a good
that consumers are willing to buy and the price of that good. According to the demand
law (discussed in detail in Unit III) the higher the price, the smaller the quantity
demanded by a consumer, everything else being equal. Therefore, the demand curve is
negatively sloped as shown in Figure 2.1 where price is shown on Y axis and quantity
demanded is shown on X axis.
We can write the relationship between quantity demanded and price as:
QD = F (P)
where; QD = Quantity Demanded; P = Price
)LJ
3ULFH
3
3
3
4'
4 4 4 4XDQWLW\GHPDQGHG
There is a negative relationship between price and quantity demanded, other things
remaining the same. The demand curve, labeled D, in Figure 2.1 shows how the quantity
of a good demanded by consumers depends on its price. The demand curve is downward
sloping; holding other things constant consumers will want to purchase more of a good
as its price goes down. The quantity demanded depends on other variables, such as
income, taste and preferences, the weather, and the prices of other goods. While drawing
the demand curve we assume that such factors remain constant. These factors lead to
shift in the demand curve. For instance, a higher income level shifts the demand curve
to the right (from D to D').
Economics for
Managers : 12
Supply Market Equilibrium
On the supply side of the market, firms sell the product to the consumers. Supply
of a commodity is defined as the total quantity of a commodity that a seller is able and
willing to sell at a certain price. Producers are willing to offer more products for sale in NOTES
the market by increasing production as a way of increasing profits only when the price
is high. Thus, the supply of product increases with increase in its price and decreases
with decrease in its price, other things remaining constant. Supply curve is the graphical
representation of the relationship between the quantity of a good that producers are
willing to sell and the price of good as shown in Figure 2.2 where price is shown on Y
axis and quantity supplied is shown on X axis.
)LJ
3ULFH
3
3
3
4 4 4 4XDQWLW\6XSSOLHG
The supply curve, labeled S in the figure, shows how the quantity of a good
offered for sale changes as the price of the good changes. The supply curve is upward
sloping which shows that higher the price, more firms are able and willing to produce
and sell. While studying the concept of supply, note that price is an independent variable
and a firm decides the quantity to be supplied at each price level. We can write this
relationship as an equation:
QS = F(P)
Where; QS = Quantity Supplied; P = Price
There is a positive relationship between price and quantity supplied, ceteris paribus.
Ceteris paribus means other things or factors that influence supply, are kept constant
over the period of analysis. Even though the price of a commodity is the most important
factor affecting the supply of a commodity, it is not the only factor. Indeed there are
many other factors that influence the supply of the commodity. In the supply curve
when there is change in other determinants, supply curve shifts either leftward or
rightward.
Economics for
When production costs decrease, output increases and the entire supply curve Managers : 13
Market Equilibrium thus shifts to the right. The supply curve is drawn on the assumption that technology
used for the production is constant over time. Further, prices of other factors of production
like land and labor remain same. These aspects of the supply curve influence the cost
NOTES of production and cause a shift in the supply curve.
2.3 Market Equilibrium

Market is where buyers and sellers come together. In this section, we will discuss
how the two sides of the market i.e. demand and supply interact with each other to
determine market price. Economic equilibrium is a state of the world where opposite
economic forces are balanced and do not change in the absence of external influences.
The "equilibrium" is state of balance between two opposite forces. An economic
equilibrium will entail balance between two economic forces in a way that the state
does not change without any external reason. In market analysis, market equilibrium is
a point where demand and supply are equal such that the amount of goods sought by
buyers is equal to the amount of goods produced by the seller. Thus, when quantity
demanded of any commodity equals the quantity supplied at a particular price, market
equilibrium establishes and that price is called market clearing price.
Market Equilibrium Price

We already know that demand curve slopes downward and is inversely related to
price. Whereas, supply curve slopes upward and supply is positively related to price.
Market equilibrium (or market clearing) price is set at the point of intersection of the
demand and supply. Thus, market equilibrium (or market clearing) price is the price
that equates the quantity supplied to the quantity demanded. Note that equilibrium is
stable where stability implies that any divergence from the equilibrium point will set in
motion the demand and supply forces in such a way that point of equilibrium is attained
again.
Consider the following linear supply function and demand function:
QS = 50 + 2P
QD = 100 - 10.5P
Where QS is quantity supplied; P is price and QD is Quantity demanded.
Based upon these two functions one can know different quantity supplied by the
producer and quantity demanded by the consumers. The quantity demanded and supplied
for different prices level in case of the above linear demand and supply curves are
given in Table 2.1. In order to determine market price, equate these two equations and
calculate price as follows:
QD = QS
Economics for 50 + 2P = 100 - 10.5P
Managers : 14
12.5P = 50 Market Equilibrium
P=4
Table 2.1:QD and QS for Different Price Levels for the above Linear Demand
and Supply Curves NOTES
Price Quantity Supplied Quantity Demanded
1 52 89.5
2 54 79
3 56 68.5
4 58 58
5 60 47.5
6 62 37
7 64 26.5
8 66 16
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Based on Table 2.1, note in Figure 2.3, E is the point of intersection, price is
shown on Y axis and quantity demanded and quantity supplied is shown on X axis. At
equilibrium price, quantity demanded and quantity supplied is OQ (58) and price is OP
Economics for
(4). Any movement in price away from the market clearing price (above or below)
Managers : 15
Market Equilibrium causes market forces of demand and supply to readjust such that new equilibrium state
is achieved. This tendency of demand and supply in the free market to readjust itself to
clear the market and to achieve a new equilibrium state is called the market mechanism.
NOTES Thus, market mechanism is the tendency in a free market for price to change until the
market clears.
Suppose there is a situation in which the quantity supplied exceeds the quantity
demanded this is called surplus. That is the price is greater than the equilibrium price
and quantity supplied exceeds quantity demanded. In Table 2.1, consider price 6 where
QS > QD (62 > 37). It leads to excess supply of goods at the current price. Then some
of the sellers would not be able to sell the amount of the good they want to sell in the
market. These sellers would try to dispose of the unsold goods by bidding the price
down. The price will go on declining till the quantity demanded equals the quantity
supplied.
Consider another situation in which the quantity demanded exceeds the quantity
supplied. Suppose price is lower than the equilibrium price at 2, and QD at 79 would
exceed QS which is 54, that give rise to excess demand for the commodity. Some
buyers would not be able to obtain the amount of good that they want to purchase at the
prevailing price. They will therefore bid price up in their effort to buy all that they
desired. The price will go on rising till the quantity demanded equals quantity supplied.
This process of price adjustment to the equilibrium level was put forward by a French
economist, Walras in his pioneer work in 1874 , "Elements of Pure Economics" that is
why it is popularly known as Walrasian Price Adjustment. This is general equilibrium
theory which is based on the assumption that all agents (sellers and buyers) are price
takers in the market as discussed in detail earlier.
We discussed at length in the beginning of this unit that both producers and
consumers are price takers that is, we are assuming that at any given price, a given
quantity will be produced and sold by the producers. This assumption is relevant only
for competitive market. This is a market where both sellers and buyers have little market
power-i.e. little ability individually to affect the market price. However competitive
market may not exist for most of the commodities. In a few one may find that supply is
controlled by a single producer or by few producers. In such instances force of supply
and demand will not determine the market clearing price. A monopolist considers the
market demand curve and either decides the price or quantity demanded to be supplied
in the market in such a way that it maximize his/her profit.
Changes in Market Equilibrium

The market clearing price changes due to shift in the demand and supply curve.
Suppose that product technology improves due to some scientific discovery. In such a
case production cost declines and supply curve shifts to right. When the supply curve
Economics for shifts to the right, the market clears at a lower price P2 and a larger quantity Q2.
Managers : 16
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Check Your Progress
1. What is market? What
Consider that due to rising income in India, people are shifting towards protein
are the factors that help
based diet in their meal. It means they are increasing the quantity of dairy product in
in defining the extent
their food basket. Thus, demand for milk increases and demand curve shifts to right.
of market?
When the demand curve shifts to the right, the market clears at a higher price P3 and a
2. Suppose technological
larger quantity Q3.
advancement reduced
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46 manufacturing mobile
phones. Draw a
diagram showing what
happens to the supply
4 curve.
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It is possible that both supply and demand curves shift over time as market
conditions change.
In this example, rightward shifts of the supply and demand curves lead to a slightly
higher price and a much larger quantity. In general, changes in price and quantity depend
Economics for
on the amount by which each curve shifts and the shape of each curve.
Managers : 17
Market Equilibrium
2.4 Market Mechanism and the Role of Government
In this unit the discussions so far is concentrated on the market mechanism where
NOTES
demand and supply forces determine the market clearing price. Does that mean that all
economic activities of a country and the world should be left to the market mechanism?
Take a while and think about this issue.
Adam Smith used the term invisible hand to explain the working of the market
mechanism that is discussed so far. Free market would tend towards equilibrium through
a mechanism whereby any excess supply leads to price cuts which in turn leads to fall
in quantity supplied (by reducing the incentives to produce and sell the product) and
increase the quantity demanded, automatically abolishing the market surplus. Similarly,
any excess demand leads to price increase, reducing the quantity demanded and
increasing the quantity supplied (as incentive to produce and sell the product rises) and
thus abolishing the disequilibrium.
Samuelson discussed about the role of government - as a "Visible Hand." In an

ideal market economy, "all" goods and services are exchanged for money at competitive
price. As mentioned above, in the words of Adam Smith it is the working of "invisible
hand". This invisible-hand doctrine applies to economy in which all markets are perfectly
competitive. However in reality, there are many cases where market can fall short of
perfect competition. It may not confirm to the ideal world of smooth functioning of
invisible hand. For instance, monopoly and other imperfections in the form of
externalities like pollutions and distribution of public goods can also arise. These are
Check Your Progress market imperfections are removed up to certain extent by the intervention of government.
1. Define the equilibrium Government responds to the flaws in the market mechanism through its policies,
of the market. Describe regulations, taxes and subsidies. The imperfections that interfere with the market
the forces that move a mechanism and government's response to the same are as follows:
market towards its
Imperfect competition arises when a single buyer or few sellers can affect the
equilibrium?
price of the commodity. Inefficiencies associated with imperfect competition are - too
2. Explain why price in
high prices and too low output. An extreme case of imperfect competition is monopoly-
the competitive
where a single supplier alone decides the price of the good for example Microsoft has
markets settles down at
monopoly in the production of windows operating system. Government takes many
the equilibrium
intersection of demand restrictive actions to curb this extreme form of imperfect competition through policies
and supply curves? and regulations like antitrust laws which prohibits actions such as price fixing and
What happen if the agreements to divide up the market. In case of India, Competition Commission plays
market price starts out an active role.
too high or too low? Externalities or spillovers are second types of imperfection in the market which
involves involuntary imposition of cost//benefits to the third party who is not involved
Economics for
in the transaction directly. Spillover effect may be positive or negative. A leather factory
Managers : 18
may sell leather product to the consumers but it also causes pollution in the environment Market Equilibrium
which is a negative externality. Similarly, a firm which invests heavily in R&D generates
positive externality or spillover for the society. Government regulations are designed
to control negative externalities like air and water pollution, hazardous waste, radioactive NOTES
material etc. government impose taxes and penalties to curb negative externality and
provide subsidy and exemptions to promote positive externalities.
Besides all these imperfections, perfectly competitive market also experience

inflation (rising prices) and recession (high unemployment) which the government
may try to control through fiscal and monetary policies. Fiscal policies involve policies
related with taxes to control expenditure. Monetary policies involve determining the
supply of money and interest rate. Using these two important tools of macroeconomic
policy, government can influence the level of total spending, rate of growth and level
of output, level of employment and unemployment, and the price level and rate of
inflation in an economy. These topics are discussed in details in the text later.
2.5 Summary
In this unit we learned about market where buyers and sellers come together for
economic transactions. In order to define the extent of market managers must analyze
the geographical reach, similar products as well as competitors in the market.
The forces of demand and supply determine the market equilibrium (or market
clearing) price that equates the quantity supplied to the quantity demanded. The quantity
demanded by consumers is inversely related to prices whereas quantity supplied by
producers is directly related to prices.
The market need not function smoothly necessitating the government to act
through its policies, regulations, taxes and subsidies.
2.6 Key Terms
Market: where buyers and sellers come together for economic transactions.
Demand Curve: graphical representation of the relationship between the quantity of a

good that consumers are willing to buy and the price of that good.
Supply Curve: graphical representation of the relationship between the quantity of a

good that producers are willing to sell and the price of the good.
Market Equilibrium: a point where demand and supply are equal such that the amount
of goods sought by buyers is equal to the amount of goods produced by the
seller. Economics for
Managers : 19
Market Equilibrium Market Equilibrium (or Market Clearing) Price: the price that equates the quantity
supplied to the quantity demanded.
NOTES 2.7 Questions and Excercises
1. Suppose that unusually hot weather causes the demand curve for ice cream to
shift to the right. Will the price of ice cream rise to a new market-clearing level?
2. Following table shows the supply and demand for steal in India. If the international
price is 9 then what is the domestic demand for steel and how much of the steel
will be imported in India. Show the excess demand diagrammatically also.
Price ($) Supply (Million Tonnes) Demand (Million Tonnes)
3 2 34
6 4 28
9 6 22
12 8 16
15 10 10
18 12 4
3. Suppose the demand curve for a product is given by Q = 300 - 2P + 4I, where I is
average income measured in thousands of dollars. The supply curve is Q = 3P -
50. If I = 25, find the market clearing price and quantity for the product. If I = 50,
find the market clearing price and quantity for the product. Draw a graph to illustrate
your answers.
4. Explain market clearing price and the mechanism to attain the same?
5. The demand for books is: Qd = 120 - P; The supply of books is: Qs = 5P. What is
the equilibrium price of books? What is the equilibrium quantity of books sold?
i) If P = $15, which of the following is true?
A) Quantity supplied is greater than quantity demanded.
B) Quantity supplied is less than quantity demanded.
C) Quantity supplied equals quantity demanded.
D) There is a surplus.
ii) If P = $25, which of the following is true?

E) There is a surplus equal to 30.
F) There is a shortage equal to 30.
G) There is a shortage, but it is impossible to determine how large.
Economics for H) There is a surplus, but it is impossible to determine how large.
Managers : 20
Market Equilibrium
1. R.S. Pindyck and D.L. Rubinfeld.Microeconomics (7th Edition), Pearson

NOTES
Prentice Hall, New Jersey, 2009.

Delhi

Economics for
Managers : 21
Demand Theory
UNIT 3 DEMAND THEORY
NOTES Structure
3.0 Introduction
3.1 Unit Objectives
3.2 Analysis of Demand
3.3 Determinants of Demand
3.4 Changes in the Demand Curve
3.5 Elasticity of Demand
3.6 Summary
3.7 Key Terms
3.0 Introduction
In the last unit, we studied market equilibrium by introducing demand and supply
curve. Demand theory is very important for a manager as it helps in analyzing the
revenue generation process of a company by understanding the consumers behaviour.
The neo-classical demand theory discussed in this unit has been around for more than
a century and has been proved time and again by empirical studies. Thus, it is studied
even now in the business schools. The demand and supply are two important sides of
the market mechanism leading to discovery of the price. The concepts of demand and
supply help us in understanding and predicting price fluctuations in the market and
evaluating the impact of various policy changes like wages, taxes, subsidies, import
quotas etc. Note that in the earlier unit we have seen how the demand of the commodity
along with the supply leads to price discovery in the market. In this unit, we will go
into the details of demand and understand the law of demand. Further, in the study of
demand we will focus on the responsiveness of demand of various commodities to the
change in prices and other factors and the direction of that response.
This unit is organised as follows: Section 3.2 discusses demand, its definition and
law of demand. Section 3.3 enumerates the determinants of demand. Section 3.4
discusses the change in demand by categorizing shift of the demand curve and movement
along the demand curve. Section 3.5 explains in detail the concept of elasticity of
demand.
3.1 Unit Objectives

Economics for * Discuss demand, its definition and law of demand.
Managers : 22 * Learn about the determinants of demand.
* Understand the change in demand by categorizing shift of the demand curve Demand Theory
and movement along the demand curve.
* Learn in detail the concept of elasticity of demand.
NOTES
3.2 Analysis of Demand
Demand is the amount of commodity that a consumer purchases or is ready to

take off from the market at various given prices in a given period of time. The consumer
of a commodity must have the desire to purchase, the willingness to pay and the ability
to pay. If a consumer has mere desire for a commodity, it doesnt constitute demand as
it has to be backed by the ability to pay. For example, if a person wishes to have a car,
it doesnt constitute demand if he/she cant afford to buy a car due to lack of ability to
pay. Similarly, even when a person has the ability to pay but does not have willingness
to buy or is not ready to spend the money at that point of time, it does not constitute
demand. Thus in economics, unless desire for a good is backed by the purchasing
power/ability to pay and willingness to purchase, it doesnt constitute demand.
Economists have gone deeper into the concept of demand and asked a very fundamental
question that is why consumers demand a particular good? According to the earlier
proponents, consumers demand a particular commodity that has a utility or want
satisfying capacity. Among the classical economists the concept of utility was extremely
popular and they made extensive attempt to quantify the same. The approaches used
are given in the Appendix for interested readers.
Law of Demand
There are many factors that affect demand of any commodity but in market
mechanism one important factor that plays the central role is price of the commodity.
It is the general experience that as the price of the commodity increases its demand
falls. When the price of cold-drinks increase from Rs. 20/- to 25/- per bottle, a person
will buy less of it. Law of demand simply establishes the relationship between price
and quantity demanded of any commodity in a given period of time considering all
other factors affecting demand as constant. Thus, the relationship describes that quantity
demand is a dependent variable and price is independent variable. The law of demand
says that keeping other things constant, quantity demanded is inversely related to price.
Followings are some famous statements of the law: According to Samuelson, law of
demand states that people will buy more at a lower price and buy less at higher price,
other things remaining the same. According to Bilas, law of demand states that other
things being the same, quantity demanded per unit of time will be greater lower the
price and smaller higher the price. Take note of the direction of causality in the
relationship that is as the price of the commodity increases/decreases quantity demanded
of that commodity decreases/increases.
Law of demand holds true keeping other things constant. There are some implicit
assumptions made for this law. It requires taste and preferences, income, price of related Economics for
Managers : 23
Demand Theory goods, wealth of consumer to remain same over the period of analysis. This condition
is popularly known as ceteris peribus i.e. other things remaining the same. The law of
demand can be explained through a demand schedule and a demand curve shown in
Table 3.1 and Figure 3.1 respectively. A demand schedule is a tabular representation of
NOTES
the response of the amount demanded to the changes in price of a commodity. In the
Table 3.1 we have given a hypothetical example showing how the demand of cold-
drink falls with the rise in price of it. Figure 3.1 is a demand curve which is a graphical
representation of the demand schedule.
Table 3.1 Demand Schedule
Price of cold-drink per bottle Bottles of cold-drinks demanded
8 6
10 5
12 4
18 3
20 2
24 1
Fig. 3.1 Demmand curve
30
25
20
Price
15
10
5
0
1 2 3 4 5 6
Quantity demanded
Demand curve D shown in the Figure 3.1 slopes downward or is negatively sloping
showing consumers buy more when prices fall as per the law of demand.
Reasons for downward slope of the demand curve

Marshall derived the demand curve based on law of diminishing marginal utility
(explained later). Besides that when price falls, a consumes who were initially buying
other substitute goods shift their demand towards that good whose price has fallen
Economics for (substitution effect). Further, as the purchasing capacity of the consumer increase due
Managers : 24
to fall in price of one commodity s(he) can buy more. (income effect), which leads to Demand Theory
rise in the demand. Keeping this in view, three reasons that can be attributed to downward
sloping of the demand curve are: operation of the law of diminishing marginal utility,
substitution effect and income effect. We now discuss each of these reasons in detail. NOTES
Law of Diminishing Marginal Utility
The utility derived from a commodity is the capacity of a commodity to satisfy
want of the consumer. In economic theory, Walras (1874) made an attempt to measure
utility using a subjective unit called - utils. There are three main economic theories that
are used for understanding the demand of consumers for a particular commodity. These
are (1) cardinal utility theory (2) indifference curve theory and (3) revealed preference
theory. Brief review of these is given in the Appendix for the interested readers.
To understand the law, firstly we must clear our idea about the concept of utility
and marginal utility. Utility is as mentioned earlier is the want satisfying capacity of
any commodity. It is the satisfaction or benefit derived from the consumption of any
commodity. Thus, if you consume a chocolate it will satisfy your hunger or liking for it
and thus has this capacity. You may notice that the kind of goods that are consumed by
you help in satisfying some or the other want. Note that, utility is a subjective term i.e.
same commodity may not provide same level of utility to each person. The amount of
money that a person is willing to pay for a commodity is the proxy of the utility of that
commodity for him. If a person wants to spend more money on a commodity it clearly
signifies that the commodity has high utility for him.
Now, total utility (TU) is the total satisfaction derived from the consumption of
all units while marginal utility (MU) is the increase in the total utility from the
consumption of one additional unit of the commodity i.e. if we have consumed four
units of a commodity then utility derived from the consumption of 4th unit i.e. last unit
of the commodity is the MU.
MUn = TUn TUn-1 (3.1)
where MU is marginal utility, TU is total utility and n is the number of units

consumed.
Law of diminishing marginal utility says that with an increase in the consumption
of any commodity, TU derived from that commodity goes on increasing but at a
diminishing rate. At a certain point of consumption, TU becomes maximum and
consumption beyond it leads to the fall in TU. The point where TU becomes maximum
is called satiation point. TU increases at a diminishing rate due to the fall in marginal
utility with the consumption of every successive unit. Figure 3.2 illustrates the total
utility and marginal utility curves. Figure 3.2 (A) clearly shows that as total utility
increases, marginal utility goes down (as shown in part B of the graph) and when total
utility gets maximum at quantity Q4 marginal utility becomes 0, it means further addition
Economics for
for the consumption of the commodity does not contribute in the maximization of
Managers : 25
Demand Theory utility and beyond that point total utility starts going down as marginal utility becomes
negative. It signifies that further consumption of the commodity beyond satiation level
leads to dissatisfaction. MU is calculated as the slope of the TU curve.
NOTES
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For example: if a person has a very high desire to eat chocolate at one point of
time then, he will be ready to buy it at any price as he would derive maximum utility
from the first unit of that chocolate. The utility of second chocolate will be a bit lower
than that of first one so, he will start bargaining or will like to pay low price for that.
Similarly, with the consumption of every extra unit of chocolate, the marginal utility
for him goes on decreasing and the amount of money that he would like to spend on
them also starts declining. After reaching to the maximum satiation level, further
consumption of the same commodity, instead of giving satisfaction starts giving
dissatisfaction and marginal utility may also become negative.
This law describes a very fundamental and familiar nature of human behaviour.
The more we have of anything, the less we want it. This also explains very fundamental
tendency that a consumer will buy more of any commodity only if its prices fall as
marginal utility derived from its consumption goes on diminishing. A person continues
to buy the good so long as the MU of the money is less than MU of the commodity. So
the significance of the law of diminishing marginal utility for the law of demand is that
Economics for
the quantity demanded of a good rises as the price falls and vice-versa.
Managers : 26
Substitution Effect Demand Theory
Law of diminishing marginal utility explains the consumer behaviour with respect
to the quantity and price of the given commodity. The substitution effect takes into
consideration the related good as well. It simply says that when price of any commodity NOTES
falls while keeping the price of the other good constant, the commodity in consideration
automatically becomes relatively cheap. The consumer who initially uses the substitute
switches the demand towards the product with reduced price and its demand increases.
It depicts consumers tend to buy more of a good that has become relatively cheap and
less of the good that is relatively more expensive. e.g. in a food basket that a consumer
purchases, if the price of the vegetable falls it becomes relatively cheap to the other one
and a consumer purchases more of it.
Income Effect
Income effect says that with the fall in price of any commodity, the real income of
the consumer increases i.e. purchasing power of the consumer increases. If the person
makes use of that surplus money for the purchase of the same commodity, price of
which has reduced, income effect for that commodity is said to be positive. On the
other hand, if the consumer makes use of the surplus money for the purchase of any
other good, income effect for that good (whose price has reduced) is said to be negative.
This can better be explained with the help of following example:
Suppose, monthly income (absolute income) of a person is Rs. 20,000/- and given
the price of commodity, the monthly consumption expenditure is Rs. 8000/-, so here
he/she will be available with surplus of Rs 12000/- at the end of the month. Now let us
suppose price of a rice (which forms a part of his consumption) declines and his/her
consumption expenditure now becomes Rs 6000/- per month. In this case he/she is
available with surplus of Rs 14000/- per month, so his real income increases. Now if
the person makes use of this surplus money for the purchase of more rice, we say that
income effect for rice is positive. While, if the person makes use of that surplus money
to buy any other commodity we say that income effect for that commodity is negative.
On the basis of income effect commodities are categorized as normal goods or inferior
goods. Income effect for inferior goods is negative while for the normal goods it is
positive (the case of inferior goods is explained in detail in the later section.)
Exceptions to the Law of Demand

Law of demand explains that on the fall in price of any commodity, its quantity
demanded increases i.e. price and demand has an inverse relationship and demand
curve slopes downward. However, there are many cases where price and demand has a
positive relationship and the demand curve instead of sloping downward slopes upward.
These exceptions to the law of demand are as follows:
Giffen Paradox Economics for

This is one of the most important exception that was given by Sir Robert Giffen a Managers : 27
Demand Theory Scottish statistician and economist, who studied the behaviour of low class blue-collar
workers of England and their consumption pattern. He found that their meal primarily
consisted of two important things, they could consume either meat or bread. He found
NOTES that when the price of bread in the economy was decreasing as against law of demand,
its demand also decreased. He associated it with negative income effect saying that
as the price of bread falls, relative income of consumer increases substantially (as they
spent large part of their income on buying bread) and consumers could use that extra
amount to buy superior commodity like meat. Similarly, when the price of bread went
up, their purchasing power decreased substantially due to which they had to cut down
Check Your Progress their consumption of meat and had to buy more of bread as it was still relatively cheaper
1. What do you
than meat. Likewise, if the price of bajra falls, consumers can use the money to buy
understand by the term
more of a superior good i.e. wheat. Then, if the price of bajra increases, then consumer
Demand? Explain
will be forced to stop the consumption of wheat and buys more of bajra. In this way, for
the Law of Demand
with an example. giffen goods demand curve slopes upward that on the rise in price, the demand increases
2. What are demand and on the fall in the prices demand for the commodity falls.
schedule and demand
Veblen Effect
curves and how are
they related with each Law of demand is not applicable in two extreme points: in case of giffen
other? commodities and in case of luxury goods. Veblen goods are basically status goods or
3. Explain the meaning of article of distinction like luxury cars, gold, diamond etc. These are goods which are
utility. What is the used as a status symbol by the consumer and their demand increases with increase in
difference between
prices. These are goods which give a psychological sense of satisfaction and distinction
total utility and
to the buyer that they are different from others. Therefore, an increase in the price of
marginal utility?
such goods also increases their demand.
Explain the law of
diminishing marginal Ignorance
utility and give an
Sometimes due to ignorance buyers associate price of the commodity with the
example.
4. What do you quality and buy more when the prices increase.
understand by Giffen Speculation
Paradox and Veblan
Effect? Income effect The future expectations about the prices also influences the buying behaviour of
on Giffen goods is the consumers. Sometimes people start hoarding or accumulating goods with the
negative. Justify the expectation that their prices will rise further. They do so in order to hedge or protect
statement. themselves from the pinch of high prices in future. Similarly, if people expect prices to
fall in future, they postpone their purchase to buy it later at cheaper price. For instance,
if in a particular year production of the rice has decreased due to low rainfall in that
region leading to the rise in price of rice, furthermore, if meteorological department
also reports that there are chances of low rainfall in future as well then people will start
purchasing more of rice at present in spite of increase in the price to save themselves
from high prices in the future. This behaviour of consumer is contrary to the law of
demand.
Economics for
Managers : 28
Demand Theory
3.3 Determinants of Demand
Law of demand is the most basic law that explains the relationship between price
NOTES
of commodity and its demand. However, this law is based upon the assumption that
various other factors that affect the demand are constant. These various factors excluding
price that have an impact over demand include (i) income of consumers (ii) price and
availability of the related goods i.e. complimentary good and substitute goods (iii)
taste and preferences of the consumers, (iv) availability of credit facilities (v) population
of the country (vi) distribution of the national income. These are discussed as follows:
Income: The income of a consumer determines purchasing power i.e. the ability
to buy. A person with high income may have a high demand for a commodity as compared
to the person with low income. So, if we have to establish relationship between income
and quantity demanded of any commodity we find a positive relation i.e. with increase
in income, the quantity demand of a commodity increases and vice-versa. But on doing
a deep analysis, we find out that relationship is a bit complex.
A German statistician Ernet Engel in 19th century made an empirical study to

identify the expenditure pattern of different households at different levels of income.
He categorised goods into four broad categories i.e. essential goods/necessities, normal
goods, luxuries/prestige goods, inferior goods. He derived a curve showing the
relationship between levels of income and quantity purchased that is called as an Engel
Curve. The Engel curve for different categories of goods has been shown in Figure 3.3
where quantity demanded is given on X axis and income on Y axis. This is to be noted
that while studying the relationship between income and quantity demanded, we consider
all factors other than income affecting demand as constant.
Essential Consumer Goods (ECG): This category involves commodities which

are necessities for all section of the society irrespective of income like medicine, food
grains, salt, vegetable oil, match-box etc. A person with no income will not be able to
afford these basic necessities and as his income increases, the demand for these category
of goods also increases and after a certain level demand becomes constant over time
and does not increases with further increase in income as shown by curve ECG in
Figure 3.3 (A).
Luxury Goods (LG): Luxury goods are article of distinction, and its demand is
created only after a certain level of income is achieved. This is the reason why in Engel
curve, curve for luxury items starts at a point P on X axis and it continuously increases
showing quantity demanded increases with the increase in income. It is shown by curve
LG in Figure 3.3(A).
Normal Goods (NG): Normal goods are goods like clothes, shoes etc. Engel curve
for normal good is upward sloping showing as income increases, consumers buy more
Economics for
of a commodity ant the demand initially increases rapidly with increase in income and
Managers : 29
Demand Theory later the rate of increase in demand goes down as shown by curve NG in the Figure
3.3(A).
Inferior Goods (IG): For inferior goods demand decreases with increase in income
NOTES as consumers tend to shift their demand to more superior goods on increasing their
purchasing power. Goods cannot be categorised as inferior in their absolute sense.
while it is only when we consider them in relation to any other good we can distinguish
between inferior and superior goods like Bajra is inferior to wheat, bus travel is inferior
to air plane travel, etc. The curve for inferior goods is shown by IG curve in Figure
3.3(A). In some instances, normal good may become inferior as the level income rises.
e.g. people may buy Dalda for a particular income level however may shift to refined
vegetable oil as income increases further. In such a case, Engel curve tends backward
as shown in Figure 3.3 (B)
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Price of the Related Goods: The related good are those for a commodity, the price
of which influences the demand of the commodity into consideration e.g. oil price
influences the demand for cars. Similarly tea-coffee, coffee-milk are related goods.
However, consequent on the kind of effect (positive or negative) related goods are
defined as substitute of complimentary goods. The demand of any commodity also
gets affected by the price of complementary goods or substitute goods.
Complementary Goods: Two goods A and B are said to be complementary goods

when they have to be used together to get the desired utility like tea and sugar, car and
petrol, pen and ink, shoes and socks etc. The demand of any commodity say car gets
affected by the change in price of its complementary goods and the relationship is
negative. It means if the price of oil will increase than demand of car goes down. Thus
there is an inverse relationship between demand of any commodity and price of its
Economics for complementary goods as shown in Figure 3.4 (A)
Managers : 30
Substitute Goods: Two goods A and B are said to be substitute of each other if one Demand Theory
good A can be used instead of B for the same purpose without any loss of utility.
Examples are: tea and coffee, sweater and sweat shirt, etc. The relationship between
demand of any commodity and the price of its substitute good is positive. It means that NOTES
if the price of coffee will increase than consumers will switch their demand towards tea
and hence the demand for tea will increase. Thus, there is a positive and direct
relationship between demand of any commodity and price of its substitute goods as
shown in Figure 3.4 (B)
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3.4 Changes in the Demand Curve
The discussion so far in this unit is concentrated on the relationship between

demand and price along with multiple factors like income etc. In Figure 3.1, demand
curve D shows different quantities of cold drink bottles that will be bought at different
prices keeping various other factors constant. Demand curve need not be static over
time. If any other factor causes changes in the quantity demanded, demand curve shifts.
There is a difference in the relationship of quantity demanded with the price and with
respect to other variables. Recall that demand curve shows the impact of price change
on the quantity demanded and if we move from one point to other point on the same
demand curve, it is due to change in the price and it is called as movement along the
demand curve.
Demand curve is constructed assuming that all other things remain constant.
Therefore, if any other factor changes, the demand curve shifts rightward or leftward
which is referred to as shift of the demand curve. Thus two types of changes in the
demand curve are as follows: (i) Movement along the demand curve i.e. quantity
demanded moves upwards or downward and (ii) shift in the demand curve either towards
right or left.
Movement along the Demand Curve

The movement along the demand curve occurs when quantity demanded of
any commodity changes due to change in the price keeping all other factors constant. Economics for
There is an important distinction between shift in the demand curve and movement Managers : 31
Demand Theory along the demand curve. When demand changes due to change in price (with other
factors constant) then demand curve moves along the same curve either in upward or
downward direction. While non-price determinants cause shift in the demand curve
NOTES either towards right or left (as shown in Figure 3.5).
Figure 3.5 represents movement along the demand curve. When price of a
commodity say ice-cream was Rs 50/- per cone than demand was 100 cones. When
price increased to Rs 100/- per cone the quantity demanded decreased to 50 cones. This
is upward movement along the demand curve called contraction in quantity demanded.
Similarly, when price will decrease from Rs 50/- per cone to Rs 25/- per cone than
quantity demanded increases from 100 cones to 150 cones. This is downward movement
along the demand curve called expansion in the quantity demanded.
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Shift in the Demand Curve

As against the movement along the demand curve we can see shift in the demand
curve as shown in Figure 3.6. Whenever quantity demanded of any commodity changes
with the change in any factor other than price, then demand curve shifts either to the
left or right. These factors are changes in taste and preferences, income, price of related
goods etc. When quantity demanded increases at any given price due to any factor
demand curve shifts to right. Similarly, when demand falls due to any factor other than
price, demand curve shifts to left. Thus, rightward shift shows increase in the demand
and leftward shift shows decrease in the demand.
A simple example can be, if the commodity is apple and as per recent World
Health Organization report those who eat apple have higher life expectancy as compared
to those who dont eat it, than health conscious people immediately increase their
consumption without any price change. Such a change is depicted through shift in the
demand curve. Figure 3.6 shows that demand was initially DD showing demand of 10
kg apples with price 10/- per kg, and later on it shifted to DD1 that shows an increase in
Economics for demand to 15 kg of apple at the same price. Similarly, when the demand curve shifts
Managers : 32 leftward to DD2 at the same price, then demand decreases from 10 kg to 5 kg.
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1. What is the difference
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Explain in detail
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Similarly, expectation about the future supply is also a very important reason for 2. What are different
factors that affect the
shift in the demand curve. Recently in 2009, when there was recession, international
demand of a
crude oil prices went very low. Similarly in 2003, when there was the situation of war
commodity?
in Iraq, the price of crude oil rose sharply and then declined immediately after war in
2004. Whenever any disturbances take place in Gulf countries or in the Middle East ,
we can see its impact on the international crude oil prices and ultimately in our country
in the prices of gasoline, petrol and diesel. What are the forces that work behind these
frequent price fluctuations of any commodity? Not only in case of petroleum products
but any other product in the market future expectations plays a significant role. When
firms who are purchasing crude oil from gulf countries expect shortage in the future
supply they increase their demand and it leads to increase in price.
Review of Key Concepts

Law of demand: quantity demanded is inversely related to price keeping other
things constant.
Total utility (TU): is the total satisfaction derived from the consumption of all
units.
Marginal utility (MU): the increase in the total utility from the consumption of
one additional unit of the commodity.
Law of diminishing marginal utility: with an increase in the consumption of any
commodity total utility derived from that commodity goes on increasing but at a
diminishing rate.
The movement along the demand curve: occurs when quantity demanded of any
commodity changes due to change in the price keeping all other factors constant.
Shift in the demand curve: when demand changes due to change in non-price
determinants like income, price of related goods, taste and preferences etc. and the
curve shifts either towards right or left. Economics for
Managers : 33
Demand Theory 3.5 Individual and Market Demand Curve
Demand curve as given in Figure 3.1 is the individual demand curve as that relates
the quantity of good that a single consumer will buy to the price of that good. To
NOTES analyse how market works, we need to determine the market demand that is sum total
of all individual demands for a particular good or service. In this section, we will
discuss how individual demand can be aggregated to determine the market demand
curve. The quantity demanded in the market is the sum of the quantities demanded by
all the buyers at each price. Thus, market demand curve is found by adding horizontally
the individual demand curve. Table 3.2 shows the demand schedule for commodity X
of two individual A and B. The market demand at each price is the sum of the two
individual demands as shown in Figure 3.7.
Table 3.2: Individual to Market Demand Curve
Price of X Quantity Quantity Market

Demanded by A Demanded by B Demand
50 12 7 19
100 10 6 16
150 8 5 13
200 6 4 10
250 4 3 7
300 2 2 4
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The aggregation of individual demand curves to attain market demand curve

Economics for
assumes that aggregation problem doesnt exist. It implies that demand of a consumer
Managers : 34
is neither influenced by nor affects others demand. However simple observation and Demand Theory
introspection suggests that this is a very restrictive assumption. Therefore, there is a
need to accommodate the interdependence between the consumption of goods by
different consumers. Leibenstien has given a taxonomy for the interdependencies which NOTES
generate the aggregation problem. He has also analysed their effects on the market
demand curve. These are classified into (i) bandwagon effect, (ii) snob effect and (iii)
Veblen effect. The discussion on bandwagon and snob effect is based on Rubenfeld
and Pindyck (2008).
Bandwagon effect: Bandwagon effect describes the interaction of demand and

preferences that arises when peoples preference for a commodity increases as the
number of people buying it increases. It is the effect in which the quantity of goods that
a consumer demands grows in response to the growth of purchases by other individuals.
Take for instance, a youngsters need to be on a social website. If the number of his/her
friends are more on a social networking site, he/she may want to join it as soon as
possible. If the number of people who owns LCD television is high in your colony, you
may also want to purchase one.
In Figure 3.8, D20 is the demand curve when consumers think that only 20,000
people have bought a certain good. D40 is the curve when consumers think that 40,000
people have bought that good similarly D60 and D80 is the demand curve when consumers
think that 60,000 and 80,000 people have bought the good. As the number of people
buying the goods increases, the demand curve shifts to right. And, due to the bandwagon
effect market demand curve becomes more elastic i.e. When the price falls from 300 to
200, if there was no bandwagon effect quantity demanded would increase from 40,000
to 48,000, but as more people buy the good, the bandwagon effect increase the quantity
demanded further, to 80,000. Thus bandwagon effect increase the response of demand
to the price change i.e., it makes the demand flat or less steep.
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Snob effect: Snob effect refers to the desire to own unique or exclusive goods.
The quantity demanded for snob good is higher the fewer the people who owns it. For
example, rare work of art, specially designed sports car, and made to order clothing are Economics for
snob goods. As given in the Figure 3.9, when the consumer believes that a few people Managers : 35
Demand Theory say only 2000 people own it, its snob effect is high. If they believe that 4000 people
own the good, it is less exclusive and its snob value is reduced. Snob effect will make
the market demand curve steep. It is the effect in which the quantity of goods that a
NOTES consumer demands falls in response to the growth of purchases by other individuals.
Figure 3.9 illustrate the snob effect. D2 is the curve when 2000 people owned the good.
When 4000 people own the good, its snob value decreases and quantity demanded will
be lower that is D4, similarly if consumers believe that 6000 people own the good,
demand is even smaller and D6 applies. The market demand curve is formed by joining
D2, D4, D6 and D8 and it is less elastic.
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Veblen effect refers to a situation when the individual judge the quality by prices.
Veblen goods are basically status goods or article of distinction like luxury cars, gold,
diamond etc. These are goods which are used as a status symbol by the consumer and
their demand increases with increase in prices. These are goods which give a
psychological sense of satisfaction and distinction to the buyer that they are different
from others. Therefore, an increase in the price of such goods also increases their demand.
It is evident that these interdependencies in the consumption lead to divergence

between the true and ordinary demand curve. The magnitude of effect in that case
depends upon the strength of the effect for any one consumer and the number of
consumers that are subject to these influences. It has been noted that there is no reason
to believe that these factors will influence consumers in isolation from each other.
Bandwagon, snob and veblen effects could be all acting together alongside normal
consumer behaviour.
It shows that, due to bandwagon and snob effect the demand curve differs from
the true demand curve. Due to snob effect demand curve is steep and bandwagon effect
leads to flat demand curve. Now the question arises how does the steepness and flatness
of the demand curve influence the firm. The steepness and flatness of the demand
Economics for
curve reflect on the price elasticity of demand that is discussed in the next section.
Managers : 36
Demand Theory
3.5 Elasticity of Demand
A manager is most concerned about the sale of the final product in the market. It
NOTES
is the total sales and the ensuing revenue generated that influences the fate of any firm.
Any variation in these sales are closely understood and watched by a manager. The
answer that every manager wants to find out how much is the market demand going to
change if the price changes? In other words, a manager is looking for the responsiveness
of the quantity demanded to the change in price. However, till now we have studied
about the law of demand which simply says that price and demand are inversely
related, means as we increase price demand decreases and vice versa. But this knowledge
of the relationship of demand and price is not enough to understand how market demand
responds to the price change. It implies, till now we were doing only qualitative study
where we were trying to understand the direction of change in demand with respect to
change in price. Whether quantity demanded will move in upward direction or in
downward direction or whether demand will expand/ contract. However, a manager
must needs to understand the magnitude of that change i.e. how much responsive/
sensitive the demand is to the change in price. The quantitative study implies finding
out, if we change price by 5% then demand will change either by 10% or 5% or remains
constant. In order to answer this we will study concept of elasticity of demand.
Price elasticity of demand means responsiveness of the quantity demanded of a

product to the change in price. A manager also needs to measure the degree/ extent to
which demand changes with factors like price, income and price of related goods.
Thus, we will study the following :
1. Price elasticity
2. Income elasticity
3. Cross elasticity
Price Elasticity of Demand

The price elasticity of demand measures the percentage change in quantity
demanded to the change in prices that implies the responsiveness of the quantity
demanded to the price. If we change price say 5%, 10% or 15% then how much does
the quantity demanded changes?
The price elasticity is defined as the percentage change in quantity demanded

divided by percentage change in price.
% change in quantity demanded

EP = ------------------------------------------------------------------------------
% change in price
Economics for
Price elasticity is calculated as proportionate change in price to the proportionate
Managers : 37
Demand Theory change in price.
(Q2 Q1)
Q1
EP =
NOTES (P2 P1)
P1
EP =Q/P * P1/Q1
where Q = change in quantity demanded.
P = change in price
P1 = Initial price.
Q1 = Initial quantity
While calculating the elasticity we ignore negative sign as it is obvious that negative
sign in Ep is due to the inverse relationship between price and demand, if price increases
(+) then quantity demanded falls and vice versa. However, for the sake of convenience
in understanding the magnitude of the response of quantity demanded, we ignore the
negative sign. There are different methods of calculating price elasticity of demand.
The method mentioned earlier is the percentage method. It is the most simple and
easiest method of calculating elasticity of demand.
While calculating price elasticity through percentage method some problems may
arise like follows: If at point A; P1= 5 /- per kg. Q1 = 15 quintal.
At point B; P2 = 4 /- per kg Q2 = 30 quintal.
In the Figure 3.10 on moving from point A to B i.e. price falls from 5/- to 4/- and
quantity demanded increases from 15 unites to 30 units; then from percentage method.
EP = Q/P * P1/Q1
EP = 15/1 * 5/15
EP = 5.
While on moving from point B to A when price increase from 4/- to 5/- and
quantity demanded falls 30 units to 15 units.
EP = Q/P * P1/Q1
EP = 15/1 * 4/30 = 2
Economics for
Managers : 38
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Though absolute changes in price and quantity in both the situations are same,
elasticises are different. The differences arise because in both the cases we are calculating
percentage changes with different bases. To avoid this problem we calculate price
elasticity by mid-point method. In this method, we calculate percentage change by
dividing the absolute change with the average of initial level and final level. Therefore,
EP = Q (P1 + P2)/2
*
(Q1 + Q2)/2 P
While calculating elasticises from mid-point method we get the same result in
either direction.
EP = Q (P1 + P2)/2
*
(Q1 + Q2)/2 P
Ep = 15/22.5 * 4.5/1
Ep = 3
Table 3.3 shows price elasticity of demand calculated through percentage method
and mid-point method.
Table 3.3: Price elasticity of demand: Percentage method and mid-point method
Price Quantity Demanded Percentage method Mid-point method
1 30
2 28 0.06 0.10
3 22 0.43 0.60
4 18 0.54 0.7
5 10 1.78 2.57
Economics for
6 5 2.50 3.66 Managers : 39
Demand Theory Another method was developed by Marshall, wherein elasticity is measured
graphically, for a liner demand curve. Suppose we are given a linear demand curve as
given in Figure 3.11 and we want to measure elasticity at a point A where price is 4/-
NOTES and demand in 10 units. At any particular point say A
EP = Lower Segment
Eu = Upper segment
i.e. the ratio of distance from point A to axis X divided by distance from point A
to Y axis.
Generally, we take vertical distance on the curve to measure elasticity.
EP at A = AD/AD1 = 4/2 =2
EP at B = BD/BD1 = 2/4 =0.5
This shows that along the demand curve, elasticity keeps on changing. At the
mid-point of the linear demand curve elasticity is 1 and at any point below mid-point
elasticity is less than 1 as lower segment (numerator) goes smaller and upper segment
(denominator) goes larger. Similarly, at any point above mid-point elasticity is greater
than 1.
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Degrees of Elasticity
Elasticity of demand varies between two 0 and 1. As mentioned above different
goods have different sensitivity to price some products demand is very sensitive to
price, while other products demand is least sensitive. So on the basis of the extent to
which the demand changes, a product can have:
1. Elastic demand; Ep >1
2. Inelastic demand; Ep < 1
3. Unitary elastic demand; Ep = 1

Economics for
4. Perfectly elastic demand; Ep =
8
Managers : 40
5. Perfectly inelastic demand; Ep = 0 Demand Theory
0< Ep<
8
Ep < 1 = It shows that 1% change in price leads to less than 1% change in quantity
NOTES
demanded. Figure 3.12 (A) shows a demand curve where 67% (mid-point method) fall
in price leads to 40% rise in demand. It is the case where on decreasing the price the
seller can earn revenue due to relatively inelastic demand. It is the case for goods with
no substitute or the essential commodities.
Ep > 1 : It shows that 1% change in price leads to more than 1% change in quantity
demanded. Figure 3.12 (B) shows a demand curve where 67% (mid-point method) fall
in price leads to 100% rise in demand. It is generally the case of luxury items or normal
goods where demand is relatively elastic.
Ep = 1 : It is the case where rate of change in quantity demanded is same as the

rate of change in price. Figure 3.12 (C) shows a demand curve where 67% (mid-point
method) fall in price leads to 67% rise in demand.
Ep = 0: At the extreme points, lie two different degrees called perfectly elastic
demand and perfectly inelastic demand. Ep = 0 means demand is completely insensitive
to the price change. Figure 3.12 (D) shows a demand curve which is a vertical straight
line parallel to Y axis. Demand for the essential commodities or necessities after a
certain point becomes inelastic.
Ep = : It is the case where demand is perfectly elastic showing, even a minute

or negligible change in price of the product may lead to fall in demand to the level zero.
Figure 3.12 (E) shows a demand curve which is a horizontal straight line parallel to X
axis.
Economics for
Managers : 41
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Total Expenditure Method

A useful indicator to measure the strength of price elasticity of demand is to
calculate whether total expenditure on the commodity has risen or fallen after the price
change. Note that the expenditure made by a consumer on the commodity is equal to
the revenue received by the firm on selling the commodity. And, total revenue
Economics for
(expenditure) of a firm (consumer) is price multiplied by quantity sold (demanded).
Managers : 42
Recall the definition of market demand curve which is the horizontal summation of Demand Theory
individuals demand curve. Therefore, for a firm, whatever is the total amount spent by
the consumer on good is collected as total revenue. The direction of change in the total
revenue is an indicator of elasticity of demand. This method shows that the direction of NOTES
the change in the total expenditure of the consumer due to price change provides an
indicator of the price elasticity.
When the price of the commodity and total expenditure changes in the same
direction then demand is relatively less elastic (EP < 1). When the price falls, consumers
do not increase their quantity demanded at the same rate and their total expenditure
falls and hence sellers total revenue also falls. Similarly, with the rise in price, consumers
do not reduce their demand proportionately and the total expenditure of consumers and
hence total revenue of the sellers increase. It says that with a change in prices, demand
changes less than proportionately and price elasticity of the product is less than 1.
When the price change and total expenditure change takes place in the opposite
direction it means that commodity has highly elastic demand (EP > 1). If the price falls,
demand increases substantially causing increase in total expenditure of consumers and
total revenue of seller. Similarly, when price rises, consumers lower their demand
substantially and their expenditure rises.
The relationship between total expenditure of consumers, price change and price
elasticity of demand can be understood clearly from Table 3.4 as given below.
Table 3.4: Change in Total Expenditure and Price Elasticity of Demand
Price change Total expenditure change Price elasticity of demand
Ep < 1
Ep < 1
Ep > 1
Ep > 1
Constant Ep = 1
Constant Ep = 1
Factors Affecting Price Elasticity of Demand

The price elasticity of demand helps a manager in understanding how much a
Economics for
consumer will move away from the good when its prices rise. The price elasticity of a
Managers : 43
Demand Theory commodity depends various factors including economic and psychological factors.
Followings are important considerations that affect the price elasticity of demand:
Availability of Close Substitutes

NOTES
A commodity that has more number of substitutes has elastic demand as compare
to goods with less or no substitutes. For example, Pepsi, Thumps-up, and Coca-cola
are close substitutes of each other, when the price of one soft drink increases consumers
immediately shift their demand to its substitute. Compare it with petrol, with no substitute
available and with less elastic demand. However, if there are substitutes available, then
the elasticity can change i.e. public transport.
Proportion of Income Spent on the Commodity

When a consumer spends high proportion of income on any commodity then its
elasticity would be very high. Example: Indian middle-class family spend a very low
proportion of their income on goods like match-box, sugar, tea, soap etc. so whenever
any change takes place in any of these commodities, households total income spent on
these commodities does not change and they do not post-pone their purchase. But
when we talk about expensive item like TV, AC, Motorbike etc. consumers spend very
high proportion of our income on these goods so when price rise, they postpone its
purchase.
Number of Uses of the Commodity

If a commodity has many uses then its price elasticity is high as on rise in price
we curtail its use on our less important purpose. For example, we can make use of milk
in making butter, ghee, curd, sweet etc. but when its prices increases we postpone all
our unnecessary uses and use only for urgent and necessary consumption.
Nature of the Commodity

The demand for essential goods is perfectly inelastic while that of luxury goods is
relatively elastic.
Time Period under Consideration

When the price of any commodity change then consumers do not change their
demand immediately that is in short-run consumers do not make any changes in the
demand. However, in long-run consumer can change and adjust the purchases in response
to price change. For example, on increasing the price of petrol consumers do not
immediately stop its purchase but gradually over a period of time one can switch to
more fuel-efficient cars, switch to public transport, or go for car-pooling.
Income Elasticity of Demand

Economics for
Income elasticity of demand measures the change in quantity demanded due to
Managers : 44
change in consumers income. It shows the degree of responsiveness of quantity Demand Theory
demanded of goods to a change in income of consumers. More precisely, income
elasticity of demand may be defined as the ratio of proportionate change in quantity
demanded of a good to the proportionate change in income. NOTES
Income elasticity = Proportionate change in quantity demanded
-----------------------------------------------------------------------------------------------------
Proportionate change in income
Ei = Q/I * I/Q
where I stands for initial income and I for a small change in income. Q for the
initial quantity demanded and Q for the change in quantity demanded.
Mid-point formula for measuring income elasticity of demand when changes in

income are quite large can be written as :
Ei = Q (I1 + I2)/2
*
(Q1 + Q2)/2 I
Income elasticity of demand can be zero, positive or negative. Zero income

elasticity of demand implies that quantity demanded of a good is quite unresponsive to
the change in income. It signifies that given increase in income does not at all leads to
any increase in quantity demanded or increase in expenditure on it.
When income elasticity is positive, then an increase in income leads to quantity

demanded of the good. This happens in case of normal or superior goods. On the other
side of the zero income elasticity are all those goods that have income elasticity less
than zero and in such cases increase in income leads to fall in the quantity demanded.
Goods having negative income elasticity are known as inferior goods.
Cross Price Elasticity of Demand

Cross price elasticity of demand measures the change in demand for one good in
response to the change in price of other good, when the price of the concerned good is
constant. In other words, we can say that cross elasticity of demand measures the
responsiveness of the change in quantity demanded of commodity x with respect to the
change in price of commodity y, when the price of x is constant and x and y are related
to each other i.e. substitute or complimentary.
Cross elasticity (Exy) = Proportionate change in quantity demanded of commodity x

------------------------------------------------------------------------------------------------------------------
Proportionate change in price of commodity y
Cross elasticity of x for y; Exy = Qx/Py * Py/Qx
If the price of coffee rises from 10/- to 12/-, consumers demand for tea as an
immediate substitute of coffee rises from 70 kg to 100 kg. Then cross elasticity of Economics for
Managers : 45
Demand Theory demand of tea for coffee;
Etea/coffee = 30/70 * 10/2 = 2.14.
Cross Elasticity for Substitutes: When two goods are substitute of each other then
NOTES
as a result of rise in price of one good, the quantity demanded of the other good increases.
Therefore, the cross elasticity between two substitute goods is positive. Thus, in response
to the price rise of one good, the demand for the other good rises.
Cross Elasticity for Complementary: When two goods are complementary to each
other just as bread and butter, tea and milk etc. the rise in price of one good brings
about the decrease in the demand for the other. Therefore, the cross elasticity between
two complementary goods is negative.
Check Your Progress

3.6 Summary
1. Define price elasticity
of demand and income
elasticity of demand. The law of demand states that the quantity demanded is inversely related to price
2. List and explain four keeping other things constant. This can be explained using law of diminishing marginal
determinants of price utility which implies that with an increase in the consumption of any commodity total
elasticity of demand. utility derived from that commodity goes on increasing but at a diminishing rate.
3. If demand is unitary
elastic, how will a From an individual demand curve we can get market demand curve which is a
decline in the price horizontal summation of the individual demand curve.
effects total revenue?
In order to understand the responsiveness of the quantity demanded to price one
Explain.
can use the concept of price elasticity of demand that is equal to percentage change in
the quantity demanded due to percentage change in price.Similarly, income elasticity
of demand is calculated as percentage change in quantity demanded due to percentage
change in consumers income.
3.7 Key Terms
Market demand curve : horizontal summation of the individual demand curve.

Bandwagon effect: describes the interaction of demand and preferences that arises
when peoples preference for a commodity increases as the number of people
buying it rises.
Snob effect: a situation where the consumer has desire to own unique or exclusive
goods.
Veblen effect: a situation when the individual judge the quality by prices.
Price elasticity of demand: percentage change in the quantity demanded due to
percentage change in price.
Economics for Income elasticity of demand: percentage change in quantity demanded due to
Managers : 46
percentage change in consumers income. Demand Theory
Cross price elasticity of demand: percentage change in demand for one good in
response to percentage change in price of other good, when the price of the
concerned good is constant. NOTES
1. Explain the difference between movement along the demand curve and shift in
the demand curve.
2. Historically, investors have considered gold commodities to be a good investment

to preserve wealth in times of inflation. If investors are no longer worried about
inflation and gold demand decreases, what do you expect will happen to gold
prices? How would your answer change if you learn that a there is a recent gold
mine discovery?
3. The cross-price elasticity of demand for peanut butter with respect to the price of
jelly is -0.3. If we expect the price of jelly to decline by 15%, what is the expected
change in the quantity demanded for peanut butter?
4. The demand for tickets to the cricket match is given by the equation QD = 350,000
- 800P. The supply of tickets to the event is given by the capacity of the ground,
which is 150,000. What is the equilibrium price of tickets to the event? What is
the price elasticity of demand at the equilibrium price?
5. Explain which of the following events would cause a movement along the demand
curve for clothes produced in India and sold in the U.S., and which would cause a
shift in the demand curve?
A. a cut in the industrys costs of producing domestic clothes that is passed on
to the market in the form of lower prices.
B. growing concern in the U.S. consumers that imported products are negatively
affecting the employment situation in the U.S.
6. Which of the following would cause an definite decrease in the real price of DVD
players?
A) A shift to the right in the supply curve for DVD players and a shift to the
right in the demand curve for DVD players.
B) A shift to the right in the supply curve for DVD players and a shift to the left
in the demand curve for DVD players.
C) A shift to the left in the supply curve for DVD players and a shift to the right
D) A shift to the left in the supply curve for DVD players and a shift to the left
Economics for
Managers : 47
Demand Theory
1. H Leibenstein, Bandwagon, Snob, and Veblen effects in the theory of

NOTES
consumers demand Quarterly Journal of Economics, May 1950.
2. Thorstein Veblen. (1932), The Theory of Leisure Class.
3. Robert S. Pindyck and Daniel L. Rubinfeld, (2008), Microeconomics, 7th

edition, pp 126-129.
APPENDIX for UNIT III

In this Appendix, we will briefly preient two opprouchei to underitand the
consumer behavior.
3A.1 Cardinal Utility Theory

A consumer purchase a good to satisfy some want as that good provides utility.
Economist have used two approaches to understand utility and derive the demand curve
for a consumer. The first approach is cardinalist approach that postulates that utility
can be measured. The concept of subjective and measurable utility is attributed to
economist like Gossen, Jevons and Walras. This school of thought postulate that utility
is a numerical score that represents the satisfaction that a consumer gets from a given
market basket. Accordingly, it is possible to have a utility function that is a formula that
assigns a level of utility to individual market baskets. For example,
U= F(X1, X2, ...Xn) 3A.1
where U is the lotul utility that depends on a basket of good with n commodities.
Further, marginal utility (MU) is additional satisfaction obtained from consuming

one additional unit of a good. It is calculated as derivative of U with respect to x1, x2,
...xn. That is:
MU from commodity x1 = dU/dx1 and 3A.2
MU from commodity xn = dU/dxn 3A.3
The theory postulates law of diminishing marginal utility that implies as more of
a good is consumed, the consumption of additional amount yields smaller additions to
utility. A consumer can buy either one more unit of xi or retain the money. Accordingly,
a consumer keep on spending on a particular good such that:
MUx1= Px1 3A.4
In case of many commodities tin equilibrium is attained at:
MUx1 MUx2 MUxn

= =............... 3A.5
Economics for Px1 Px2 Pxn
Managers : 48
The utility derived from spending nn additional money must be same for all Demand Theory
commodities. In case a consume derives greater utility from any one commodity he/
she enn increase their by increasing the consumption of thai pnrtieulnr commodity. As
given in the main text, diminishing MU one can derive the demand curve of a consumer NOTES
for a particular good.
3A.2 Ordinal Utility Theory
The ordinal approach says thai utility is not mensurable. However, u consumer
can rank the various baskets of goods depending upon the satisfaction thul each basket
provides. The two main ordinal theories arc indifference curve and revealed preferences.
Indifference Curve
This approach is based on three main assumptions: (i) a rational consumer, (ii)
consistent and transitive choices (thai is if A is preferred to B and B is preferred to C
then a consumer prefers A to C) and (iii) more is always preferred to less. On the basis
of these assumptions it is possible to derive an indifference curve. Let us say one has
commodity L on X axis and M on Y axis as given in Figure 3A.I. It is a curve that
represents all combinations of market baskets that provide a consumer with the same
level of satisfaction. The indifference curve IC| that passes throuch market basket A
shows all baskets that give the consumer the same level of satisfaction as doe market
basket A; these include baskets B and D. The consumer prefers basket E, which lie
above ICi, to A. but prefers A to H or G, which lie below 1C ,. According to this
diagram toe consumer should be indifferent among market baskets A, U. und D, The
level of satisfaction remain same as consumer move from point A to 13 since ho/she
has loss or L but more of M.
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Economics for
curves showing the market baskets among which a consumer is indifferent as shown
Managers : 49
Demand Theory in Figure 3A.2. In case of indifference map, any market basket on indifference curve
IC3. such us basket A, is preferred to any basket on curve 1C2 (e.g., basket B), which in
turn is preferred to any basket on IC1, such as D. Two indifference curves do not
NOTES intersect each other. If indifference curves 1C1 and 1C2 intersect, one of the assumptions
of consumer theory is violated. Consider Figure 3A.3 where indifference curves 1C1
and IC2 intersect each other at point A. Now consider point B and C, both points have
same level of capital L, however, C has more of M by M1M2. Consider now the basic
definition of indifference curve that states that all the points on an indifference curve
give same level of satisfaction to consumer. Accordingly, satisfaction at B = A and A =
C, therefore satisfaction given by B should be equal to C. This is a contradiction as C
has more of M and same level of L as B. Therefore, two indifference curves cannot
intersect each other.
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Economics for
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Managers : 50
As mentioned earlier, The level of satisfaction remain same as consumer move Demand Theory
from point A to B since he/she has less of L but more of M. The maximum amount of
a good that a consumer is willing to give up in order to obtain one additional unit of
another good is called as marginal rate of substitution. The magnitude of the slope of NOTES
an indifference curve measures the consumers marginal rate of substitution (MRS)
between two goods. In Figure 3A.4, the MRS between M and L falls from 2 (between
A and B) to 1 (between B and C) to .25 (between D and E). The decline in the MRS
reflects a diminishing marginal rate of substitution. When diminishes along an
indifference curve, the curve is convex.
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Utility Functions and Indifference Curves: A utility function can be represented

by a set o indifference curves, each with a numerical indicator. Therefore, different
indifference curves given in Figure 3A.2 that are 1C1, IC2 and IC3 can be associated
with a utility function with utility levels or25, 50, and 100. respectively.
Consumer Choice
A consumer expresses his/her choice through the indifference curve that we have
seen can be associated with utility level. Now a consumer faces a problem that he/she
wants to maximize their utility and in the process faces a budget constraint. A budget
constraints that consumers face is the result of limited incomes. Based on the total
income available a consumer can have a budget line that shows all combinations of
goods for which the total expenditure is equal to income. For example, if a consumer
has total income of 80 and price of L is 1 Rs. and that of M is 2 Rs. A consumer can
either purchase 40 units of M and 0 unit of L (basket A) or 80 units of L and 0 unit of
M (basket G) or any other combination as given in Table 3.A.1 and Figure 3A.5. It is
constructed as
PL*L+PM*M = I 3A.6
where PL is price of L. L is amount of commodity L, PM is price of M, M is Economics for

quantity of M and I is consumers income. Managers : 51
Demand Theory TABLE 3A.1 Market Baskets and the Budget Line
Basket L M Total Expenditure
A 0 40 80
NOTES
B 20 30 80
D 40 20 80
E 60 10 80
G 80 0 80
A budget line describes the combinations of goods that can be purchased given
the consumers income and the prices of the goods. The slope of the budget line is -P1/
PM = -10/20 = -1/2.
L = I/PL - (PM/ PL) *M 3A.7

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A change in income (with prices unchanged) causes the budget line lo shift parallel
to the original line. When the income of 80 (on L1) is decreased to 40. the budget line
shifts inward to L2 as given in Figure 3A.5. On the same lines, if the income increases
and price remain same the budget line will shift outward.
If there is a change in the price of one good (with income unchanged), it causes
the budget line lo rotate about one intercept. When the price of L increases from 1 to 2.
the budget line rotates inward from L| to L2. However, when the price decreases other
things remaining the same the line rotates outward from L| to L3. This is shown in
Figure 3A.6.
Economics for
Managers : 52
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Now with the budget constrain a consumer intends to maximize his/her utility. In
terms of indifference curve, a consumer wants to reach the highest possible indifference
curve. Take note of Figure 3A.7. Let say I1, represent the budget constrain, then a
consumer can have maximum mer The point of utility represented by IC1. IC1 is
attainable given the income of the consumer. The point of equilibrium is point E. Note
that F represent low level of satisfaction as it is on lower indifference curve IC2. No
higher level of satisfaction (for example, market basket K on IC3) can be attained. At
E, the point of maximization, the MRS between the two goods equals the price ratio.
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Based on the indifference curve analysis also it is possible to derive the demand
curve of a consumer. Consider Figure 3A.8 (I) where, different equilibrium levels A, B and
C are given when the price of L commodity increase such that budget line shift from I1 to I2
to I3. In such a case, price of M and income are constant. Moreover, I3 gives the lowest price
of L. If we take the amount of good demanded from Figure 3 A.8 (I) to 3A.8 (11) and put
it against the price, you can derive the demand curve. Points A. B and C are concurrent to Economics for
the equilibrium output level shown by A, B and C. Managers : 53
Demand Theory )LJXUH$,
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The theory of revealed preference is also based on the choices and ranking of a
consumer. If a consumer chooses one market basket over another, and if the chosen
market basket is more expensive than the alternative, then the consumer must prefer
the chosen market basket. If individual facing budget line I1 chose market basket A
rather than market basket B, A is revealed to be preferred to B. Likewise, the individual
Economics for facing budget line I2 chooses market basket B, which is then revealed to be preferred
Managers : 54 to market basket D. Whereas A is preferred to all market baskets in the area shaded
with horizontal lines, all baskets in the vertical shaded line are preferred to A. Using Demand Theory
this approach one may check for the consistency of consumer choicer as well as derive
indifference curve for a consumer.
NOTES
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Economics for
Managers : 55
Supply Analysis
UNIT 4 SUPPLY ANALYSIS
NOTES Structure
4.0 Introduction
4.1 Unit Objectives
4.2 Price Elasticity of Supply
4.3 Changes in the Supply Curve
4.4 Summary
4.5 Key Terms
4.0 Introduction
In the previous unit, we considered the demand side of a market and will focus on
supply side in the present unit. Supply is defined as the total quantity of a commodity
that a seller is able and willing to sell at a certain price. As we know that producers are
willing/intend to offer more products for sale in the market at higher prices by increasing
the production as a way of increasing profits. The law of supply says that there is a
direct relationship between price and quantity in the market. The supply of product
increases with increase in its price and decreases with decrease in its price, other things
remaining constant. From a managers perspective, supply analysis is equally important.
This unit provides a link to the rest of the units as supply of a firm is based on the
production technology, factor prices, and the interaction between the firms in an industry.
Thus, in this unit we will very briefly cover the price elasticity of supply and movement
along and shift of the supply curve. This unit is organized as follows: Section 4.2
discuses the concept of price elasticity of supply. Section 4.3 covers the movement
along and shift of the supply curve.
4.1 Unit Objectives

* To study the concept of price elasticity of supply
* To understand the movement along and shift of the supply curve.
* To learn about various factors influencing supply apart from prices.
4.2 Price Elasticity of Supply

Economics for
Managers : 56 Price elasticity of supply (PES) measures the responsiveness of quantity supplied
to a change in price. It is necessary for a firm to know how quickly, and effectively, it Supply Analysis
can respond to changing market conditions, especially to price changes. The following
equation is used to calculate PES.
PES = Percentage change in quantity supplied/percentage change in prices NOTES
For instance, if a firms market price increases from 1 to 1.10, and its supply
increases from 10 to 12.5 then PES will be 2.5 ((2.5/0.1)*(1/10)). Note that in this case
we have used percentage method with 1 and 10 as base price and quantity supplied
respectively. You are already aware of the limitation of percentage method to calculate
elasticity. Therefore, as in the case of price elasticy of demand, one can use either
percentage method or mid-point method to caluclate PES. The sign for PES is positive in
value as prices and supply of a commodity are positively related. The positive sign
reflects the fact that higher prices will act as an incentive to supply more. PES ranges
from 0, perfectly inelastic, to infinite, perfectly elastic.
1. When PES > 1, then supply is price elastic
2. When PES < 1, then supply is price inelastic
3. When PES = 0, supply is perfectly inelastic
4. When PES = infinity, supply is perfectly elastic following a change in de-
mand
Supply curve with different price elasticity are given in Figure 4.1 (A-D).
Perfectly inelastic supply curve: When supply is perfectly inelastic, PES supply
= 0 and the supply curve is vertical as shown in the Figure 4.1 (A). In such a case,
change in the price has no effect on the equilibrium quantity supplied in the market.
Examples for inelastic supply include the tickets for sports or musical venues, and the
short-run supply of agricultural products (where the yield is fixed at harvest time). In
such cases, any shift in demand is absorbed in price change as shown in figure 4.1 (A).
Perfectly elastic supply: Perfectly elastic supply happens when a producer can
supply an unlimited quantity at a given price or higher, but none at a lower price as
shown in the Figure 4.1 (B). Perfectly elastic supply doesnt happen often, A hypothetical
example for a perfectly elastic demand may be that of a pen having production cost of
say Rs 3 /-. If the buyer pays 3/- each for the pen they can get as many pen as they want.
But if they lower the money they offer for the pen by a small amount, then sellers do
not supply pen to them. In this case, shift in demand doesnot lead to any change in
prices.
When supply is relatively inelastic (PES < 1) a shift in demand affects the price
more than the quantity supplied as shown in the figure 4.1 (C). The reverse is the case
when supply is relatively elastic (PES > 1). A shift in demand can be met without or
small a change in market price as shown in the figure 4.1(D). Diagrammatically, the
supply of a good with inelastic supply is steeper than the good with elastic supply. Economics for
Managers : 57
Supply Analysis )LJ$'
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The information about PES for a firm is highly significant as it reflects on the
capability of a firm to respond to changes in the demand condition. The key
considerations for a firm that influence the PES are:
Availability of Inputs: If the firm has enough raw materials and other resources
required for the production of goods, then it would be easy for it to increase the supply
to the market and hence supply would be more elastic. However, if the producer is
unable to increase the output by employing more and more resources, the supply of
most of the goods and services therefore, will be price inelastic.
Nature of the Commodity and Storage Possibility: The supply of a good is elastic,
if the product is non-perishable i.e. can be stocked with ease have a long shelf life, and
producer has excess storage capacity such that he/she can quickly respond to the market
changes and can increase the supply to the market.
Current Usage of the Production Capacity: It is one of the important factors

affecting price elasticity of supply. If seller has unused capacity then he/she can (and
will) quickly react to the price changes in the market assuming that variable factors are
readily available.
Economics for The Ease and Cost of Factor Substitution: If both capital and labor are easy to
Managers : 58
substitute then the elasticity of supply for a product is higher than if capital and labor Supply Analysis
cannot easily be switched. For example, most of the musical instruments can be made
by labor as well by machine.
Time period and production speed: The supply is price elastic the longer the time NOTES
period that a firm has to adjust its production levels. For various agricultural
commodities, the supply at a point is fixed (for a season) and is determined mainly by
planting decisions made months before, and also climatic conditions, which affect the Check Your Progress
production yield. In contrast the supply of milk is price elastic because of a short time 1. How is the price
span from cows producing milk and products reaching the market place. elasticity of supply
calculated? Explain
what it measures?
4.3 Changes in the Supply Curve 2. Explain in detail
various factors that
Movement along the Supply Curve influence price
A movement along the supply curve is a change in supply as a result of the change elasticity of supply.
in price.
In the Figure 4.2, supply curve S indicates that at a price of 5/- per unit, supplier
is willing to offer 50 units of a commodity. Other things constant, if the price of
commodity increases to 10/-supplier would be willing to offer 100 units of the
commodity. Thus, increase in price is reflected by a movement along the supply curve
causing more to be supplied. Such a change in supply due to a change in the price is
called increase/decrease in (supply/quantity supplied).
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Shifts in the Supply Curve

A shift in a supply curve is a change in supply for a reason other than a change in
price.
In the Figure 4.2 (B), supply curve S indicates the original supply and when there
is any change in other factors except price like change in the price or availability of raw
Economics for
material, supply of the commodity will change at every price level. This results in shift
Managers : 59
Supply Analysis in the supply curve (left/right). Such a shift to right/left in the supply curve indicates
that at each of the possible price shown suppliers are now willing to offer larger/smaller
quantities and at each of the possible quantity shown suppliers are ready to accept
NOTES higher/lower price. When the supply curve shifts to the right, this means that more is
supplied at every price. If the price was 5 Rs. the quantity supplied has increased from
50 to 100. When s0 shifts to s1 when the supply curve shifts to the left, this means that
less is supplied at every price.
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Factors Causing the Shift in Supply Curve

Production technology: If there is a technological advancement in the production
of a good, production efficiency increase the supply and supply curve shifts to the
right. Technology is usually perceived as a variable that would cause a rightward shift
in the supply curve, due to an ability to increase supply at lower prices.
Cost of factors of production: In general, an increase in the price of raw materials

or other factors of production will lead to a decrease in supply at each price point,
shifting curve to the left. As the prices of the factors of production rises and supply
falls. On the other hand, a decrease in the price of inputs will lead to an increase in
supply at each price point, shifting the curve to the right.
Numbers of firms in the market: The market supply curve is the horizontal
summation of the individual supply curves. As more firms enter the industry, the market
supply curve will shift out, driving down prices. When a market becomes saturated,
companies would leave the market thus decreasing supply of products. This would
cause the supply curve to shift leftward.
Price of the related goods: Many times companies have the ability to use existing
methodology or technology to produce other related items or provide similar services.
A firm making leather shoes may also start making leather purse or leather covers for
mobile phones similarly a call center that provides services for computer support could
be trained to take calls for other products, such as printers, to provide support. If a
customer needs increased support in computers, people supporting printers can be
Economics for
reassigned to assist. This would shift the supply curve to the left for the printer support
Managers : 60
since that supply will be decreased. Supply Analysis
Government policy: Government intervention can have a significant effect on

supply. Government intervention can take many forms, including environmental and
health regulations, hour and wage laws, taxes, electrical and natural gas rates, and NOTES
zoning and land use regulations etc. Governments can influence market supply and
shift the curve to the right or left depending upon their actions. International treaties
such as General Agreement on Trade and Tariff that remove trade restrictions makes
more items available for trade in a country. This is a rightward shift in the supply curve
as increase in trade would lead to rise in the supply. If a government becomes
protectionist, that is restrict the trade by imposing tariffs on imports, the supply decreases
and the curve shifts leftward.
Expectation for future prices: If producers expect future price to be higher, they
will try to hold on to their inventories and offer the products to the buyers in the future,
thus they can capture the higher price. If a producer of a product has an expectation that
prices could decrease in the foreseeable future due to new firms entering the market,
they may increase production to sell as much as possible at the current price. This
would shift the supply curve to the right increasing the supply in the market at each
price. This strategy is to maximize revenues before the price decreases
The discussion in this section on supply side of the market is incomplete. As

mentioned earlier, this unit is a link between the previous and the units to follow. It has
already mentioned that production technology, cost analysis and interaction between
the firms determine the overall market supply of the commodity. The following units
are focusing on these issues.
4.4 Summary
Supply is defined as the total quantity of a commodity that a seller is able and
willing to sell at certain price. The producers are willing/intend to offer more products
for sale in the market at higher prices by increasing the production. The law of supply
says that there is a direct relationship between price and quantity in the market.The
supply of product increases with increase in its price and decreases with decrease in its
price, other things remaining constant.
Price elasticity of supply (PES) measures the responsiveness of quantity supplied

to a change in price. It is necessary for a firm to know how quickly, and effectively, it
can respond to changing market conditions, especially to price changes.
A movement along the supply curve is a change in supply as a result of the

change in price. A shift in a supply curve is a change in supply for a reason other than
a change in price. The shift can be due to change production technology, cost of factors
of production, number of firms in the market, prices of the related goods, government Economics for
policy and future expectations. Managers : 61
Supply Analysis
4.5 Key Terms
Price elasticity of supply (PES): measures the responsiveness of quantity supplied

NOTES
to a change in price.
Perfectly inelastic supply curve: when supply is perfectly inelastic, PES is equal to
zero and the supply curve is vertical.
Perfectly elastic supply: when a producer can supply an unlimited quantity at a

given price or higher, PES is infinite and the supply curve is horizontal.
Movement along the supply curve: a change in supply as a result of the change in
price.
Shift in a supply curve: is a change in supply for a reason other than a change in
price.
1. The demand for tickets to the cricket match is given by the equation QD = 350,000
- 800P. The supply of tickets to the event is given by the capacity of the ground,
which is 150,000. What is the equilibrium price of tickets to the event? What is
the price elasticity of demand at the equilibrium price? What is the price elasticity
of supply at the equilibrium price?
2. To protect the fishery off the east coast, the government may limit the amount of
fish that each boat can catch in the fishery. The result of this public policy is to:
a. shift the fish demand curve to the left.
b. shift the fish demand curve to the right.
c. shift the fish supply curve to the right.
d. shift the fish supply curve to the left.
3. Explain the difference between a shift in the supply curve and a movement along
the supply curve.

1. R.S. Pindyck and D.L. Rubinfeld. Microeconomics (7th Edition), Pearson
Delhi
Economics for
Managers : 62
Economics of Production
UNIT 5 ECONOMICS OF PRODUCTION
Structure NOTES
5.0 Introduction
5.1 Unit Objectives
5.2 Basic Concepts
5.3 Production with One Variable
5.4 Production with Two Variables
5.5 Returns to Scale
5.6 Summary
5.7 Key Terms
5.0 Introduction
The present unit will focus on the supply side of the market. It explains the decision
making process of the producers of the goods and services. A firm needs to decide
about the optimal combination of different factors of production to produce a level of
output. Moreover, it also requires information about the alterative combinations in face
of the changing demand conditions. For instance, a company like Maruti Suzuki while
establishing a new plant needs to decide the number of assembly line machines that
should be installed along with the number of labors to be employed. Interestingly, this
decision requires data on demand forecast that has been discussed in the previous chapter.
In case of increase in demand a company needs to decide if a new plant should be set
up to cater to increase in the demand or use the existing plant capacity. The production
theory addresses these issues and provides answer to the firm for efficient decision
making. The production theory covers the technological aspects of the production where
as the cost theory (to be covered in next chapter) deals with monetary side of the firm.
Moreover, while considering the production aspects we will implicitly assume that the
prices of different factors of production are given that a firm takes as such while making
choices. A single firm does not influence the prices of the factors of production.
The analysis of production for a firm and its decision making process is analogous
to that of a consumer. Recall that a consumer first uses a utility function for identifying
the tastes and preferences and derive an indifference curve. Then a budget line that
represents the prices of the different goods and income of the consumer is used to
decide about the optimal combination of the goods to be purchased such that utility is Economics for
maximized. Similarly, a producer uses a production function that helps in deriving Managers : 63
Economics of Production different combination of inputs that can produce a given level of output. Akin to budget
line, a producer uses an isocost line, that is based on the prices of the inputs and total
expenditure of the producer. Using a production function and isocost line a producer
NOTES decide about the combination of factors of production that is employed to produce
output such that production is optimized. As earlier, where the utility maximization
that is equivalent to expenditure minimization, production optimization and cost
minimization yield same results. There is a difference as well between consumer and
producer analysis. A utility function is subjective as utility cannot be computed where
as production function is objective that leads to measurable level of output.
The present unit is organized as follows: Section 5.2 explains some basic concepts
related to production theory. Section 5.3 deals with production with one variable and
there we will see how the law of diminishing marginal product works. This is also
referred to as short-run analysis. This will be followed by introducing complexity in terms
of two factors of production in Section 5.4 and carrying the analysis for long-run.
5.1 Unit Objectives

* To explain some basic concepts related to production theory.
* To study production with one variable factor of production and law of
diminishing marginal product.
* To learn returns to scale.
5.2 Basic Concepts
Factors of Production
Production is a process carried out by a firm to obtain final goods. It involves
transformation of inputs into output. The process involves factors of production namely
land, labor, raw material and capital to produce the final product. Broadly, there are
many factors that help in the transformation process like man-hours, machines, tools,
equipments, material, capital, electricity and fuel etc. For instance, in a clothes making
unit, cloth and buttons are the raw material, sewing machines, tables, chairs and other
equipments are part of capital and workers use raw material and equipments to produce
shirts, pants and dresses. Analogy can be made for a cafe as well that is in the service
sector where breads, food items, coffee powder, milk are the raw material, coffee making
machines, oven, tables, chairs are the capital and chefs and waiters are part of the labor.
A brief discussion on major factors of production follows:
Land: In general, land refers to surface of land. In production theory, it refers to

Economics for all natural resources including land, timber, fisheries, farms and other similar items.
Managers : 64 This factor of production is often seen as a passive or a fixed economic resource.
Labor: It includes physical efforts needed for using the raw materials, machines Economics of Production
and other equipments for the transformation of input into output. Labor is seen as an
active factor of production because it moves or shift according to the opportunities
available within an economy as well as across countries. Workers are usually NOTES
compensated for their services through wages.
Raw Materials: It includes steel, plastic, electricity, water, cotton or other material
that may be required to produce final goods. Note that final good of a firm can be raw-
material for another. For example iron-ore may be used in steel plant and steel is raw
material for various other firms. Wheat may be used a raw-material to produce flour
that is a raw-material for a bakery.
Capital: Capital refers to long-term investment of a firm in the production process.

Monetary capital represents the money companies use to purchase physical assets or
pay workers for their labor. Capital also includes buildings, production facilities,
equipments, technology and other tangible items. Capital is also seen as an active
resource because it shifts to meet the needs of individuals and businesses in an economy.
Entrepreneurship is sometimes considered as a factor of production as individuals

usually have ideas and attempt to make economic profit from their ideas using other
factors of production. Entrepreneurs often have knowledge and education that help
them gather, transform and produce products for individuals or businesses to use in
their daily lives or operations. The entrepreneur also carries most if not all risks associated
with turning his idea into a lucrative business.
The factors of production are not homogenous or same within the firm as well as
across firms. For instance, with in a firm one may find employment of both skilled
(engineers) and unskilled labor. A wine maker may have a vineyard where she may not
get the same quality of grapes depending upon the extent of sunlight received at different
points. It is very difficult to begin the analysis of production by considering such
variations. Thus, in order to simplify, the theory of production assumes homogeneity
of factors of production.
A fixed input is defined as one whose quantity cannot be changed when the market
conditions indicate that the output quantity changes are desirable. Inputs like building,
machinery, managers are example of fixed inputs that cannot be swiftly increased or
decreased. A variable input is one whose quantity can be altered as per the market
requirements for the final good. Labor, raw materials are examples of variable inputs.
Corresponding to the distinction of fixed and variable input there is another distinction
of short-run and long-run. The short-run refers to a time period when the supply of
some of the factors is fixed and cannot be changed. Note that short-run not necessarily
means 1 or 2 years. It is associated with the flexibility to change the factors of production.
If the flexibility to alter the inputs is limited then a producer is operating in short-run.
The long-run is simply that time period in which all inputs are variable. The long-run is Economics for
therefore like a future planning phase when an entrepreneur can attain output by Managers : 65
Economics of Production combining inputs in the most efficient manner. For example, in case of a sudden increase
in the demand during short-run an entrepreneur can merely make labor work overtime
and/or operates the plant overtime. However, in the long-run larger or additional
NOTES production capacity can be installed. The duration of short vs. long may vary for different
industries as in some industries like capital goods, shipping, power generation, short
term may be 3-4 yrs. (as it takes around 3-4 yrs to expand the scale of operation) but in
other industries like banking, retail short-run may be that of 3-4 months (as scale of
operation can be expanded in that period).
Production Function
Production function is a mathematical expression of functional relationship
between physical inputs and output of a firm. A production function states the highest
output (q) that can be obtained from different combinations of inputs. A production
function can be shown as a table, a graph or as an equation. Algebraically, it can be
written as
q = F (L, K) (I)
The equation I gives the relationship between inputs labor (L) and capital (K) and
the resulting output (q). It helps us in knowing what maximum amount of output can be
produced from different combination of inputs during a certain period with available
technology. For example it may explain the number of breads that may be baked using
20 ovens and 10 labors in a bakery. It may also describe the quintal of wheat produced
on a 10 acre of land by a farmer using a tractor. Note that in the present case we have
only used two factors of production to simplify the analysis. The equation can be
extended for n inputs that may include different equipments, raw materials, fuel and
electricity. For advance and mathematical discussion on production function refer the
appendix.
In studying the input output relationship in a production function, the technology

utilized is considered to be constant and given for a firm. This implies that at a point of
time a production function assumes the given state of technology. Note that technology
Check Your Progress
is the technical information regarding the input combinations for producing output. It
1. What are different
includes all physical possibilities. A production function assumes technical efficiency
factors of production?
and state the maximum output possible from different input combinations. The
Explain in detail.
technology advances in future and in all likelihood a same level of inputs may give
2. Explain the concept of
more output. In such a case, new production function is considered based on the new
production function.
technology. Moreover, a production function describe technically feasible outcome
Why is it useful in the
when a firm operates efficiently without wasting any resources.
analysis of firms
behaviour? The production function analysis can be divided into short-run and long-run.
While analyzing the production function in the short-run, quantity of only one factor is
varied (L) and the quantity of other input (K) is kept constant.
Economics for
Managers : 66
5.3 Production with One Variable
We begin the production analysis with one factor of production as variable and
NOTES
another as fixed. Thus, we are dealing with short-run. Take for instance, a farmer who
decides to sow wheat on a land plot of 10 acres. Table 5.1 gives the total output produced
as the number of labor increases on the same plot. Using this data we will learn about
three very important concepts related to production.
Table 5.1: Total Product of Wheat on 10 Acres of Given Land with Varying
Labor
Land Labor Total Product
1 0 0
1 1 10
1 2 24
1 3 39
1 4 52
1 5 61
1 6 66
1 7 66
1 8 64
Total Product: It is the quantity of total output (TP) produced with the help of
given inputs. In the present case, one input is held constant (land) and different level of
labor hours is employed on the same pieces of land. Table 5.1 gives the total output that
is produced for different levels of labor. The hypothetical data given in Table 5.1 is
further depicted as a TP curve in Figure 5.1. In that figure output is plotted on Y axis
and labor on X axis. It is evident that as we keep on increasing the variable factor over
the fixed factor, initially the output increases rapidly followed by slow increases and it
reaches a maximum following that TP begins to decline. Initially, when one farmer was
working on a same plot of land he could only plow limited land and has less output.
However, as the number of laborer employed increases the work is divided and the
output increases. However, this increase is likely to be enjoyed only up to a particular
point. As the number of people increases they will come into each others way and may
be counterproductive reducing TP. This is referred to as law of diminishing marginal
returns. We will return to this concept later and will discuss it in detail.
Average Product: Average product (AP) is the product per unit of variable factor Economics for
Managers : 67
Economics of Production input, keeping the amount of fixed factor constant. In other words, it is the TP (q)
divided by amount of labor employed with a given quantity of capital used to produce
a commodity (Table 5.2). /L where AP is average product and q is total product
NOTES and L is units of labor employed. AP curve is shown in Figure 5.2 below the TP curve.
AP curves initially increases and then begins to decline after attaining the peak at 13
related to TP of 52 units. AP curve as shown in figure is inverted U shape.
Marginal Product: Marginal product (MP) refers to the addition made to the TP
by using one more unit of variable factor input (labor) keeping the level of fixed input
constant (Table 5.2). It is the change in TP due to change in the variable factor by one
unit. It is also mentioned as incremental output. For example when labor increase from
3 to 4 the total product raises from 39 to 52 and increase in the total output is 13 (52-39)
units. Marginal output is written as where is the change in output and is
the change in labor. MP curves initially increases and then begins to decline following
after attaining the peak at 15 associated with TP of 39 units. MP curve as shown in
figure is inverted U shape
Table5.2: Average and Marginal Output of Wheat on 10 Acres of Given Land

with Varying Labor
Land Labor Total Product Average Product Marginal Product Output Elasticity
1 0 0 0
1 1 10 10 10 1
1 2 24 12 14 1.17
1 3 39 13 15 1.15
1 4 52 13 13 1
1 5 61 12.2 9 0.74
1 6 66 11 5 0.45
1 7 66 9.4 0 0
1 8 64 8 -2 -0.25
Economics for
Managers : 68
Output / NOTES
Total
product
Labour
Figure 5.2: Average and Marginal Product CurvesLabor
Average and Marginal Product
AP
MP
Labour
Average Product - Marginal Product
Relationship between Total, Average and Marginal Product
There is an important relationship between total, average and marginal product

curves that is elicited through the slope of TP in Figure 5.1 and 5.2.
Total Product and Average Product: AP is equal to the slope of line drawn on TP
curve from the origin at a point. For example, AP for 2 workers is 12 (calculated as 24/
2) i.e. the slope of the line drawn from origin at point 24 on TP curve.
Total Product and Marginal Product: MP of labor is calculated as the slope of TP

curve at a point. For example for labor 1 it is calculated as the slope of line draw
Economics for
tangential at point 10 on total product curve. The TP curve is increasing till 7 units of
Managers : 69
Economics of Production labor are employed and begins to decline afterward. Initially the MP of labor is rising
and as the result TP curve is also increasing at faster rate. After labor unit of 3 is
employed MP begins to decline and consequently TP curve rises at the slower rate.
NOTES Since, MP is still positive TP is increasing albeit at slower rate. The lower panel shows
that the MP is negative for 8th unit of labor then TP begins to decline. Note that when
AP is equal to MP for unit 4 the slope of line drawn from origin is equivalent to tangent
drawn at the same point.
Average Product and Marginal Product: There is an interesting relationship

between AP and MP. In order to understand that remember that MP represents the
addition made to TP and AP is per unit output. Note that when MP is larger than AP in
Table 5.2 and accordingly MP curve is higher than the AP curve in Figure 5.2, then AP
curve is rising. This is because the addition made to TP is large than per unit output, in
the next level average product increases. Thus, for labor up to 3 units, increments due
to one more labor is greater than the AP and it is rising. In such a case, adding one more
labor is increasing the TP and therefore per unit output is increasing. Using the similar
logic one can deduce that when MP is less than AP, AP is declining. As labor increase
to 6 units, TP increases to 66 with AP of 11. In this case, MP has increased only by 5
units (less than AP) and therefore AP declines.
Output Elasticity
Output elasticity of a factor of production shows the percentage change in the
output due to the percentage change in the factor of production. It is the responsiveness
of the output to change in the inputs. For instance, in the earlier example output elasticity
of labor can be calculated as.
EL = Percentage change in output/Percentage change in labor
EL =
Rewriting the above equation we can find that:
EL = MPL/APL
The above equation shows that the ratio of MP to AP shows the proportional
change that is expected in output due to a percentage change in labor. The last column
of Table 5.1 shows the output elasticity. EL > 1 shows that output changes more than
proportionally as compare to input, EL = 1 reflects that the proportional change in the
output is same and EL < 1 shows that output changes less than proportionally in response
to change in labor.
The Law of Diminishing Marginal Returns

The law states that if there is an increase in the use of an input keeping the other
input as constant a point will be reached when the addition of the input will result in the
decline of output. It implies that if we keep on increasing variable factors over the
Economics for
fixed factors, initially we get very high returns but gradually returns per variable factor
Managers : 70
start declining. In other words, total product initially increases at increasing rate (due Economics of Production
to increase in marginal product i.e. - every additional variable factor adds more and
more to the total product) gradually total product starts increasing at decreasing rate
(due to fall in marginal product every additional variable factor adds less and less to NOTES
the total product). After a certain point, marginal product becomes negative i.e. instead
of adding to the total product, every additional variable factor with the same fixed
factor starts hampering the production of the factor combination and total product starts
declining.
The law of diminishing returns is also called as a law of variable proportions and
it holds well under the following assumptions: (i) Short-run: The law assumes short-
run situation. The time is too short for a firm to change the quantity of fixed factors and
all the resources apart from the variable are unchanged. (ii) Constant technology: The
law assumes that the technique of production remains unchanged during production.
(iii) Homogeneous factors: Each factor unit is assumed to be identical in amount and
quality as discussed earlier.
The law of variable proportions has vast significance. For instance: it is helpful in
understanding clearly the process of production. It explains the input output relationship.
One can find out by-how much the total product will increase as a result of an increase
in the inputs. The law tells us that the tendency of diminishing returns is found in all
sectors of the economy which may be agriculture or industry.
In an earlier example and figure, the law of variable proportions explained where
it is assumed that a farmer has only 10 acres of land for cultivation. The investment on
it in the form of tube wells, machinery (capital) is fixed. Thus land and capital with the
farmer is fixed and labor is the variable resource. There are three phases or stages of
production, as determined by the law of diminishing marginal returns. These three
stages are explained given the earlier Table 5.5 and Figures 5.1 and 5.2.
Stage I: As the farmer increases units of labor from 1-3, to the amount of other
fixed resources TP, AP and MP increase. This is stage I.
Stage II: The point where TP starts increasing at decreasing rate, MP is at its
maximum point and later it begins to fall. In the Table 5.2, stage II ranges from labor 3-
7. The point at which MP is at its maximum and then it begins to decline is called point
of inflexion. The point of inflexion is at labor unit of 3 with TP of 39.
Stage III: After the employment of 7th worker, if more labor is employed MP
becomes negative due to which total product begins to fall. This is the third stage of
production.
The first phase of increasing TP, AP and MP starts when the quantity of a fixed
factor is abundant relative to the quantity of the variable factor. As more units of the
variable factor are added to the constant quantity of the fixed factor, it increases more
Economics for
intensively. This causes the production to increase at a rapid rate. Another reason is
Managers : 71
Economics of Production that the fixed factor initially taken is indivisible. As more units of the variable factor
are employed to work on it, output increases greatly due to fuller and effective utilization
of the variable factor. Stage II occurs when the fixed factor becomes inadequate relative
NOTES to the quantity of the variable factor. And the fixed indivisible factor is being over-
worked. Thus, as more units of a variable factor are employed, MP and AP decline.
Stage III starts when the variable factor is used excessively in relation to the fixed
factor. A producer cannot operate in this stage because total production declines with
the employment of additional labor. A rational producer always seeks to produce in
Stage II where average and marginal product of the variable factor are diminishing.
While doing production in Stage I, fixed resources are underutilized and in Stage III
variable factors are over employed, so ideal stage is second phase where optimum
combination of fixed and variable factor is reached. At this particular point, the
producers decision to produce depends upon the price of the factors of production.
The producer will employ the variable factor (say labor) up to the point where MP of
the labor equals the given wage rate in the labor market.
The law of diminishing returns provides an explanation for the Malthusian Theory
of Population. Thomas Malthus (1766-1834) was a political economist who believed
that world is headed for great draught as with the limited land, increase in the labor for
food production may reduce the average and marginal labor productivity3. He argued
that food output was likely to increase in a series of twenty-five year intervals in the
arithmetic progression. On the other hand, population was capable of increasing in the
geometric progression. As population increases, high pressure on land without any
improvement in technology decreases marginal productivity. This doomsday prediction,
however, did not come true. The explanation for the same is the technical improvement
over a period of note. Remember that total product curve is constructed for a given
Check Your Progress level of technology. In terms of total product curve, technical change would imply that
there is a shift in the curve as shown in Figure 5.3, where T0, T1 and T2 are drawn for
between marginal
different technological levels.
product and average
product of labour (or a )LJ7RWDO3URGXFWFXUYHDQG7HFKQLFDOFKDQJH
variable input)?
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diminishing returns.
Why does diminishing
T1
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input occur eventually? T0

Can they become
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Economics for
Managers : 72 /DERU
In case of improvement in technology, output from the same level of labor will Economics of Production
increase. For example the same unit of labor (4) with a given capital produces 4 units
of output if technology is given with total product curve T1. In case of technical change
total product curve shifts upward to T2 and 4 units of labor can produce approximately NOTES
5 units of output. Clearly, labor producttivity has increased as new technology is
introduced.
Review of Key Concepts

Production Process : A process through which a firm transforms inputs into
output.
Factors of Production : Various inputs that go into the production process

(land, labor, and capital).
Production Function : A function that states the highest output that can be
obtained from different combinations of inputs.
Total Product : It is the quantity of total output produced with the help of
given inputs.
Average Product : It is the product per unit of variable factor input, keeping
the amount of fixed factor constant.
Marginal Product : It is the addition made to the total product by using one
more unit of variable factor input (labor) keeping the level of fixed input as constant.
The Law of Diminishing Marginal Returns : The law states that if there is
an increase in the use of an input keeping the other input as constant a point will be
reached when the addition of the input will result in the decline of output.
All terms in brackets should be bold.
5.4 Production with Two Variables
The analysis so far assumes that all factors of production are not variable and a
few remain fixed during the short duration. Over a period of time, however, it is possible
to alter, plan and decide about the amount of various factors of production that can be
employed. This decision making process involves understanding the production
techniques and output that can be produced using different combinations of the factors
of production. This section will elaborate on the concept and laws involved in long-run
production when all factors of production are variable. Firstly, we will derive the
isoquants and then discuss the returns to scale.
Isoquants
In a simple case of two factors of production namely labor and capital a producer Economics for
can use different combinations of both to produce output. Table 5.3 shows different Managers : 73
Economics of Production combinations of labor and capital along with the output level. As evident from the
table, it is possible that the same level of output can be obtained by having different
combinations of two inputs. See for instance, output level of 75 that can be produced
NOTES using 3L and 2K, 2L and 3K, and 1L and 5K.
Table 5.3: Output Produced by Different Combinations of Labor and Capital
Labor
Capital 1 2 3 4 5
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120
For the output level of 75 note that as we decrease the number of workers employed,
the capital used is increasing. Therefore, an increase in one factor of production is
followed by a decrease in the other to maintain the output level same. In such a case,
capital substitutes some portion of labor and the same level of output is produced. In
the table you may find that there are different combinations that will give same level of
output. Find different combinations for output level 65.
The same information is given in graphical form in Figure 5.4. Note points J (3
units of capital and 1 unit of labor) and M (3 units of labor and 1 unit of capital). Both
yield output equivalent to 55. If we join these points we get a curve Q1. It is an isoquant.
Formally, an isoquant is a locus of different combinations of inputs that produce same
level of output. It is a curve that shows the different combinations of factors of production
such that each combination gives the same level of output. Figure 5.4 shows an isoquant
map as it has three isoquants Q1, Q2, and Q3 each of which shows output levels of 55,
75 and 90 respectively. Evidently, as we move higher on the isoquant map the level of
output increases. However, note that a single isoquant will represent a single level of
output and will show different combinations of labor and capital that will produce a
given output. Note that as we move from point J to K to L even though capital unit
remain same output keeps on increasing. This is so because we are increasing the level
of labor employed at each combination. Therefore, if the level of output has to be kept
same on an isoquant one has to decrease the level of one input and increases that of
another.
Economics for
Managers : 74
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NOTES

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One can use a production function as well and get the resulting isoquant from the
same. The most commonly employed production function in economics is Cobb-Douglas
Production Function (CDPF). This production function was developed by two American
economists C.W. Cobb and Paul H. Douglas who studied the American manufacturing
industry for 4 yrs and propounded a function as follow:
q = A La Kb
Take log on both sides
Log q = A + a Log L + b Log K
where q = Output; A = constant; K = capital; L = labor
Suppose A = 50, a = 0.5, b = 0.5
Then q= 50 L0.5K0.5
By putting different values of labor and capital we can have different amount of
q. These levels are shown in Table 5.4. Table 5.4 shows, if we have 10 units of labor
and capital each, then we can have 100 different combinations of these to have hundred
different output levels. Similarly, these can be plotted on a graph and get resulting
isoquants as given in the table below. Note the output level highlighted in the table. If
you will join the points with 158 output level, you can see the isoquant formed. Try for
output levels of 212, 274 and 424.
CDPF has significant contribution in empirical research. This function is used to

calculate various production related aspect of a firm by economist. After taking data on
output, labor and capital, the logarithmic form of the function can be estimated to get Economics for
Managers : 75
Economics of Production the coefficients a and b. These coefficients are very important and are used extensively
in economic studies of production. We will discuss their interpretation later in the text.
Table 5.4: Level of q from CDPF with Different Levels of Labor and Capital
NOTES
K
10 158 224 274 316 354 387 418 447 474 500
9 150 212 260 300 335 367 397 424 450 474
8 141 200 245 283 316 346 374 400 424 447
7 132 187 229 264 296 324 350 374 397 418
6 122 173 212 245 274 300 324 346 367 387
5 112 158 194 224 250 274 296 316 335 354
4 100 141 173 200 224 245 264 283 300 316
3 87 122 150 173 194 212 229 245 260 274
2 71 100 122 141 158 173 187 200 212 224
1 50 71 87 100 112 122 132 141 150 158
L 1 2 3 4 5 6 7 8 9 10
Isoquants are constructed using some assumptions that are given as follows: (i)
There are only two factors labor (L) and capital (K) to produce a commodity X. (ii)
Both L and K and product X are completely divisible. (iii) Two inputs L & K are
substitute of each other but at diminishing rate. (iv) Technology of production is constant.
An isoquant curve has following properties: (i) Isoquant curve is downward sloping
showing substitution of two factor inputs. If one factor is being decreased, other factor
has to be increased to keep the output constant. (ii) It is convex to the origin due to
diminishing marginal rate of technical substitution. It says that in case of imperfect
substitutions, in order to add one factor, other factor has to be reduced but not in the
same proportion. And the rate of substitutions goes on diminishing with every subsequent
substitution. This aspect is discussed in detail later in the chapter. (iii) No two isoquant
curve can intersect each other. Consider the Figure 5.5 where isoquant Q1 and Q2
intersect each other at point A. Now consider point B and C, both points have same
level of capital OK1, however, C has more of labor by L1L2. Consider now the basic
definition of isoquant that states that all the points on an isoquant give same level of
output. Accordingly, output at B = A and A = C, therefore output given by B should be
equal to C. This is a contradiction as C has more of labor and same level of capital as
B. Therefore, two isoquants cannot intersect each other. (iv) Higher isoquant curve
Economics for
represents higher output.
Managers : 76
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Marginal Rate of Technical Substitution

In Figure 5.6 as we move from point A to B to C to D on the same curve you may
find that the level of capital employed is decreasing but that of labor is increasing. As
we move from point A to B, almost 2 units of capital are substituted by 1 unit of labor
and the level of output remains same at 75. This rate is called as marginal rate of
technical substitution (MRTS). MRTS of labor for capital is defined as the number of
units of capital that can be replaced by one unit of labor so that the level of output
remained unchanged. It is calculated as that is change in capital divided by
change in labor. It has a negative sign as we are reducing one variable, in the earlier
case it was capital. Note that MRTS of capital for labor would be reverse of MRTS of
labor for capital. MRTS is defined for a given level of output for two factors of
production.
MRTS depicts the substitution flexibility available with a manager while deciding
about the resource allocation for a given task. Consider a situation where a firm has
plant in two different countries with similar demand. Assume that these two countries
have different resource availability. For instance, a country A has relatively more
availability of labor and less of capital where as country B has relatively more availability
of capital. A manger who wishes to employ labor and capital may choose to produce
output 75 with 5L and 1K in country A and her counterpart in country B may choose 1L
and 5K for same level of output. Please note the decision choice here is independent of
cost considerations. It is purely technical and the use of isoquant implies that there is a
possibility of substitution between inputs. This is not something uncommon as you
may find that self-service restaurants are more popular in developed countries. So a
curve like isoquant shows the flexibility a manager may enjoy in terms of employing
different factors of production.
It is possible to decipher the degree of substitution based on the shape of the

isoquant. If the curvature of the isoquant is small, it implies that it is easy to substitute
one input by another. On the other hand, if the curvature is large, it is difficult to Economics for
substitute one input for another. Managers : 77
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Diminishing MRTS
The figure shows that as we move from point A to B to C to D, the amount of
capital that is given up for the same level of labor is declining. In movement from A to
B, you see 2 units of capital are substituted by 1 unit of labor. Further, the movement
from B to C involves giving up only 1 unit of capital for same and later less than 1
when there is a movement from C to D. This decline in the rate at which capital is
substituted by labor is referred to as diminishing MRTS.
The declining MRTS shows that for the production a balanced mix of inputs is
required. As we employ more and more of an input in the above case labor instead of
capital the productivity of labor is declining. In that case, producer will be willing to
give up less of capital for the same level of addition of the labor. The same would apply
that in case producer is giving up labor that would be referred to MRTS of capital for
labor. In the same example as we move from D to C to B to A, note that initial one level
of labor can be substituted by half a unit of capital. However, at later stage as now
capital is becoming less productive for the same addition of labor we may need more
capital.
Table 5.5: Calculation of Marginal Rate of Technical Substitution
MRTS of labor for capital = K/L MRTS of capital for labor = L/K
A-B -2/1 = -2 D-C -1/0.5 = -2
B-C -1/1 = -1 C-B -1/1 = -1
C-D -0.5/1= -.05 B-A -1/2= -.05
Note that while determining that the MRTS is declining we will be ignoring the
minus sign. There is an interesting result that shows that MRTS between two inputs is
equivalent to the ratio of their marginal products. In case, if we decrease capital then
Economics for the resulting fall in output will be measured by using marginal product of capital and
change in capital (MPK X K) and similarly the increase in the output due to rise in
Managers : 78
labor should be measured by using marginal product of labor and change in labor Economics of Production
(MPL X L). Therefore, to calculate MRTS of labor for capital, we must consider both
of these values. From the definition of isoquant, we know that output remain same if
one input is increased at the expense of other. This would mean as we move from the NOTES
point A-B the sum of change in output due to reduction in capital plus change in output
due to increase in labor is equal to zero. This is written as:
(MPK X K) + (MPL X L) = 0 (I)
Taking (MPK X K) to the left and rearranging the terms we get the result:
(MPL)/(MPK) = -(K/L) = MRTS of labor for capital (II)
This equation shows that that the MRTS of labor for capital is equal to the ratio of
MP of labor and capital. This is an important result that is used later.
Special Cases of Isoquants

For some special production functions we may get special types of isoquants.
Two of these are (i) isoquant in case of fixed proportion production function given in
Figure 5.7 (A) and (ii) isoquants when inputs are perfect substitutes given in Figure 5.7
(B).
L-shaped isoquants
Fixed proportion production function implies that in order to produce a particular
level of output both labor and capital is required in fixed proportion. The two inputs are
perfect complement to each other. For instance, in order to produce a dosa a chef may
need pulses and rice in a fixed proportion. The ratio cannot change and if there is Check Your Progress
increase in the quantity of dosas to be made chef must increase both the ingredients in 5. What are isoquants?
the same ratio. It is not possible to substitute one input by another and both are required Why does an isoquant
in fixed proportion. This type of production function is named after famous economist slopes downward?
and is called Leonitief production function. The shape of isoquant that represent this Why are they convex
type of production function is L shaped as depicted in the Figure 5.7 (A). Note that as to origin?
we move on to higher isoquant the level of output increases but the inputs are used in 6. What is meant by
fixed proportion OL1 of labor and OK1 of capital. Moreover, if you are operating at Q1 Marginal Rate of
any increase in capital from OK1 will not increase the output. It implies MPK along the Technical Substitution
vertical line is zero and similarly MPL along the horizontal line is zero. In fact the (MRTS) between
production is possible only at A, B or C. The proportion in which both labor and capital factors?
is employed could be 2:1, 1:2 or any other ratio depending upon the technology. Some
examples of perfect complementary inputs include four wheels and frame of the car,
engine and body of the car, and chemicals required to be combined in a fixed ratio.
Isoquants with perfect substitution of inputs

A straight line isoquant as depicted in the Figure 5.7 (B) is a case when each
input is a perfect substitute of each other. In this case, labor can perfectly substitute
Economics for
capital or vice versa and rate of substitution remains same at all points on an isoquant.
Managers : 79
Economics of Production This isoquant shows that output can be produced by using only capital or labor as well
as with a combination of both. For example, in the figure output level Q1 can be produced
either by employing OL1 labor or OC1 capital or any combination of the same. For
NOTES example, a small entrepreneur can produce a musical instrument like flute using either
2 hours of labor or 1 machine-hour. MPK and MPL changes as we move along the line
as we are changing the level of capital and labor. So if we are move lower on an
isoquant MPL declines as less capital is used and MPK increases as more labor is employed.
However, along the entire isoquant MRTS of labor for capital remains constant.
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5.5 Returns to Scale
The production theory so far discusses the substitutability of factors of production

to produce a given level of output. A firm in long-run can increase the scale of operation,
that is increase the factors of production in proportion. For instance, double both labor
and capital. A manager in such a case is interested in knowing about the resulting
impact on the output as factors of production increase by same proportion. Returns to
scale is the concept that is used to explain the impact on total product when both the
inputs are increased in same proportion. That is to say, if we increase labor and capital
by same proportion then the resulting impact is measured by returns to scale. It is
possible that the total output may increase, remain same or decrease. The change is
accordingly named as increasing returns to scale, constant returns to scale, and decreasing
returns to scale. It is possible that with a same production function initial increase in
inputs may lead to increasing returns, followed by constant returns and then decreasing
returns. In case of Cobb-Douglas production function returns to scale are measured by
the sum of a and b. If the sum is > 1, the production function is said to be having
increasing returns to scale, if it = 1 then constant returns to scale and < 1 is a case of
decreasing returns to scale.
Increasing Returns to Scale: Increasing returns to scale means that the output
increases in greater proportion than the increase in input i.e. if all inputs are increased
by 50%, output may increase by more than 50%. Figure 5.8 (A) depicts increasing
Economics for
returns to scale using isoquants. Notice that the isoquants are placed closer to each as
Managers : 80
the output increase more than proportional increase in the inputs. The reasons for Economics of Production
increasing returns to scale are given below.
1. Indivisibility of the factors: There are some state of the art machineries or
other factors which can be utilized in large scale with utmost efficiency. NOTES
Thus, when scale of production increases from small to large, these machines
are better utilised and results in increasing returns.
2. Specialisation of labour and machineries: The returns to scale also increases

because of greater possibilities of specialisation of labour and machineries.
For instance, the owner of a shirt making unit employs 5 people. There are
two possibilities in term of division of labor, (i) each one is producing a
single shirt and, (ii) each one is performing a single task like cutting the
cloth, sewing the shirt, putting the collar, putting the buttons and packaging.
In scenario (ii) the number of shirts that will be produced is likely to be more
as each one is specializing in a single task. Therefore, as the owner increases
both labor and capital the possibility of such divisions of labor increases and
accordingly with the specialization output is likely to increase more than
proportionally.
Constant Returns to Scale: When all factors of production are increased and the
output increases in the same proportion, then the returns to scale obtained are called
constant (Figure 5.8 (B)).
Decreasing Returns to Scale: If we increase all inputs in a proportion and output

increases in the smaller proportion than increase in all inputs, returns to scale is said to
be decreasing. These are given in Figure 5.8 (C). The decreasing returns to scale
eventually occur because of increasing difficulty of management, coordination and
control. When the firm has expanded to too gigantic size, it is difficult to manage it
with the same efficiency as previously.
It is noteworthy that returns to scale may not be same across all the production
level. In the initial stage beginning with a low level of output, doubling the inputs may
increase the output more than double. However, as the level of output increases at the
later stage doubling the inputs lead to less than twice increase in the output. Please note
decreasing returns does not imply that output begins to decline as there is an increase in
inputs. In fact, it is increasing; it is the proportion in which the output increase is
relatively less than proportion by which inputs are increased.
The returns to scale are depicted graphically in the Figure 5.8. The line in the
Figure 5.8 (A) depicts increasing returns to scale and in such a case isoqunats are
places near to each other and you may find that increase in inputs from (5,2) combination
to (10,4) leads to increase in output from 10 to 30. In case of decreasing returns the
output increases to 15 only. Economics for
Managers : 81
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5.6 Summary
Production involves transformation of inputs into output. The production process

involves factors of production namely land, labor, raw material and capital to produce
the final product. Production function is a mathematical expression of functional
relationship between physical inputs and output of a firm. Total product is the quantity
of total output produced with the help of given inputs. Average product is the output
per unit of variable factor input, keeping the amount of fixed factor constant. Marginal
product is the addition made to the total product by using one more unit of variable
factor input (labor) keeping the level of fixed input as constant. Law of diminishing
marginal returns states that if there is an increase in the use of an input keeping the
other input as constant a point will be reached when the addition of the input will
result in the decline of output. In the long-run all factors of production are variable. In
that case returns to scale explains the rate at which total product changes when the
inputs are increased in the same proportion. An increasing return to scale impliesthat
output increases in greater proportion than the increase in all the inputs. A decreasing
return to scale impliesthat output increases in smaller proportion than the proportional
increase in all the inputs. A constant return to scale implies that output increases in the
same proportion as the increase in all the inputs.
5.7 Key Terms
Isoquant: A curve that shows different combinations of factors of production such

that each combination gives the same level of output.
Marginal Rate of Technical Substitution of Labor for Capital: The amount by

which the quantity of capital is reduced when an extra unit of labor is
employed such that the output remains same.
Economics for Marginal Rate of Technical Substitution of Capital for Labor: The amount by
Managers : 82 which the quantity of labor is reduced when an extra unit of capital is
employed such that the output remains same. Economics of Production
Returns to Scale: Explains the rate at which total product changes when the inputs
are increased in the same proportion.
NOTES
Increasing Returns to Scale: Implies that output increases in greater proportion
than the increase in all the inputs.
Decreasing Returns to Scale: Implies that output increases in smaller proportion

than the proportional increase in all the inputs.
Constant Returns to Scale: Implies that output increases in the same proportion as
the increase in all the inputs.
Questions
1. What is a production function? What is the difference between short-run and
long-run production function.
2. A bakery operating in the short-run has found that when the level of employment
in its baking room was increased from 4 to 10, in increments of one, its
corresponding levels of production of bread were 110, 115, 122, 127, 130, 132,
and 133.
a. Calculate the marginal product of labor.
b. Explain whether this production function exhibits diminishing marginal

productivity of labor.
3. Explain why the marginal rate of substitution is likely to diminish in short-run as

more of labor is employed for a given capital.
4. Can a firm have a production function that exhibits increasing returns to scale,
constant returns to scale and diminishing returns to scale? Explain.
5. What criteria determine whether a factor of production is fixed or variable?
Economics for
Managers : 83
Economics of Production 6. Fill in the gaps in the table below:
Output Total Product Average Product Marginal Product
NOTES 0 0 - -
1 225
2 375
3 300
4 1140
5 225
6 225
7. Describe an isoquant curve, and an isoquant map?
8. Show that the MRTS of two inputs is equal to the ratio of their marginal products.
9. Draw an isoquant for the following conditions:
a. A firm finds that it can always trade two units of labor for one unit of capital.
b. A firm requires exactly 2 units of labor to operate on one capital equipment.

1. R. S. Pindyck and D. L. Rubinfeld. Microeconomics (7th Edition), Perason
2. Dominick Salvator, `Managerial Economics, Sixth Edition, Oxford, New
Delhi.
3. Craig H. Peterson, W. Cris Lewis and Sudhir K. Jain, `Managerial Econom-
ics, Fourth Edition, Pearson Education, New Delhi.
Economics for
Managers : 84
APPENDIX 5.1 Economics of Production
The Production function
q = f (x1, x2) - 5.1.1

NOTES
Where a firm utilises two variable inputs (x1, x2) in order to produce a single
output . It may also the one or move fixed inputs for production.
5.1 is a single valued production function. It is continious with continious first

and second order parllal daivatives.
In the present content, negative values are meaningless. therefore production

function in defined only for non negatives values of inputs & outputs.
In short run
q = f (x1, x20) - 5.1.2
Where x20 is fined such that q becomes function of x1 only.
q f (x1, x20)
Average product = ----- = ------------- - 5.1.3
x1 x1
dq
Marginal product = ----- = fx1 (x1, x20) - 5.1.4
dx1
M. P. is the partial derivative of q with respect to x1 that is a variable input. fx1

represent. first order derivative of q w.r.t. x1
Average product is equal to marginal product at its maximum.
from 5.1.3 we know

q
AP = ---------
x1
Maximum of AP would mean partial derivative w. r. t. x1 is put equal to zero.
dAP x1 fx1 (x1, x20) - f (x1, x20)

-------- = -------------------------------------- = 0
dx1 x1 2
This can be written as
fx1 (x1, x20) = f (x1, x20) - 5.1.5

-----------
x1
Using 5.1.3 and 5.1.4 we know that left hand turn is MP and right hand turn is
AD
MP = AP when AP is at its maximum.

Economics for
Managers : 85
Economics of Production APPENDIX 5.3
The output elasticity : As mentioned in the text. it refers to percentage change in
output due to % chage in input.
NOTES
d(in q) x1 dq MP
EL = ---------- = --------- X ------- = ---------
d(in x1) q1 dx1 AP
Example : for a given production function calculate AP, MP, MRTS = output
elarticity.
q = A x1 x2
q A x1 x2
AP of x1 = ------ --------------
x1 x1
q A x1 x2
AP of x2 = ------ --------------
x2 x2
dq1 q
MP of x2 = ------ = A x11 x2 --------
dx1 x1
dq1 q
MP of x2 = ------ = A x1 x21 --------
dx2 x1
AP of x1
Ex1 = --------------- =
AP of x1
MP of x2
Ex2 = --------------- =
AP of x1
x2
MRTS of x1 for x2 = ------ = Ratio of MP
x1
Economics for
Managers : 86
APPENDIX 5.4 Economics of Production
Marignal Rate of Technical substitution.
An isoquant is the locus of all combination of factors of production that yield a

NOTES
given level of output. For a particulars level of output the production function would
be :
q0 = f (x1 x2)
Now as we move from one point on an isoquant to another the total output remains
same. Therefore total differental of production function is
df (x1 x2) df (x1 x2)

dq = ---------- = dx1 + ------------------ dx2
dx1 dx2
Note that for an ----- dq = 0
fx1 dx2 + fx2 dx2 = 0
dx2 f1
= --------- = --------------
dx1 f2
MRTS between two inputs in equal to the ratio of marginal product of the inputs.
Economics for
Managers : 87
Cost Analysis
UNIT 6 COST ANALYSIS
NOTES Structure
6.0 Introduction
6.1 Unit Objectives
6.2 Basic Concepts
6.3 Short-Run Costs
6.4 Production with the Cost-Minimizing Inputs
6.5 Long-Run Costs
6.6 Learning Curve
6.7 Summary
6.8 Key Terms
6.0 Introduction
In the last chapter, we covered production related aspects for a firm in order to
understand supply side of the market. As mentioned earlier, production aspects were
presented without any reference to the cost. The focus was on the technical decision
making about the combination of the inputs to be employed for the production of output.
The cost of production is another important factor governing the supply of the goods.
Along with the production related aspects the cost factor enters into picture to decide
about the employment of various inputs in the production process. In terms of the
earlier example, Maruti will be able to obtain different combinations of labor and capital
to produce a given level of output. The manager will further use information about the
cost and the amount to be paid for labor and capital and accordingly determines the
combination that will produce the given output at the minimum possible cost. In terms
of products, company must look into what types of products it must produce (small
cars or sports utility vehicles). If it decides to produce two types of goods then an
important consideration is, whether both should be produced at a same plant or at
different plants.
The present chapter is organized as follows: Section 6.2 explains some basic
concepts related to cost theory. Section 6.3 deals with costs in short run that is followed
by the concept of least-cost combination of inputs in section 6.4 and cost analysis in
the long run in Section 6.4. Section 6.5 discusses learning curve that is part of the
Economics for recent developments in the cost theory.
Managers : 88
Cost Analysis
6.1 Unit Objectives

NOTES
* To explain basic concepts related to cost theory in the short-run and long-run.
* To learn about the economies of scale, economies of scope and learning curve.
6.2 Basic Concepts
In very general terms, cost is the price paid to gain something. In terms of factors
of production employed by a firm, wages, rent and rate of interest is the cost associated
with labor, land and capital respectively. Thus, while deciding about the expenditure
incurred, a manager looks into these costs and arrives at the total cost of the production.
In the entire discussion about the cost, there is an implicit assumption that the manager
takes the prices of different factors of production as given. It implies that for example,
in case of hiring contractual labor the manager may be governed by the minimum wage
in an economy. Similarly, for other factors of production, manager will take the market
rate given as well. It is probable for a manager to influence the price of different factors
of production by bulk buying. However, the theory of cost assumes that the factor
prices are determined in the factor market and accordingly the manager decides about
the cost of production.
The costs aspects of a firm are linked to the production technology of a firm.
Similar to production function discussion, producer also draws distinction between
short-run and long-run costs. Remember that the difference between the short- run and
long- run is based on if some factors of production can be changed or not. If it is not
possible to alter some inputs then a firm is said to be operating in the short-run whereas
a firm may vary all factors of production in long-run. Short-run costs are those costs
that are incurred when a firm cannot change the plant size. On the other hand, long
term costs are those costs that are incurred during a period which is sufficiently long
enough to allow the variation in all factors of production including capital equipment,
land and managerial staff.
Consider that a company owns the plot on which the manufacturing plant is
constructed, should the cost calculation include the rent of the plot? The answer to this
question leads to an important distinction between economic cost and accounting cost.
From accounting point, cost includes all monetary payments but from economics point
of view, cost has a wider meaning and includes monetary and non-monetary aspects.
Therefore, for calculating economic cost the firm will include the cost of the plot. The
key distinction is from an economists perspective; expenditure should include the cost
paid for using all the resources. It may appear bizarre, however, economists consider
the utilization of resources in the particular activity instead of merely looking at the Economics for
cost aspect. This distinction will become clear as we proceed. Managers : 89
Cost Analysis Accounting Cost
All kind of cash expenditure that is incurred is included in the accounting costs.
These are explicit expenditures which are expressed for the accounting purpose. A firm
NOTES pays wages to the laborers, rent for the building, price for raw material etc. All these
costs are considered by the accountant for accounting purpose and hence are accounting
cost. The view of accountants is retrospective as they look back and identify various
expenses made and accordingly calculate the cost of production. However, accountants
take future into consideration by using depreciation rate that is used to depreciate the
capital assets as these are used over a period of time and loose value. Accounting profit
is then calculated using accounting costs:
Accounting Profit = Total Revenue Total Costs (6.1)
Economic Cost
Economists not only consider accounting costs, but take into consideration costs
that are implicit (hidden costs). For example, economic cost of any investment option
is the actual cash expenditure required for that investment plus benefit of second best
alternative that has to be sacrificed. Continuing with the earlier example, if the firm
would have rented out the plot, the rent it would have earned will be part of the
expenditure. The view of economists is holistic as they identify that resources are scarce
and they can be put to alternative uses. They look into various avenues in which a
resource could be allocated and compute economic costs.
Economic costs = Accounting Cost + Implicit Cost (6.2)
Accordingly,
Economic Profit = Total Revenue Economic Costs (6.3)
It is evident from 6.1 and 6.3 that there will be distinction between accounting
and economic profits.
Opportunity Cost
Why economists consider implicit cost? As mentioned earlier, the key concern
for economist is the utilization of resources that are limited in availability and can be
put to various uses. For example, a piece of land can be used for constructing a building
or for agricultural purpose. There is a need to calculate the cost of resources in terms of
the opportunity forgone while it was put into particular use.
Opportunity cost of input is the next best alternative (choices) sacrificed or foregone
that could have been employed. For example a person has Rs. 1,00,000/- which he
can invest in purchase of either a printing machine or a photocopy machine. Expected
monthly earning from the printing machine is Rs 15,000/- and that from photocopy
machine is Rs 20,000/- If the person decides to invest money for the purchase of printing
Economics for machine then opportunity cost of that purchase is the earning from the photocopy
Managers : 90 machine that have been sacrificed. Consideration of opportunity cost makes difference
between the accounting and economic profit of firm. Consider the following example: Cost Analysis
Suppose a software engineer leaves his job in a software company and starts his
own software firm initially from his own garage with the help of his friend whom he
promises to pay 20,000 Rs. per month. The initial capital investment is of 60,000 Rs. NOTES
for buying computers. Other expenditures are electricity (1000 Rs.), internet (2000
Rs.) and miscellaneous (5000 Rs.) in a month. They made software in the first month
and sold it to company for Rs 1 lakh. Whether the software engineer made profit or
loss? The following table shows the calculations:
Accounting Cost Accounting Cost Economic Cost
Capital expenditure 60000 60000
Electricity 1000 1000
Internet charges 2000 2000
Miscellaneous 5000 5000
Salary to friends 20000 20000
Rent Nil 4000
Salary Nil 60000
Total Cost 88,000/- 1,54,000/-
Accounting Profit Economic Profit

Check Your Progress
12000 -52000
1. Distinguish between
Rent and salary are two components that are not included in the accounting costs economic costs and
but are part of the economic costs. These are implicit costs that are incurred by the accounting costs.
software engineer while running the unit. The rent is the amount that would have been Which should be taken
generated had he given the garage on rent to someone else and salary is the amount he into account for
would have earned in his earlier company. So these two resources that are used in the calculating economic
production are not taken into consideration in the accounting cost but are part of the profits of the firm?
economic costs. Accordingly, notice that though he earns accounting profits, as per the 2. What is the difference
economic costs calculation he makes a loss of 52000 Rs. The basis for calculating the between explicit and
implicit cost is to find out the amount generated by putting the resource to alternative implicit cost? Should
best use. both be considered for
optimal decision
making by the firm?
6.3 Short-Run Costs
In the short-run, when all the inputs are not variable, cost of production can be
divided into fixed and variable costs. Fixed costs are those that do not vary with output Economics for
where as variable costs are dependent on the level of output produced. In terms of fixed Managers : 91
Cost Analysis costs, typically, from a firms point of view fixed costs comprise of fixed expenses of
the plant of production like insurance, electricity and water charges, depreciation of
the fixed capital, salaries of administrative staff, and production staff paid on fixed
NOTES basis. Variable costs include contractual labor that changes with output, raw material
costs, fuel and running expenses of the machinery.
Interestingly, the classification into fixed and variable costs depends upon the
time duration that a firm is looking at while dividing these costs into different categories.
For instance, suppose an airline is planning to reduce costs over next six months. The
company has taken some planes on lease for running its operations for one year. Clearly,
the lease cost will be fixed and cannot be changed in six months. However, if the
company decides the time duration to be more than one year, they can clearly reconsider
the number of planes to take on lease after one year and plan cost minimization. As
discussed earlier, the duration will also vary with the type of industry. For instance, if
we keep the time duration fixed for software firm and oil producing company to one
year, clearly, the number of items in the fixed component will vary for both the firms.
In fact, for a software firm there are very less items in the fixed component apart from
the administrative salaries and rent. However, for an oil producing firm, all capital
equipments and machinery is a significant part of the fixed costs.
The costs of production includes the concepts of total cost, total fixed cost, total
variable cost, average total cost, average fixed cost, average variable cost, and marginal
cost. We explain these concepts in detail now.
Total cost
Total cost is the sum of all costs incurred on all resources necessary to produce a
particular level of output. Total cost (TC) is divided into total fixed cost (TFC) and
total variable cost (TVC). TFC is the sum of all costs that are incurred for inputs that
are fixed and cannot be changed in the short duration. Total variable costs include all
expenses incurred on variable inputs.
TC = TFC + TVC (6.4)
Average Cost
Average cost (AC) is the total cost divided by number of units of the output
produced. It shows per unit cost of production. Further, average fixed cost (AFC) is
calculated as TFC divided by level of output and it shows per unit fixed cost of
production. Similarly, average variable cost (AVC) is obtained by dividing total variable
cost with the level of output and it shows per unit variable cost of production.
AC = TC/Q (6.5)
AFC = Total Fixed Cost/ Output (6.6)
AVC = Total Variable Cost/Output (6.7)

Economics for
Managers : 92
Marginal Cost Cost Analysis
Marginal cost is the addition to the total cost caused by producing one more unit
of output. As the fixed cost remains same, it is effectively the change in the TVC as we
increase the output by one more unit. In other words, it is an addition to the total cost of NOTES
producing one more unit of output.
MCn = TVCn-TVCn-1 (6.8), where n is the unit of output.
Since marginal cost is change in total variable cost per unit change in output, it
can also be written as:
MC = (6.9)
All the cost concepts discussed are explained through the Table 6.1. Figures 6.1
and 6.2 show the shapes of the different cost curves. Table 6.1 shows variations in
different costs as per the level of output produced. The costs are associated with the
kind of production technology used for producing the output. We have already seen
that in the short run for a production technology, law of diminishing marginal returns
operate. Recall that the law states that as we increase the variable input given a fixed
input, the output increases initially at increasing rate, then at decreasing rate and later
begins to falls. There is also a relationship between the law of diminishing marginal
returns of the production theory with the cost. Since, the cost is the price paid to the
variable and fixed inputs in short-run for producing output. This relationship will become
clear as we move further in the discussion.
Table 6.1: Total, Average and Marginal Costs
Output TFC TVC TC AFC AVC ATC MC
0 50 0 50 - - - -
1 50 50 100 50 50 100 50
2 50 78 128 25 39 64 28
3 50 98 148 17 33 49 20
4 50 112 162 13 28 41 14
5 50 130 180 10 26 36 18
6 50 150 200 8 25 33 20
7 50 175 225 7 25 32 25
8 50 204 254 6 26 32 29
9 50 242 292 6 27 32 38
10 50 300 350 5 30 35 58
Economics for
11 50 385 435 5 35 40 85 Managers : 93
Cost Analysis TC, TVC and TFC are depicted in Figure 6.1 where we have output on the X axis
and cost on Y axis . TFC remains at 50 on Y axis which shows that even when the level
of production is 0, still firm has to incur some fixed costs and these costs do not change
NOTES with the change in the level of production. Therefore, it is shown as a horizontal line,
parallel to X axis. On the other hand, total variable cost starts from origin which shows
that when level of production is zero, total variable cost is zero, and it increases with
increase in level of production. TC is shown as a sum of TFC and TVC. The shape of
TVC curve is inverse S shape. The reasons for the same are explained later. Note that
TC is running parallel to TVC and the distance between the two should be equal to
TFC.
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Figure 6.2 shows average cost, average fixed cost, average variable cost and
marginal cost curves. Notice the shapes of these curves as we will now discuss the
reason behind these shapes. As you see these curves following questions arise. Why
Does AFC curve slopes downward? Why does AVC curve is U Shaped? Why does AC
curve is U Shaped and above the AVC curve? Why is MC curve U shaped and cut AVC
curve and AC curve from below?
Economics for
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Shape of AFC, AVC and ATC Curves
In short run, TFC is constant, so with the increase in the output, the same fixed
cost gets spread over large number of output and per unit fixed cost decreases. Thus,
AFC is inversely proportional to output produced and is continuously declining. Even
though AFC curve is declining, it will never touch the X axis as some fixed costs are Check Your Progress
always associated with output regardless of how small they get. 3. Explain the concept of
total fixed cost, total
AVC curve is U shaped. It falls as the output increases from zero to a particular
variable cost and total
level that is 7 in the current context. After that it begins to rise. The reason for this
costs. How are they
particular shape of AVC can be attributed to increase in productivity of the variable
related to each other?
factors employed to produce the output. However, there is a point at which the plant is
Illustrate them through
operated optimally and beyond that the cost begins to rise. Behavior of the ATC depends
curves.
upon the behavior of AFC and AVC. In the beginning, both AFC and AVC curves fall,
4. Explain ATC, AFC and
the ATC curve therefore falls sharply in the beginning. When AVC curve begins to rise,
AVC. Why does ATC
but AFC curve is falling steeply, ATC curve continues to fall. This is because, at this
curve reach its lowest
stage fall in AFC curve weighs more than the rise in AVC which offsets the fall in AFC.
point after the AVC
However, as the output increases further, the fall in AFC can be overcome by increase
curves? Why does the
in the AVC and as the result ATC begins to rise. Thus, ATC begins to rise at a point later
MC curve intersect
than the rise in AVC. In Table 6.1, note that, AVC rises after output level 7, whereas
below the AVC and
ATC starts increasing after output level of 9.
ATC curves at their
Shape of MC Curve minimum points?
We know from the study of law of diminishing marginal returns that, as the output
increases in the beginning, marginal product of the variable product rises. This will Economics for
cause marginal cost to decline as the output increases in the beginning. Further, marginal Managers : 95
Cost Analysis product declines after a certain level of output. This cause marginal cost to rise after a
certain level of output. Thus, the fact that marginal product rises first, reaches its
maximum then declines, ensures that marginal cost of the firm decline first, reaches its
NOTES minimum level and then rises. We know from equation 6.9 that MC = TVC/q. As
mentioned earlier, a firm takes the market wage rate as given therefore, it can be written as
TVC L
MC = (6.10) ----------------- = ---------------
q q
where w is the wage rate and L/q is the change in labor required to produce an
additional unit of output. Recall from the earlier chapter that L/q is equal to 1/MPL,
that is inverse of the marginal product of the labor. Thus, equation 6.10 can be written
as:
MC = w/MPL (6.11)
Equation 6.11 implies inverse relationship between marginal cost of employing a

labor and its marginal product. Higher the marginal product lower will be the cost.
Remember that it is with a given wage price in the market and assuming short-run with
a fixed input. For example, if the MP of labor is 4 and cost is 40 Rs. then the MC would
be 10 Rs. As MP of labor declines to 2, the cost of employing that labor in adding one
more unit of output would cost 20 Rs.
Relationship between AVC, ATC and MC

AVC, ATC and MC also have an interesting relationship. As long as AVC is
decreasing MC will be lower than it. However, when AVC begins to rise MC will be
higher than it. See output levels from 1-7 where AVC is higher than MC at all points.
After output level 7 MC is higher than AVC. Remember that MC reflects the change in
the TVC as output increases by one more unit. If AVC related to a particular output is
declining, then the addition made to the TVC by producing that unit should be lower.
However, if AVC is rising, the increase in the cost due to production of additional unit
must be higher. There is a point at which both AVC and MC are same and that comes at
a point when AVC is at minimum. This is the reason why MC always cut AVC from
below at output level 7 in Table 6.1. Similar explanation is given for relationship between
ATC and MC. And, ATC = MC at output level between 8 and 9 in the given Table 6.1.
Review of the Key Concepts

(Accounting Cost) : Explicit or actual expenses incurred by a firm including the
depreciation of the capital goods, equipments and machinery.
(Economic Cost) : Explicit and implicit costs incurred by a firm that include the
opportunity cost of utilizing the resources.
(Opportunity Cost) : The amount foregone or sacrificed as an input is not put

Economics for for use in the best alternative.
Managers : 96
Total Cost : TC is the sum of all economic costs incurred on all resources (fixed Cost Analysis
and variable) necessary to produce a particular level of output.
Total Fixed Cost : TFC is the sum of all costs that are incurred for inputs that are
fixed and do not change with the level of output. NOTES
Total Variable Costs : TVC include all expenses incurred on variable inputs that
changes with the level of output.
Average Cost : AC is the total cost divided by number of units of the output
produced and shows per unit cost of production.
Average Fixed Cost : AFC is calculated as TFC divided by the level of output
and it shows per unit fixed cost of production.
Average Variable Cost : AVC is obtained by dividing total variable cost with the
level of output and it shows per unit variable cost of production.
Marginal Cost : MC is the addition to the total cost by producing one more unit
of output.
6.4 Production with the Cost-Minimizing Inputs
We now turn to a fundamental problem that all firms face about the selection of
inputs to produce a given output at minimum cost. For simplicity, we will work with
two variable inputs: labor and capital with prices of such inputs given as wages and
rate of interest respectively. As mentioned earlier, we also assume that the prices of
inputs are given and a firm accepts the same without having any influence on the prices
of output.
In order to decide about the production of a given level of output at the minimum
possible cost for a firm, we will bring together the concept of isoquants (covered in the
earlier unit on production) with cost. Recall that an isoquant gives different combinations
of labor and capital such that each combination produces the same level of output. In
order to bring this aspect with cost, firstly we will understand the concept of isocost
line.
Isocost Line
An isocost line is a line showing all possible combinations of labor and capital
that can be purchased for a given total cost.
Consider a firm has a total expenditure of 100 that you may scale up for lakhs or
crores. The wage rate (w) in the market is given as 20 Rs. per day and rate of interest (r)
is 10 Rs. Using this information, the Table 6.2 below gives different combination of
labor and capital that a firm can employ. For example, given the total cost expenditure
of 100 a firm can buy (i) 5L and 0K, (ii) 4L and 2K or (iii) 0L and 10K. In the first case, Economics for
entire amount is spent on labor as against the last case where entire amount is spent on Managers : 97
Cost Analysis capital. Note that as the units of capital employed increase, the units of labor decrease
as the expenditure is fixed, a firm can employ more of a factor only when it gives up on
some units of another input. These different combinations given in Table 6.2 are
NOTES represented by an isocost line in Figure 6.3 (A). In the figure, X axis shows labor and
Y axis shows capital. The point A on the X axis is defined using combination A when
no capital is employed. Similarly, the point F on Y axis is based on combination F
when no labor is used. All other combinations of labor and capital (B, C, D, and E) are
plotted on the same line AB representing constant expenditure of Rs 100. This is an
isocost line, which is formed by joining all possible combinations of two factors which
are required to have a constant expenditure.
Table 6.2: Units of Labor and Capital at given Factor Prices and Cost
Expenditure
L K L K L K L K
w=20; w=20; w=10; w=20;

r=10 and r=10 and r=10 and r=5 and
C=100 C=200 C=100 C=100
A 5 0 10 0 10 0 5 0
B 4 2 8 4 8 2 4 4
C 3 4 6 8 6 4 3 8
D 2 6 4 12 4 6 2 12
E 1 8 2 16 2 8 1 16
F 0 10 0 20 0 10 0 20
The total cost C of producing any particular output is given by the sum of the
firms labor cost (wL) and its capital cost (rK):
C= wL + rK (6.12)
The total cost equation can be written as an equation for a straight line as following:
K = C / r - (w/r) / L (6.13)
The slope of this straight line is - (w/r), which is the ratio of the wage rate to the
rate of interest. This is similar to the slope of budget line that is equal to the negative of
the ratio of the prices of two goods. The slope is also referred to as K/L.
Isocost line shifts upward as the total expenditure of the firm increases and shifts
downward as the expenditure reduces keeping the prices of inputs same. This is shown
in Column II of Table 6.2 and in Figure 6.3 (A). As the total cost increases to 200
Economics for double of both labor and capital are employed by a firm and isocost line shifts to IC2
Managers : 98 that is higher than IC1.
The isocost line like shifts to right if the price of labor falls while total expenditure Cost Analysis
and price of capital remains same as shown in Column III of Table 6.2 and Figure 6.3
(B) when wage rate reduce to 10 keeping rate of interest and total expenditure constant.
Similarly, the movement is leftward as the price of labor will increase keeping other NOTES
things constant.
The isocost line shifts to right on the Y axis as the price of capital falls other
things remaining the same. This is shown in Column III of Table 6.2 and Figure 6.3 (C)
when the rate of interest is reduced. Likewise, the isocost line shifts to left as price of
capital increases.
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Producing Output at Minimum Cost

Suppose a firm intends to produce maximum level of output given the cost. The
objective of the firm is represented by the production function that it wants to maximize
output with the constraint of the total cost available. This total cost in the short run is
divided between fixed and variable costs associated with different inputs. This is a
constrained optimization problem that is solved in mathematics. We leave the mathematic
to appendix and explain diagrammatically in the main text.
In Figure 6.4 (A), the problem is defined as a given isocost line IC1 that shows the
constraint on the firm in terms of total expenditure available. Now the firm has to attain
the maximum possible output for the same. In the Figure 6.4 (A), isocost line IC1 is
tangent to isoquant IS1 at point A. Given the cost, the maximum possible attainable
output for the firm is given by IS1. Why not by IS2 and IS3? IS2 represents lower level
of output and a firm can increase the output for the same cost by moving to IS1. IS3 is
not attainable given the cost by IC1. The point of tangency A between IS1 and IC1 shows
that combination of OL1 units of labor and OK1 of capital should be used to produce
output represented by IS1. A is a point of equilibrium such that there is no other
combination of labor and capital that a firm can purchase to produce output represented
by IS1. However, if a firm chooses a point like B then firm will produce output IS1 but
with higher expenditure represented by higher isocost i.e. IC2. Any isoquant higher
than IS1 is not attainable given the constraint on cost. Therefore, the tangency of the Economics for
Managers : 99
Cost Analysis isocost line to an isoquant represents the production maximizing combination of labor
and capital.
Recall that in our analysis of production technology, we showed that the marginal
NOTES rate of technical substitution of labor for capital (MRTS) is the negative of the slope of
the isoquant and is equal to the ratio of the marginal products of labor and capital:
MRTS = = MPL/MPK (6.14)
It follows that when a firm minimizes the cost of producing a particular output,
the following condition holds (recall the slope of isocost line):
MPL/MPK = -w/r (6.15)
We can rewrite this condition as follows:
MPL/w = MPK/r (6.16)
This implies that marginal products of different factors of production as a ratio of

their prices is equal in equilibrium. It means a firm will hire different factors of production
till a level where the price paid for each and the marginal product attained is equal.
Predominantly, a firm is ensuring that the ratio of output obtained and the price paid for
the last unit of a factor of productions employed are equal. This is an important condition
for output maximization. The calculus behind the result is given in the Appendix.
A firm may also face a situation where it wants to produce a given level of output
at the minimum possible cost. Diagrammatically, the problem can be framed as one
where an isoquant is given and the firm attempts to reach the lowest possible isocost
line. It is shown in Figure 6.4 (B) where a firm intends to produce output represented
by IS1. The cost options available are shown by IC1, IC2 and IC3. Interestingly, the
result is again attained at the tangency point of isocost line and an isoquant (A in Figure
6.4 (B)). The isocost line that is tangent to the given isoquant helps a firm in deciding
about the combination of labor and capital to be employed such that output is produced
at the minimum possible cost. The mathematics for the same is given in the Appendix.
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Cost Minimization with Varying Output Levels Cost Analysis
Using the above-mentioned technique, we can get cost minimizing combinations

of inputs to be employed for different levels of output. Clearly, for higher level of
output, a firm employs more labor and capital. However, each combination produces NOTES
output at minimum possible cost. See Table 6.3. that shows the minimum possible
expenditure for different levels of output and the associated AC and MC.
Table 6.3: Derivation of TC, AC and MC
Output Total Cost Average Cost Marginal Cost
0 0
5 1750 350 1750
10 3500 350 1750
15 5250 350 1750
20 7000 350 1750
25 8750 350 1750
30 10500 350 1750
35 12250 350 1750
40 14000 350 1750
45 15750 350 1750
50 17500 350 1750
If we join all points of tangency between isocost line and isoquants we get an
expansion curve. An expansion curve passes through all such points where a firms
isocost lines and its isoquants are tangent. An expansion curve is shown in Figure 6.5
(A). In Figure 6.5 (A) labor is shown on X axis and capital on Y axis. Take note of
points A, B and C of tangency between the isoquant and isocost lines. These points
show the combinations of labor and capital that should be employed to produce a given
level of output at minimum possible cost. The line E1 that joins all such points is an
expansion curve.
The expansion path is used to derive the total cost curve for a firm. In Figure 6.5
(A), take note of points A, B and C of tangency between the isoquants and isocost lines
that are joined to derive expansion curve of the firm that may represent output level of
5, 10 and 15 in Table 6.3. Using the information in Figure 6.5 (A), we will derive long-
run total cost of a firm. We already know the output level from the isoquant and the
associated cost from the isocost line. Thus, from the expansion curve we can derive Economics for
different points on the long-run total cost (LTC) curve. In order to draw LTC, take Managers : 101
Cost Analysis output on X axis and total cost on Y axis as given in Figure 6.5(B). LTC associates
minimum possible cost to produce a given level of output for a firm. For instance, if
point A represents 1000 units of output and the combinations OL1 and OK1 can be
NOTES employed (given wages and rate of interest) for Rs. 10,000/- then in Figure 6.5 (B), A1
represents 1000 units of output and Rs. 10,000 as the total cost. Similarly, points B1
and C1 in Figure 6.5 (B) are derived from points B and C in Figure 6.5 (A).
To move from the expansion path to the cost curve, follow the following steps:
1. Choose an output level that is represented by an isoquant.
2. Find out the point of tangency of that isoquant with an isocost line.
3. The tangency point will tell you the amount of labor and capital that can be
used to determine the minimum cost of producing the output level that has
been selected.
4. Draw the graph the output-cost combination.
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From the discussion above, it is evident that cost functions are derived functions
based on knowledge about the production technology, and given factor prices. The
term cost function denotes cost as a function of output and input prices. After deciding
about the optimal combination of labor and capital the associated cost is calculated.
This is the reason that cost is represented as a function of output as you may have
noticed in each diagram output is taken on X axis and cost on Y axis. The cost derived
thus is the minimum possible cost for a given level of output. Having derived that
minimum possible cost, a firm finds that these cost curves are U shaped. And a firm
may decide the level of output that it shall produce such that its average cost is minimum.
Thus, a cost function is written as:
In the short-run where there are fixed inputs cost is represented by B:
C = F(Q) + B (6.17)
In long-run:
C = F(Q) (6.18)
Economics for
Managers : 102 where C is total cost, Q is level of output and F represents that C is a function of Q.
The key reason behind writing cost as a function of output is that a firm will have Cost Analysis
a revenue function that is a function of output. Using the revenue and cost function, a
firm gets its profit function and accordingly it optimizes the same.
NOTES
6.5 Long-Run Costs
In the long-run a firm can completely adjust to the changes in the environment by
varying all inputs as per the new requirements. For instance, increase in the demand is
catered to by a firm in the short-run by running the existing plants and employing labor
overtime. In the long-run, a firm can construct a new plant. Therefore, a firm can change
its scale of production or plant size in the long run as per the changes in the demand
conditions.
The cost curves in the long-run include total, average and marginal cost curves.
However, in case of total and average cost there are only variable cost curves and
clearly not fixed cost curves. The shape of cost curves in long run is associated with the
returns to scale as the scale of production increases.
In the Figure 6.5 (B), you find that the expansion curve is a straight line through
the origin. This happens in case of constant returns to scale. Recall the definition of
average and marginal cost where average cost is per unit cost and marginal cost is the
addition made to the total cost by producing one more unit of output. Using the same
for long-run in the above case, we find that as LTC is a straight line, average and
marginal cost remains constant as given in Table 6.3. A straight line represent that a
firm is operating with constant returns to scale. As the input doubles output also doubles
the TC will grow at the constant rate and long-run average cost (LAC) curve will
remain constant.
Suppose, a firm is operating with increasing returns to scale. It implies that doubling
the inputs will increase the output by more than double. Consequently, the LTC will
increase but at the decreasing rate. Even though the total cost will increase per unit cost
that is LAC will decline. Therefore, an AC curve will decline over the range of production
where a firm is experiencing increasing returns to scale.
The decreasing returns to scale implies that input should be increased by more
than double if a firm intends to double the output. In this case, the LTC will rise at an
increasing rate. Clearly, per unit cost of production will begin to rise in such a case.
Based on the above discussion, the LTC curve is S shaped and LAC curve is U shaped
in the long-run. Figure 6.6 shows the LTC curve and Figure 6.7 shows the LAC curve.
Note that it is similar to short-run average cost curve. However, there is a difference
between the reason behind the U shape of short-run and long-run cost curves. In short-
run the U shape of AC is due to the law of diminishing marginal returns, where as in the
long run it is due to returns to scale (increasing, constant and decreasing). Economics for
Marginal cost in the long-run is also calculated using LTC. It is calculated as the Managers : 103
Cost Analysis change in the TC as the output increases by a small unit. MC in long-run is also a U-
shaped curve that cuts the AC curve from below. Therefore, it is lower than the AC
when it is declining and it is higher when AC is increasing. The reasons for the same is
NOTES as discussed in the case of short-run.
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LAC curve is also known as Envelop Curve which encapsulates many short-
run AC curves and it depends upon the returns to scale. In long-run all inputs including
capital equipment can be altered, therefore, the relevant principle governing the shape
of the long-run average cost curve is that of returns to scale. Figure 6.8 shows the long-
run AC curve as an envelope of the short-run AC curves. The idea is that since a firm
has an option to alter the factors of production as per the requirements, it will produce
each output level at the minimum possible cost. To explain further, consider short-run
AC curve SAC1 in Figure 6.8, it produces output Q1 with the cost of C1. However, the
same level of output can also be produced at higher cost of C2 with a plant size having
cost structure represented by SAC2 but in long run firm has the option to shift their
production from small plant size for smaller optimum production to a larger plant size
having relatively larger optimum production, firm will choose to produce at a firm
having cost structure SAC1. Therefore, point A will be on the long-run AC (LAC).
However, any increase in output beyond Q2 can be produced with a cheaper cost using
SAC2. In this case, we are assuming only three SAC curves. Now it is possible that
between SAC1 and SAC2 there lies a curve that can produce Q2 at the cheaper cost. The
LAC will envelop all such SAC curves. Note following important point about LAC
with respect to SAC:
1. LAC will always lie below the SAC curves.
2. It will be tangent to the declining part of SAC curves while declining and
tangent to rising part of SAC curves while rising.
3. It is a simple locus of the minimum point of production of each SAC as there
is always a possibility to built a plant that can produce the same level of
output at lower possible cost.
Economics for 4. At its minimum point, LAC will be tangent to the minimum point of the
Managers : 104 corresponding SAC.
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LMC curve is not an envelope curve like LAC in the long-run but is derived from
SMC. Take note of LMC in Figure 6.8 where it is drawn below the LAC when it is
declining and above while increasing. Also note that SMC associated with different
SAC curves are also given and LMC does not envelop those curves. LMC is based on
the minimum possible total cost of production related to each output level in the long-
run. LMC cuts SMC of each plant size at the level where SAC and LAC are tangent to
each other. For instance, LAC is tangent to SAC1 at point A and produce output level
OA at the average cost of OC1. LMC intersect SMC1 at point L for the same output
level of OA. Therefore, by joining all the points associated with the output level where
LAC is tangent to respective SMC we derive LMC.
Economies of Scale
In the long-run, as a firm increases its scale of production it requires hiring of
more labor, using more capital, raw material and other inputs. Now the question that is
faced by a firm is the ensuing impact on the cost. Obviously, the cost will increase as
more inputs are employed but the most important concern for the firm is the relative
proportion by which the cost increases as compare to the output. The increase in the
cost may be less than, equal to or more than proportionate increase in the output.
If as a firm expands its scale of operation and the per unit cost of manufacturing
declines it is referred to as economies of scale. In simpler words, increasing the output
by a certain proportion requires less than proportional change in the cost. Thus,
economies of scale are the cost advantage that a firm achieves through increasing the
scale of operation (due to reduction in the average cost of production). These economies
of scale that can be achieved are either monetary or non-monetary. The non-monetary
economies arise due to labor specialization and technical reasons as the quantity
requirements of inputs including labor, raw material and capital decline. Such economies Economics for
of scale include production economies of labor and technology. Monetary economies Managers : 105
Cost Analysis are due to reduction in the price of inputs used for production and other factors like
marketing and advertising used for the distribution of the product. Following are the
reasons for economies of scale:
NOTES 1. Labor Economies: On increasing the scale of operation managerial econo-
mies is achieved through specialization or division of labour. When a firm
begins to work at a larger scale, it begins to employ specialized manpower
with expert knowledge and skill-set reducing chances of errors and increased
productivity.
2. Technological Economies: On increasing the scale of operation state of the
art technology can be utilized efficiently to increase the productivity and
reduce cost. Example: a retailer who is working at a very smaller scale cant
install any specialized and costly software providing inventory management
solutions or logistic tracking system etc. As it will unnecessarily increase his
overall cost without any returns. On the other hand, an owner of any super
market can install such specialized software to reduce the per unit cost of
operation.
3. Financial Economies: Such cost advantages are achieved through reduction
in cost of acquiring capital/funds and increase in the share prices i.e. cost
advantages achieved at the financial level. When a firm increases its scale of
operation it has more assets, credit worthiness and growth potential that helps
in getting loans from banks and other financial institutions at relatively
cheaper rates. Similarly, investors also like to invest in the firms having
future growth potentials, which again strengthen its market position.
4. Commercial Economies: This is the cost advantage achieved due to pur-
chase and sale or commercial transactions. Bulk purchases of raw material,
parts and components reduce the cost of production. Transport and storage
costs associated with per unit also reduce as the scale of production increases.
5. Selling or Marketing Economies: These costs are associated with the final
distribution of the goods in the market. Such costs include advertising space
in the newspaper, magazines, television, internet websites and social media
websites. Large-scale of such activities reduces per unit cost.
A firm not necessarily experience decline in the cost always as a firm continues to
increase its scale of operation as after a certain limit LTC and LAC begins to rise. Such
a situation is referred to as diseconomies of scale as the proportional increase in cost is
higher than the proportional increase in the output. Such diseconomies arises due to
poor control and co-ordination, or exhaustive resources and other problems associated
with large scale of operation. Some of the reasons are discussed below:
1. Managerial Diseconomies: This is the cost disadvantage achieved at the
managerial level that arises due to poor co-ordination, control and commu-
Economics for
nication due to complex organizational structure. On increasing the scale,
Managers : 106
line of communication becomes lengthy which may create distortion of in- Cost Analysis
formation and duplication of the efforts as well.
2. Labour Diseconomies: When a firm increases its scale of operation without
consideration of labor welfare, labour economies can get converted into NOTES
diseconomies causing strikes and lockout.
3. Exhaustive Resources: Many raw materials are exhaustive in nature with
limited supply like crude oil, cotton, coal etc. As the scale of operation in-
creases, the demand for such raw material increases but supply does not
increases proportionately, causing rise in the prices of raw material.
The economies that we have discussed so far arise within a firm. Firms may also
experience economies as the entire industry begins to expand. Such economies are
referred to as external economies. These are economies of scale or cost advantage
extended to all firms in an industry due to increase in the overall industrial output. It is
achieved due to any external changes in the industry, benefitting all firms in the industry.
For example, as the Information Technology expanded in India, over a period of time
various engineering institutions starting to establish to provide skilled labor for the
industry and reducing the cost of labor for the firms. External economies of scale are
the cost advantage extended to all firms in the industry due to external changes. It can
be achieved in the following ways:
1. Growth of Ancillary Firms: As an industry expands, the ancillary firms or
component providers also grow. For instance, in automobile industry, when
ancillary firms or original equipment manufacturers expand their scale of
operation and achieve economies of scale, they further extend the benefit of
reduced per unit cost of production to their clients as well. Various firms
having assembly plants in automobile industry will now be able to get com-
ponent parts at reduced price which in turn further reduce their cost of pro-
duction.
2. Economies of Concentration: It is the economies achieved by localization of
firms. When many firms in the industry establish their manufacturing plant
in one location, then all firms benefit by sharing of resources, better linkage
facility, and infrastructure.
3. R&D Activities: Due to the expansion of entire industry, there will be a
scope for developing or generating new technological knowledge. Further
pooled or joined R&D may also help each and every firm in the industry to
get the benefit in optimizing their production and reducing their cost of pro-
duction.
4. Development of Industry Information Services: As an industry expands, the
firm may form the trade associations to distribute information regarding tech-
nical knowledge and market possibility in the industry through publication
Economics for
of trade journal.
Managers : 107
Cost Analysis Economies of Scope
The above discussion in the unit implicitly assumes that a firm produces only one
product. However, firms may be involved in multi-product production activity. For
NOTES instance, a carmaker may produce cars of different segments like small, mid, sedan or
sport utility vehicles. A firm involved in production of sugar may produce alcoholic
beverages using the molasses that is the by-product of sugar production. An important
question is which economic concept explains this behavior of the firms? One possible
explanation is due to the economies of scope. A firm achieves economies of scope
when its cost of production decreases as a result of increasing the number of products
produced. Economies of scope are cost advantages that result when firms provide a
variety of products rather than specializing in the production or delivery of a single
product or service. Economies of scope can arise from the sharing or joint utilization of
Check Your Progress
inputs and lead to reductions in unit costs. Remember that economies of scale primarily
5. Give reasons for the U-
deals with reduction in per unit cost of production by increasing scale of operation for
shape of long-run
a single product type, while economies of scope refers to lowering the cost for a firm
average cost curves.
in producing two or more products. It is about making product diversification more
Why is long-run
efficient. If a sales force sell several products, it can often do so more efficiently than if
average cost curve
it is selling only one product. The cost of its travel time is distributed over a greater
usually called
revenue base, so cost efficiency improves. There can also be synergies between products
planning curve?
such that offering a range of products gives the consumer a more desirable product
6. Explain various
offering than would a single product. An example is a company such as Proctor &
economies of scale and
Gamble, which produces different products from razors to toothpaste. They can afford
diseconomies of scale
to hire expensive graphic designers and marketing experts who will use their skills
that accrue to the firm
across the product lines. Because the costs are spread out, this lowers the average cost
when it expands its
of production for each product.
scale of production.
The degree of economies of scope1 is calculated as:
EC = C(q1) + C(q2) - C(q1, q2) / C(q1, q2) (6.19)
Where, EC represents economies of scope, C(q1) and C(q2) are the cost of producing
q1 and q2, and C(q1, q2) is the combined cost of production of q1 and q2. Clearly, in case
of economies of scope joint production cost will be less than the individual production
cost. Therefore, if EC>0 then economies of scope are existing. On the other hand, if
EC<0, diseconomies of scope are said to be existing.
6.6 Learning Curve
The concept of the learning curve was first introduced to the aircraft industry in
1936 when T. P. Wright published an article in February 1936 in Journal of the
Aeronautical Science. Learning curve refers to a situation when the cumulative
Economics for production of the same type of product over time increases efficiency in the use of
Managers : 108 inputs such as labor and raw material and thereby lowers cost per unit of output. As a
firm continuously produces more and more units of output over a period of time, it Cost Analysis
learns either to achieve higher level of output with the given input/resources or to
produce given level of output with less resources (through reduced wastage and scraps,
increased speed, less mistakes, more familiarity with work process/method etc.). For NOTES
example, a company may require 100 labor to produce first lot of 5 airplanes but after
producing this lot, next year only 180 laborer may produce 10 airplanes. Many industries
like aviation, shipbuilding, appliances, refined petroleum experience learning curve. A
company experiences fall in the production cost for a given level of output because of
following reasons. (i) While performing a task for the first time many workers take
time to become familiar with it. However, once a comfort level is attained the same
task is performed at faster pace. (ii) A manager may have to put in place entire chain of
events in a production process that may not be accomplished in the first time. As one
lot of goods is produced, the improvised process can be run. A firm learns over time as
cumulative output increases.
The learning curve is graphically being shown in Figure 6.9, where X axis shows,
cumulative total output over successive period of time and on Y axis cost per unit is
measured. In the figure, learning curve slopes downward which clearly shows cost per
unit of output declines with increased output over time as firm learns from its experience.
Note that the fall in the cost is steep initially and decline in the cost reduces at a later
stage. As the learning from the initial lot of production for workers and manager is
high. As they become more efficient at production, the cost does not reduces considerably
at the later stage.
The concept of learning curve is different from that of Economies of scale as

economies of scale refers to decline in the cost per unit of output as output increases
while in learning curve cost per unit of output reduces with the increase in cumulative
output over successive time periods, while the output per period remains the same.
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; Economics for

&XPXODWLYH7RWDO2XWSXW Managers : 109
Cost Analysis
6.7 Summary
The economic costs are different from accounting cost that are only explicit or
NOTES
actual expenses incurred by a firm including the depreciation of the capital goods,
equipment and machinery.Economic Costs include both explicit and implicit costs
incurred by a firm that include the opportunity cost which is the amount foregone or
sacrificed as an input is not put for use in the next best alternative available.
The total cost is sum of all economic costs incurred on all resources (fixed and
variable) necessary to produce a particular level of output. It comprises of total fixed
coststhat are incurred for fixed inputs and do not change with the level of output and
total variable costs that include expenses incurred on variable inputs that changes with
the level of output.
Further average costis the total cost divided by number of units of the output
produced and shows per unit cost of production. Marginal costis the addition to the
total cost by producing one more unit of output.Economies of scale imply that the
firms cost increases in smaller proportion than the proportional increase in the output.
Diseconomies of scale mean that the firms cost increases in larger proportion than the
proportional increase in the output. Economies of scopeimply that the cost of production
for a firm of producing two goods is lower than producing them separately.
6.8 Key Terms
Isocost line: A line that shows all possible combinations of labor and capital that can
be purchased given the wage, rate of interest and total expenditure.
Expansion Curve: It is a curve passing through the points where a firms isocost lines
and its isoquants are tangent.
Long-run Average Cost: It is per unit cost of production in the long run when all
factors of production are variable.
Long-run Marginal Cost: LMC is the change in the long-run total cost as the output
increases by a one unit.
Economies of Scale: Implies that the firms cost increases in smaller proportion than
the proportional increase in the output.
Diseconomies of Scale: Implies that the firms cost increases in larger proportion than
the proportional increase in the output.
Economies of Scope: It implies that the cost of production for a firm of producing two
goods is lower than producing them separately.
Economics for Diseconomies of Scope: It implies that the cost of production for a firm of producing
Managers : 110 two goods is higher than producing them separately.
Cost Analysis
1. Complete the Table:

NOTES
Output TC FC AFC AVC ATC MC
0 100 100
1 125
2 145
3 157
4 177
5 202
6 236
7 270
8 326
9 398
10 490
a. Using the data in the table draw TC,FC, AFC, AVC, ATC and MC curve.
2. Suppose, you own a cloth manufacturing unit where you mass produce mens
wear. Noticing the growth in the market, you plan to introduce other products like
womens wear and kids wear. What factor will affect your decision for the joint
production of these products?
3. Why are isocost lines straight lines?
4. If the firms AVC and ATC are U shaped, why the AVC attains minimum at the
output level lower than output level at which ATC attain minimum?
5. What is the difference between economies of scale and returns to scale?
6. Distinguish between economies of scale and economies of scope.
7. What is a learning curve?
8. You manage a plant that mass-produces engines by teams of workers using

assembly machines. The technology is summarized by the production function q
= 5 KL, where q is the number of engines per week, K is the number of assembly
machines, and L is the number of labor teams. Each assembly machine rents for r
= Rs. 10,000 per week, and each team costs w = Rs. 5000 per week. Engine costs Economics for
are given by the cost of labor teams and machines, plus Rs. 2000 per engine for Managers : 111
Cost Analysis raw materials. Your plant has a fixed installation of 5 assembly machines as part
of its design. a. What is the cost function for your plant namely, how much
would it cost to produce q engines? What are average and marginal costs for
NOTES producing q engines? How do average costs vary with output? How many teams
are required to produce 250 engines? What is the average cost per engine? You
are asked to make recommendations for the design of a new production facility.
What capital/labor (K/L) ratio should the new plant accommodate if it wants to
minimize the total cost of producing at any level of output q?

Delhi.
Economics for
Managers : 112
APPENDIX 6.1 Cost Analysis
Output Maximization : The equilibilum condition for obtaining highest level of

output for a given cost can be formulated and solved in this way.
NOTES
Maximize = Q = F (L, K) - (6A.1)
Subject to = C = WL + LK - cost constraint (6A.2)
This is graphically represented an a situation where an isocost line is given and a

firm attempts to achieve the highest possible isoquant representing a particular level of
output. In mathematical term, this is a typical problem of constrained maximization
that is solved using langrangian multiplier. The soultion involves following steps.
Rewrite the constraint as following and multiply by a which is a langrangian

multiplier to get.
(C - WL - K) = 0 (6A.3)
The langrangian multiplier are undefined constraints that are used for solving
constrained maximization and minimization problems. Using the constraint formulate
the following langiangian function.
= Q + (C- WL - RK) - (6A.4)
The first order condition for maximization of a function is that its partial derivative
should be equal to zero. The partial derivatives of 6A.4 w.r.t. L, K and are :
Q
= W = 0 (6A.5)
L L

= L = 0 (6A.6)
K L

= C - WL - RK = 0 (6A.7)

So these equations can be solved to obtain the values of L, K
Using 6A.5 = 6A.6 we can get the following results.
Q Q
W = L (6A.8)
L L
Q Q
Recall that and are MPL and MPK. Thus, 6A.5 can be written as:
L K
MPL
MPL - W = 0 or = ---------- (6A.9)
W Economics for
Managers : 113
Cost Analysis MPK
MPK - R = 0 or = ---------- (6A.10)
W
6A.9 = 6A.10 shows that
NOTES
MPL W
= - (6A.11)
MPK R
The firm is in equilibium when it equates the ratio of the marginal product of
factors to the ratio of their prices. This is the result similar to one attained by the
tangency of isoquant to an isocost line.
Cost Minimization : As mentioned in the text a firm may decide that it has to
produce a given level of output at mimimum possible cost. In that case the problem is
formulated as :
Minimize = C = WL + RK = Co (6A.12)
Subject to = 0 = F (L, K) (6A.13)
Rewrite (6A.13) and multiply by
[Q0 - F (LK)] = 0 (6A.14)
Then the langnangian function will be :
= C - [Q - F (L, K)] = 0 (6A.15)
Again differente w. r. t. L, K, and and equate to zero
f (L, K)
------ = W - ------------------ = 0 = W - MPL (6A.16)
L L
f (L, K)
------ = r - ------------------ = 0 = r - MPK (6A.17)
K K

------ = [Q0 - F (L, K)] = 0 (6A.18)

Using (6A.16) and 6A.17) one will get the same result.
MPL W
------ = -------- - (6A.19)
MPK R
Economics for
Managers : 114
Perfect Competition
Unit 7 PERFECT COMPETITION
Structure NOTES
7.0 Introduction
7.1 Unit Objectives
7.2 Meaning and Characteristics of Perfect Competition
7.3 Price and Output Determination under Perfect Competition
7.4 Summary
7.5 Key Terms
7.6 Question and Exercises
7.0 Introduction
In the next four units, we will deal with different types of market structures.
These units bring together the discussion on demand, production and cost analysis in
the context of different market structure in which a firm may operate. The current
chapter deals with price and output determination of firms under perfect competition.
Section 7.2 explains the definition of market structure and different types of market
structure. Then we discuss the characteristics of firms in the market condition. Section
7.3 deals with price and output decision process of firms under perfect competition, of
which sub section 7.3.1 explains short run equilibrium and 7.3.2 explains long run
equilibrium. Section 7.4 summarizes the unit.
7.1 Unit Objectives

* To understand the characteristics of perfect competition.
* To understand the decision making by a firm in a perfectly competitive
industry.
* To know the price and output determination of a perfectly competitive firm
and industry in the short run as well as long run.
7.2 Meaning and Characteristics of Perfect Competition
Market structure implies the environment in which a firm operates. As a market Economics for
comprises of buyers and sellers all these players will operate in the competitive Managers : 115
Perfect Competition environment. Firstly, let us consider from sellers' perspective. The number of other
firms operating in the industry, types of products the competing firms produces
(homogenous or differentiated), the extent of knowledge firms have, and the demand-
NOTES supply conditions in the market influence the market structure. So market structure is
predominantly the competitive environment in which a firm operates. Broadly speaking,
there can be four types of such structures. At one extreme we have perfect competition
with monopoly at the other end. Monopolistic structure and oligopoly are situated
between these two extremes. We give a brief description of each now with detailed
information in the following units.
Perfect competition: It refers to a market situation where there are many buyers
and sellers of a product such that each is too small to assert any influence on the price
of the product. In this case, the product sold by all the sellers is homogenous, there is
perfect flow of information and resources are also perfectly mobile.
Monopoly: It refers to a market situation in which there is a single seller of a

product and there are no sellers with substitute goods as well. Clearly, entry into such
a market is difficult.
Monopolistic competition: It refers to market situation in which there are many

sellers with products that are close substitutes of each other. Such products are
differentiated from others and entry and exit into such a market is easy.
Oligopoly: It refers to a situation when there are a few sellers of product that may
or may not be differentiated. The new firm may enter the market which is however not
very easy as evident from the small number of firms existing.
As mentioned earlier, these definitions of monopoly, monopolistic competition

and oligopoly illustrate sellers' perspective. In the same way, depending upon the number
of buyers there can be cases of monopsony, monopsonistic competition and oligopsony.
Evidently, if there is a single buyer the situation is monopsony. Further, monopsonistic
competition and oligopsony are defined in the analogous manner. Such a classification
becomes pertinent in case of input market. For instance, in India there is a single buyer
of railway engine drivers i.e. Indian Railways. In our discussion, we will focus on the
sellers' perspective and we will discuss each of these market forms in detail in the next
four units including the current one where we begin with perfect competition.
7.2.1 Perfect competition

Perfect competition is defined as the market situation where the demand and
supply conditions determine the market price of a product under certain assumptions.
Perfect competition is a market structure where there is a perfect degree of competition
and single price prevails. The degree to which a market or industry can be described as
competitive depends in part on how many suppliers are seeking the demand of consumers
and the ease with which new businesses can enter and exit a particular market in the
Economics for
long run. Competitive markets operate on the basis of a number of assumptions. When
Managers : 116
these assumptions are dropped we move into the world of imperfect competition. These Perfect Competition
assumptions are:
1. There is a large number of buyers and sellers of the product and each firm is
producing either homogeneous or identical product. As a small participant in large NOTES
market no individual player in the market - buyer or seller - is able to influence
the prevailing price by increasing or reducing supply or demand of the product in
a given industry.
2. There are no barriers to entry and exit of firms from the industry. Afirm can easily
enter in to the market if the situation is profitable to produce and can leave if the
situation becomes unprofitable.
3. Consumers, resource owners and firms in the market have perfect knowledge
about price, cost and economic conditions.
Check Your Progress
4. All firms have equal access to resources (technology, other factor inputs).
5. There is no governmental intervention in the mobility of resources that can be 1. Define market
easily transferred from one place to another. structure and key
6. Buyers and sellers do not incur costs in making an exchange of goods in a perfectly factors that
competitive market that is there are no transportation costs. influence it.
2. How is perfect
When these assumptions are met a market is defined as perfect competition. It is competition
evident that it is very difficult to find such a perfect competition in the real world. different from
However, some of the examples are those of the stock market, bullion market, monopolistic
international currency market, commodities market and certain vegetable or fish markets competition?
3. What are the major
and so on. In these markets, there exists unique price at any point of time, although it
assumptions of
keeps changing from time to time depending on the increase or decrease in total demand
perfect
or supply which may be caused due to actual changes or information about likely
competition?
changes affecting supply or demand. Perfect competition acts as a benchmark against
which real-life and imperfectly competitive markets are compared.
7.3 Price and Output Determination under Perfect

Competition
Under perfect competition, the price of a product for the industry is determined at
the intersection of market demand and market supply curve. The market demand curve/
supply curve for a product is simply representing the horizontal summation of the
demand/supply curves of all the consumers and/or producers in the market as shown in
Figure 7.1 (left-side) where Md is the market demand curve and Ms is the market
supply curve. The equilibrium price for the industry, P1 is determined at the point E
where Md and Ms intersect each other. Any changes in supply and demand conditions
change equilibrium price by creating excess supply/or shortage of product and
successively price will rise/fall until it reaches equilibrium level. Considering that the Economics for
Managers : 117
Perfect Competition price of a product is determined in the market no single firm can influence it. As we are
considering market demand and total supply in the industry a single firm is too small to
influence the price of product. Therefore, the demand curve faced by an individual
NOTES firm will be horizontal to x axis at the level where price is determined in the industry. It
is shown in the right-side part of Figure 7.1. A firm operating in the perfect competition
will take this price as given and will decide the amount of output it will produce. Now
we turn to the decision making process of the firm about the level of output to be
produced.
The decision making process for the firm includes taking into consideration both
revenue and cost related aspects. First consider the revenue side aspects. We define
some key concepts:
Total Revenue (TR) = Price X Units Sold (1)
Average Revenue (AR) = Total Revenue / No. of Units (2)
Marginal Revenue (MR) = Change in Revenue/1 Unit Change in Output (3)
Total revenue is the total sales realized by a firm for selling their product. Average
product gives us revenue per unit of sales and marginal revenue implies the change in
revenue as one more unit of output is sold. Note that the total, average and marginal
revenue numbers will depend upon the kind of demand function. In case of perfect
competition with price as given we find that demand curve for a firm is same as the
marginal and average revenue. Therefore, in Figure 7.1 right-side figure we find
AR=MR=P. This is also evident from Table 7.1.When the product price is constant, the
MR is also constant and is equal to product price. Remember in a perfect competition
every firm is a price taker.
Table 7.1: Total revenue, average revenue and marginal revenue of a firm in perfect
competition
No. of Units Price Total Revenue Average Revenue Marginal Revenue
1 5 5 5 --
2 5 10 5 5
3 5 15 5 5
4 5 20 5 5
5 5 25 5 5
6 5 30 5 5
7 5 35 5 5
Economics for
Managers : 118
Perfect Competition
NOTES
Figure 7.1
A profit-maximizing manufacturer who faces a market price maximizes the profit

obtained at a given level of price of product as well as the cost of production. This
decision process will vary with short-run and long-run time frame.
In the short-run a firm has fixed costs thus even in case a firm incur losses it will
stay in business as long as it can recover the variable costs. We will now discuss the
mechanism through which a firm decides how much to produce at a given prices.
Intuitively, a firm will produce to a point where any more increase in output does not
generate revenue enough to cover the additional costs to be incurred. Simply the rule
will be to produce where price equal to its marginal cost (P=MC).
It allows for derivation of the supply curve on which the neoclassical approach is
based. The abandonment of price taking creates considerable difficulties for the
demonstration of a general equilibrium except under other, very specific conditions
such as that of monopolistic competition.
There are some specific reasons that a firm does not have an independent pricing
policy under the market structure. Firstly, if a firm charges a higher price than the
market prevailing price, certainly it will lose its customers as they have alternative
sellers in the market. Secondly, if they charge a price below market price, certainly it
will incur losses. We can see that market price is equal to average cost and if any firm
charges a price below it they can't afford and suffer losses.
7.3.1 Short Run Price and Output for Perfectly Competitive

Industry and Firm
As we said in the short-run the equilibrium market price is determined by the
interaction between market demand and market supply. In Figure 7.1 shown above,
price P1 is the market-clearing price and this price is then taken by each of the firms in Economics for
the industry as given. Because the market price is constant for each unit sold, the AR Managers : 119
Perfect Competition curve also becomes the Marginal Revenue curve (MR). Hence, P=AR=MR=d. A firm
maximizes profits when marginal revenue = marginal cost (MR=MC). As pointed out
in the figure, as long as MR curve exceeds MC, firms are expanding output because by
NOTES doing so the firm would add more to its total revenue than to its total cost. On the other
hand, when MC exceeds MR firm will reduce their output. Thus the best level of
output of any firm will be MC=MR. In Figure 7.1, the profit-maximizing output is Q1.
The firm sells Q1 at price P1. The vertical difference between AC and AR through the
equilibrium represents unit profit earned by the firm while producing Q1 level of output.
The area shaded is the economic profit (supernormal profit) made in the short run
because the ruling market price P1 is greater than ATC. In short, the conditions of
equilibrium of a firm are a) MC=MR and b) MC curve should cut MR curve from
below.
Not all firms make supernormal profits in the short run. Their profits depend on
the position of their short run cost curves i.e. average total costs (ATC) should not
exceed the current market price for profits to be made. Other firms may be making
normal profits where total revenue equals total cost (break-even output). In Figure 7.2,
the firm shown has high short run costs such that the ruling market price is below the
average total cost curve and therefore the firm is making an economic loss as shown in
the shaded area. In short run, depending on the position of AC curve, perfectly
competitive firm either make super normal profit,or make normal profit or incur losses.
Figure 7.2
Now the question is whether firm will continue their production if their AC>AR
when the firm incur losses. As we know total cost of firm consist of fixed and variable
cost, the shut down decision depends on the behavior of variable cost. A firm continues
to produce as long as their AR covers its Average Variable Cost (AVC).
Economics for
Managers : 120
We will discuss now in detail as to why a firm will continue in a situation where Perfect Competition
it may be incurring losses but continue to produce as long as price is more than or
equal to its AVC. This decision is called as Shut-down rule in literature. Recall that
total costs (TC) of a firm comprise of Total Fixed Costs (TFC) and Total Variable NOTES
Costs (TVC) and accordingly for Average Cost (AC) there are two components namely
Average Fixed Costs (AFC) and Average Variable Costs (AVC). The most important
characteristic of AFC is that a firm incurs such cost even if it closes it plants. A firm
will be able to do away with these costs only if it sells of it plants. We need to make a
distinction between firm closing a plant and shutting-down where closing means a
firm will still retain the ownership of the property and continue to incur some minimal
fixed costs against shut-down where it will stop production and just sell-off everything
Check Your Progress
and will not incur any more costs on the production plant.
1. Why a firm is price
Now consider a possibility whereby a firm is making losses in short run and now taker in competitive
it has to decide whether to shut down the plant or continue. Now a loss making firm market?
will consider the implication of its decision to either close or shut-down keeping in 2. Explain the condition
view of the future demand and supply situation. If it expects to earn profit in the future of equilibrium of a firm
when price of the product increases or cost of production falls, it may chooses to to decide the output to
continue production. It will keep on doing so as long as the price covers AVC even be produced in a
though it is less than ATC as fixed costs will be incurred to keep the plant with them if competitive industry.
is closed. However, if price cannot cover even AFC then a firm will shut-down. It is so 3. Make diagram of a
because if price of product is at least covering AVC, firm may continue production as profit making firm in a
in case if there is a price rise in future reopening the plant would imply incurring all competitive economy.
those fixed costs once again that may include hiring new people, training them and
constructing the plant itself. Thus a firm is unlikely to shut-down if it at least covers its
AVC. In this case, all the points above the point where MC cuts AVC will become part
of firms' supply curve. In other words, for a firm its supply curve is MC curve over and
above where it intersects the AVC.
7.3.2 The Effects of a change in Market Demand

In Figure 7.3 there is an increase in market demand (all else held constant) from
Md to Md2. This causes an increase in market price and quantity traded. The firm's
average revenue curve shifts up to AR2 (=MR2) and the profit maximizing output
expands to Q2. MC curve is the firm's supply curve. Higher prices cause an expansion
of supply curve. Following the increase in demand, total profits increase as shown in
the Figure earlier profits were blue shaded area that expands to include brown spotted
area after an increase in the demand. An inward shift in market demand (contractions)
would have the opposite effect that is either the profit may reduce; firms may make no
profit or may make losses. You can perform that as an exercise with shift of demand
curve downward in Figure 7.3.
Economics for
Managers : 121
Perfect Competition
NOTES
Figure 7.3
7.3.3The Long Run Adjustment Process

If most firms are making abnormal profits in the short run there will be an expansion
of the output of existing firms and we expect to see the entry of new firms into the
industry. Firms responding to the profit motive and supernormal profits act as a signal
for a reallocation of resources within the market. The addition of new suppliers causes
an outward shift in the market supply curve. This is shown in Figure 7.4 as Ms shifts to
MS2.
Figure 7.4
Making the assumption that the market demand curve remains unchanged, higher
market supply will reduce the equilibrium market price until the price = long run average
cost. At this point each firm is making normal profits only. There is no further incentive
for movement of firms in and out of the industry and a long-run equilibrium has been
established.The entry of new firms shifts the market supply curve to MS2 and drives
down the market price to P2. At the profit-maximising output level Q2 only normal
profits are being made. Therefore, there is no incentive for firms to enter or leave the
industry. Thus a long-run equilibrium is established.
Economics for
In the short run, perfectly-competitive markets are not productively efficient as
Managers : 122
output will not occur where marginal cost is equal to average cost (MC=AC). They are Perfect Competition
allocatively efficient, as output will always occur where marginal cost is equal to
marginal revenue (MC=MR). In the long run, perfectly competitive markets are both
allocative(MC= MR) and productively efficient (MC=AC). It is evident from Figure 7.5. NOTES
Figure 7.5
7.4 Summary
Perfect competition is a market structure where there is large number of buyers

and sellers for a product. Every competitive firm is a price taker as it faces an infinitely
elastic demand curve. The optimum level of output for a competitive firm in the short
run is at a point where P=MR=MC. In the long run, depending on the profit a competitive
firm earns, new firms will enter in to the market until all profits will eliminates. On the
contrary, if firms in the industry incur losses, some of them will leave the industry until
the remaining firms earn normal profit.
7.5 Key Terms

Market structure : It implies the environment in which a firm operates.
Perfect competition : It refers to a market situation where there are many
buyers and sellers of a product such that each is too small to assert
any influence on the price of the product. In this case, the product
sold by all the sellers is homogenous, there is perfect flow of
information and resources are also perfectly mobile.
Shut down Rule : A firm shut downs if the price of product is less than the
Economics for
AVC.
Managers : 123
Perfect Competition
7.6 Questions and Exercises
1. Distinguish between the industry demand curve and firm's demand curve in a
NOTES
perfectly competitive market. Will a firm in a perfectly competitive market reduces
price to increase sales? Why or why not?
2. Distinguish the conditions of equilibrium of a firm in the short run and long run.
3. Show diagrammatically the impact on firm's profit if in the short run demand for
the product reduces.
4. Why firms under perfect competition make only normal profit in the long run?
How the profit conditions of long run different from that of short run?
5. Do firms produce at productive efficient point in short-run? Why or why not?
1. Dominic Salvator.2009. Managerial Economics-Principles and worldwide

applications, sixth edition.
2. W.B. Bruce Allen,K.Wieght, N.Doherthy and E. Mansfield.2011. Managerial

Economics- Theory,Application,and cases, Seventh edition.
3. C.H. Petersen, W.C. Lewis and S.K. Jain. Managerial Economics, Fourth Edition.
Economics for
Managers : 124
Monopoly
Unit 8 MONOPOLY
Structure NOTES
8.0 Introduction
8.1 Unit Objectives
8.2 Meaning and Characteristics of Monopoly
8.3 Price and Output Determination under Monopoly
8.4 Perfect Competition and Monopoly
8.5 Monopoly Power
8.6 Social Cost of Monopoly Power and Competition Commission
8.7 Summary
8.8 Key Terms
8.9 Question and Exercises
8.0 Introduction
As mentioned earlier, there are four basic types of market structures: perfect
competition, monopolistic competition, oligopoly and monopoly. A monopoly is a market
structure in which a single supplier produces and sells a given product to the whole
market. If there is a single seller in a certain industry and there are no close substitutes
for the product, then the market structure is that of a "pure monopoly". Sometimes,
there are many sellers in an industry and/or there exist many close substitutes for the
goods being produced, but nevertheless companies retain some market power. This is
termed monopolistic competition, whereas by oligopoly the companies interact
strategically. In this unit, we will study monopoly in detail.
8.1 Unit Objective

* To understand the characteristics of market under monopoly.
* To know the price and output determination of monopoly firm in the short
run as well as long run.
* To understand the differences between perfect competition and monopoly.

Economics for
Managers : 125
Monopoly
8.2. Meaning and Characteristics of Monopoly
The word Monopoly comes from two Greek words monos meaning alone or single
NOTES
and polein which means to sell. A monopoly is a unique situation where a particular
individual or enterprise is the only supplier of that commodity. Monopolies are thus
characterized by lack of economic competition to produce the good or service and a
lack of viable substitute goods. A monopoly as a single seller and a business entity has
significant market power to charge high prices. Market power is the ability to increase
the product's price above marginal cost without losing all customers. Although
monopolies may be big businesses, size is not a distinctive characteristic of monopoly.
A small business may also have the power to raise price in a market.
Monopolies typically maximize their profit by producing less output and selling
them at higher prices compared to perfect competition. Monopolies can be established
by a government, form naturally, or form by integration.
There are four basic reasons to monopoly. Firstly, it may exist due to control of
the entire supply of the raw materials required to produce the product. For instance,
single owner of diamond mines in a country will be a monopolist. Secondly, monopoly
may emerge from the patent or copyright that excludes other from producing the same
product or using the particular process for the product.A government-granted monopoly
or legal monopoly is the third source of the monopoly, which is sanctioned by the state
to provide incentives to invest in risky ventures or those with long gestation period
and/or very high level of investment. The government may also reserve the venture for
itself, thus forming a government monopoly.For instance, Railways require huge
investment (to lay tracks, build platform and stations) and have long gestation period
(as it should reach large number of customers before a firm can make profit) necessitating
government intervention. Final source is the natural monopoly, which arises from the
economies of scale. In some industries economies of scale over a sufficient large range
of output leaves only one firm to operate in the industry. For example, landline connection
for telecommunication (or now a day's broadband internet connection) requires that
some minimum number of people should subscribe so that the firm can at least cover
the cost of laying the wire. If a firm already exists in a particular locality or city another
firm may have very little incentive to enter.
A monopsony, on the other hand is a market with only one buyer of a product or
service. Therefore, the market power is on the demand side and not the supply side as
in the case of monopoly.
8.2.1 Characteristics of Monopoly

Following are the characteristics of a monopoly:
Economics for
1. Single seller: A monopolist produces the entire output singlehandedly to cater to
Managers : 126
the demand. Hence, there is no distinction between firm and industry and the Monopoly
whole industry is controlled by a single seller.
2. No substitute: The product sold in the market is unique and no close substitute for
the product is available. Hence, firms are free from direct competition. NOTES
3. Price Maker: There is no threat of other competitors and monopolists can set the
price or the quantity of the product to be sold.
4. High Barriers to Entry: Other sellers are unable to enter the market of the
monopolist due to high barriers to entry.
Monopolies derive their market power from barriers to entry - conditions that
thwart or greatly impede a likely competitor's ability to compete in a monopolist's
market. Barriers to entry can be broadly categorized into three types economic, legal
and deliberate. We will elaborate on these barriers now:
I) Economic barriers : These include economies of scale, high capital requirements,

cost advantages and technological superiority.
1. Economies of scale: Monopolies are characterized by decreasing costs for a
relatively large range of production over a period of time. Monopolies often
reduce prices below a new entrant's operating costs preventing them from
competing since the long-term average cost is constantly decreasing.
2. Capital requirements: Production processes that require large investments
of capital, or large research and development costs or substantial sunk costs
limit the number of companies in an industry.
3. Technological superiority: A monopolist may be better able to assess, acquire,
adapt, integrate and use the best available technology in producing goods
while new entrants usually do not have the size or finances to do that.
4. No substitute goods: A monopolist sells goods for which there is no close
substitute. The absence of substitutes makes the demand for the good
relatively inelastic enabling monopolies to extract positive profits.
5. Control of natural resources: A prime source of monopoly power is the control
of resources that are critical to the production of a final good. Check Your Progress
II) Legal barriers : Legal rights can provide opportunity to monopolise the market 1. Define monopoly and
of a good or service. Intellectual property rights, including patents and copyrights, reasons for its
give a monopolist exclusive control of the production and selling of certain goods. existence.
Property rights may give a company exclusive control of the materials necessary 2. What are the
to produce a good. characteristics of
monopoly?
III) Deliberate actions : A company wanting to create monopoly in a market may
engage in various types of deliberate action to exclude competitors or eliminate
competition. Such actions include collusion, lobbying governmental authorities, Economics for
and force. Managers : 127
Monopoly In addition to barriers to entry and competition, barriers to exit may be a source of
market power. Barriers to exit are market conditions that make it difficult or expensive
for a company to end its involvement with a market. Great liquidation costs are a
NOTES primary barrier for exiting.
8.3 Price and Output Determination under Monopoly
8.3.1 Short Run

A monopolist can set the price of the product and is therefore known as price
maker. They face a negatively sloped market demand curve as it is the sole seller of the
product for which there is no close substitute. The negatively sloped demand curve
means that a monopolist can sell more products only by lowering its price. Therefore
the marginal revenue curve of the monopolist lies below the demand curve. In the
figure 8.1 is the market demand curve and MR is the corresponding marginal revenue
curve. Note that when the demand curve is linear, the absolute slope of the MR curve
twice that of DD and MR curve lays half way between DD curve and price axis. To see
this phenomenon lets go through a numerical example
a p
Let the monopolist demand function be Q = or P = a bQ
b
Where a is the price intercept and b is the slope of the demand curve.
Q
Then TR = pQ =( a bQ )
= aQ bQ 2
The first difference of the TR will provide the corresponding MR curve hence,
d (TR)
MR = = a 2bQ
dQ
This shows that MR has the same price intercept as demand curve,but the slope is
twice (2b) the slope of the demand curve(b).Suppose the demand curve is given as P =
8 - Q. For different levels of price, the quantity demanded by consumers, total, marginal
and average revenue received by a firm is given in Table 8.1. Note an important point
from the table. As the demand curve is downward sloping AR is greater than MR for
units of product sold. It is so because in order to sell additional unit a monopolist has to
lower the price and the new reduced price is applicable to all the units. For example if
a monopolist wants to increase units sold from 3 to 4 they have to reduce the price from
5 to 4 and now all 4 units will sell at price 4 instead 3 units at price 5 and the 4that 4.
Therefore, MR is less than price or AR. The same is depicted in the diagram by
constructing MR curve below the demand or AR curve. It is shown in Figure 8.1.
Economics for
Managers : 128
Table 8.1 Monopoly
Price Quantity Total Revenue Marginal Revenue Average Revenue

(TR) (MR) (AR)
NOTES
8 0 0 -- --
7 1 7 7 7
6 2 12 5 6
5 3 15 3 5
4 4 16 1 4
3 5 15 -1 3
2 6 12 -3 2
1 7 7 -5 1
Now the monopolist has to decide about the output to be sold or the price to be
charged in such a way that it maximizes the profit. The optimum level of output in the
short run is decided at the intersection MR and MC curve which is point E in Figure
8.1. Any point to the left of the equilibrium that is when MR>MC, the total profit of the
monopolist can be increased by expanding the output. On the other hand, any point to
the right of the equilibrium MC>MR and total profit of the firm can be increased by
reducing the output that will reduce the cost of additional unit produced. Thus, the
profit maximizing output for monopolist is Q1 given in Figure 8.1 decided on the basis
of point E where MC = MR.
Having decided the output, the price at which the monopolist will charge the
product is given on the AR curve or demand curve, which is P1 in Figure 8.1. In order
to arrive at the price, extend the line from point E such that it cuts the AR curve. The
price decision is based on point where the line cuts and in the Figure 8.1 that point is
given as r. And the price that a monopolist will charge for Q1 is given as P1.
The level of average cost (AC) decides the unit profit of the product. In this case,
the firm will earn a unit profit of kr which is the vertical distance between AC and AR
at equilibrium. The shaded area P1mrk is the total profit of the firm by producing Q1
units of output and charging a price P1 per unit. Hence, we can say that in this situation
a firm earns super normal profit.As in case of perfect competition, the behavior of AC
curve decides whether a monopoly firm makes supernormal profit, normal profit or
incurs losses. Try to draw the following situations: (i) where a firm makes only normal
profit, and (ii) where a firm makes normal losses
Economics for
Managers : 129
Monopoly Figure 8.1
MC AC
NOTES P1 r
m
k
E
MR AR = DD
Q1
8.3.2 Long Run
As in the case of perfect competition, the optimum level of output is at the point
at which MR=LMC. Since, the entry is blocked or not possible in case of monopoly, it
is not necessary that the firm will produce at the lowest of its LAC. In the long run, all
factors of productions are variable;hence, the monopolist can construct an optimal scale
of plant to produce the best level of output. In this case, the quantity will be higher and
price will be lower than in the case of short run. However, unlike firm in a perfect
competition, a monopolist may earn supernormal profit in the long-run and the same
can be depicted using Figure 8.1.
8.4 Perfect Competition and Monopoly
Monopoly and perfect competition are two extreme market forms. In real world,
it is very hard to find examples of perfect competition and perfect monopoly. Probably,
a case of same grade wheat market may be close to perfect competition and Railways
(note that road and air transportation are a close substitutes in that case). In reality,
most of the industries tend to fit between these two extreme forms of market structure.
Thus an important question arises as to why we need to study these cases. One must
understand that these two models provide managers and policymakers a benchmark
against which to measure the industries. For instance, a manager may strive to move
towards monopoly to generate supernormal profits where as a policy maker would like
to ensure more competition in any industry. Therefore, it is very important to understand
the working of these two extreme cases. A comparative analysis that follows this
Economics for discussion will further enhance our understanding.
Managers : 130
Firstly, let us see some similarities among these two. First of all their cost functions Monopoly
are same. Both monopolies and perfectly competitive companies minimize cost and
maximize profit. Secondly, their shutdown decisions are the same. Finally, both are
assumed to have perfectly competitive inputs markets i.e. labor and other inputs are NOTES
available in competitive markets. However, most importantly, there are major differences,
that are as follows:
Marginal revenue and price: In a perfectly competitive market, price equals

marginal cost. In a monopolistic market, however, price is set above marginal cost.
Product differentiation: There is zero product differentiation in a perfectly

competitive market. Every product is perfectly homogeneous and a perfect substitute
for each other. With a monopoly, there is absolute product differentiation in the sense
that there is no available substitute for a monopolized good. The monopolist is the sole
supplier of the good in question. A customer either buys from the monopolist entity or
does without the product.
Number of competitors: Perfectly competitive markets are populated by an infinite

number of buyers and sellers. Monopoly involves a single seller and many buyers.
Barriers to Entry: Barriers to entry are factors and circumstances that prevent
entry into market by would-be competitors and limit new companies from operating
and expanding within the market. Under perfect competition, there is free entry and
exit. There are no barriers to entry, exit or competition. Monopolies have relatively
high barriers to entry. The barriers must be strong enough to prevent or discourage any
potential competitor from entering the market.
Elasticity of Demand: Recall that the price elasticity of demand is the percentage
change of demand caused by a one percent change of relative price. A successful
monopoly would have a relatively inelastic demand curve. A low coefficient of elasticity
is indicative of effective barriers to entry. A firm in a competitive industry has a perfectly
elastic demand curve. The coefficient of elasticity for a perfectly competitive demand
curve is infinite.
Excess Profits: Excess or positive profits are profit more than the normal expected
return on investment. A firm in a competitive industry makes excess profits in the short
term but excess profits attract competitors who can enter the market freely and decrease
prices, eventually reducing excess profits to zero in long run. A monopoly can preserve
excess profits because barriers to entry prevent competitors from entering the market.
Profit Maximization: A firm in a competitive industry maximizes profits by

producing such that price equals marginal costs. A monopoly maximizes profits by
producing where marginal revenue equals marginal costs. However, charges the price
according to demand situation. The rules are not equivalent. The demand curve for a
firm in competitive industry is perfectly elastic - flat. The demand curve is identical to
Economics for
the average revenue curve and the price line. Since the average revenue curve is constant
Managers : 131
Monopoly the marginal revenue curve is also constant and equals the demand curve. Thus the
price line is also identical to the demand curve. In sum, D = AR = MR = P.
Profit maximizing quantity, price and profit: If a monopolist obtains control of a

NOTES formerly perfectly competitive industry, the monopolist would increase prices, reduce
production, and realize positive economic profits.
Supply Curve: In a perfectly competitive market there is a well-defined supply

function with a one to one relationship between price and quantity supplied. In a
monopolistic market no such supply relationship exists. A monopolist cannot trace a
short term supply curve because for a given price there is not a unique quantity supplied.
The most significant distinction between perfectly competitive firms and monopoly
is that the monopoly has a downward-sloping demand curve rather than the "perceived"
perfectly elastic curve of a firm in a competitive industry. Practically, all the variations
mentioned above relate to this fact. If there is a downward-sloping demand curve then
by necessity there is a distinct marginal revenue curve. The implications of this fact are
best made manifest with a linear demand curve. As we stated above, we assumes the
inverse demand curve is of the form . Then the total revenue curve is TR =
and the marginal revenue curve is thus MR = . From this we can
deduce number of factors. First the marginal revenue curve has the same y intercept as
the inverse demand curve. Second the slope of the marginal revenue curve is twice that
of the inverse demand curve. Third the x intercept of the marginal revenue curve is half
P=
a
aQ
that of the inverse demand curve. What is not quite so evident is that the marginal
revenue curve is below the inverse demand curve at all points. Since all companies
maximize profits by equating MR and MC it must be the case that at the profit-
maximizing quantity MR and MC are less than price, which further implies that a
monopoly produces less quantity at a higher price than if the market were perfectly
competitive. Diagrammatically, it is shown in Figure 8.2 which is very similar to Figure
1. Note that in this case we draw another line extended horizontally from point E to AR
curve. Afirm in a competitive industry would have received P2 for Q2 output. P2 as
MC = MR at that point and Q2 as we extend the same to AR. Thus supplying more at
relatively less price as compare to monopoly.
Economics for
Managers : 132
Figure 8.2 Monopoly

MCAC
NOTES
r
P1
m
k
E
P2
MRAR=DD
Q1 Q2
The fact that a monopoly has a downward-sloping demand curve means that the
relationship between total revenue and output for a monopoly is much different than
that of competitive companies. Total revenue equals Price X Quantity. A competitive
company has a perfectly elastic demand curve meaning that total revenue is proportional
to output. Thus the total revenue curve for a competitive company is a ray with a slope
equal to the market price. A competitive company can sell all the output it desires at the
market price. For a monopoly to increase sales it must reduce price. Thus the total
revenue curve for a monopoly begins at the origin and reaches a maximum value then
continuously decreases until total revenue is again zero. Total revenue has its maximum
value when the slope of the total revenue function is zero. The slope of the total revenue
function is marginal revenue. So the revenue maximizing quantity and price occur
when MR = 0. For example assume that the monopoly's demand function is
P= 50-2Q. The total revenue function would be TR = 5Q-2Q2 and marginal revenue
would be 50-4Q. Setting marginal revenue equal to zero we have
50 - 4Q = 0
- 4Q = -50
Q = 12.5
So the revenue maximizing quantity for the monopoly is 12.5 units and the revenue
maximizing price is 25.A company with a monopoly does not experience price pressure
from competitors, although it may experience pricing pressure from potential future
competition. If a company increases prices too much, then others may enter the market
if they are able to provide the same good, or a substitute, at a lesser price. A pure
monopoly has the same economic rationality of perfectly competitive companies, i.e.
Economics for
to optimize a profit function. By the assumptions of increasing marginal costs, exogenous
Managers : 133
Monopoly inputs' prices, and control concentrated on a single agent or entrepreneur, the optimal
decision is to equate the marginal cost and marginal revenue of production. Nonetheless,
a pure monopoly can - unlike a competitive company - alter the market price for its
NOTES own convenience: a decrease of production results in a higher price. In the economics'
jargon, it is said that pure monopolies have "a downward-sloping demand". An important
Check Your Progress consequence of such behavior is worth noticing: typically a monopoly selects a higher
1. What are the price and lesser quantity of output than a price-taking company; again, less is available
conditions for profit at a higher price.
maximization for a
monopolist?
2. How a monopolist
8.5 Monopoly Power
decides about the
Monopoly power is the ability to increase the product's price above marginal cost
price to be charged
having made a without losing all customers or the ability to affect the terms and conditions of exchange
decision about the so that the price of a product is set by a single company. A firm in perfectly competitive
output? industry has zero market power when it comes to setting prices as all firms in such an
3. Which of these lead to industry are price takers. The price is set by the interaction of demand and supply at the
low price and more market or aggregate level. Individual companies simply take the price determined by
output in a market? the market and produce that quantity of output that maximizes the company's profits.
(A) A monopolist or Under perfect competition, if a company attempts to increase prices above the market
(B) A firm in a level all its customers would abandon the company and purchase at the market price
competitive industry. from other companies. A monopoly has considerable although not unlimited market
And how? power. A monopoly has the power to set prices or quantities although not both.
In order to quantify the monopoly power of a firm, economists use Lerner Index
of Monopoly Power given by Abba Lerner in 1934. It is the difference between price
(P) and marginal cost (MC) divided by price, i.e.
L = (P - MC) / P;
Thus in a competitive industry where P- MC = 0 as P = MC no firm enjoys any

monopoly power. Clearly, a large value of L implies high monopoly power enjoyed by
the firm.
As mentioned earlier, in real world no industry may be a case of perfect monopoly

but may exist between the two extremes of perfect competition and monopoly power.
In such cases, each firm may enjoy some degree of monopoly power that can be
quantified by using Lerner Index. The extent of monopoly power of a single firm in
such industries depends upon (i)number of other firms, (ii) nature of interaction among
the existing firms and (iii) the elasticity of demand. A large number of firms in an
industry will reduce the capacity of a single firm to charge price higher than its MC
thereby reducing its monopoly power. Moreover, if these firms continuously compete
with each other, a single firm's ability to raise the price will be further constrained. On
Economics for the other hand, if there is a possibility of cooperative or collusive behavior each firm
Managers : 134 may enjoy monopoly power. The elasticity of demand influences the slope of the demand
curve of a firm. Note in Figure 8.3 where we show two demand curves DD1 and DD2. Monopoly
Clearly DD1 is more elastic then DD2. Following our earlier discussion, we derive the
price that will be charged if in both cases a firm has same MC. We find that the difference
between MC and P is larger in case of DD2 and thus a firm may enjoy more monopoly NOTES
power.
Figure 8.3
MC
P1
P2
AR1 = DD1
MR1
AR2 = DD2
MR2
8.6 Social Cost of Monopoly Power and Competition

Commission
The capacity of a monopolist to charge price higher than its MC imposes heavy
cost on the society. Firstly, we have seen that the price charged by monopolist is higher
with lesser output being produced (refer to Figure 8.2). Thus, the consumer suffers as
their welfare is reduced with high price and less output being available in the market.
Clearly, this happens as the monopolist earns super-normal profit which implies that
there is a redistribution of welfare from many consumers to a single producer.
Super-normal profits earned in monopoly also give motivation to monopolist to

make efforts to acquire and maintain monopoly position in any industry. For instance,
a producer may be ready to bribe government officials to receive exclusive rights to
mine minerals in some particular mines. In such a case, the amount spent on these
activities is referred to as rent seeking. Evidently, such an expenditure is a waste and
socially undesirable. Producers may therefore be involved in various activities to
establish or maintain the monopoly position.
Considering that firms may be involved in activities that may be socially

Economics for
undesirable as those may lead to creation of monopoly and/or abuse of such monopoly
Managers : 135
Monopoly power, there is a need for intervention by the government to regulate such activities.
This is one of the basic reasons behind creation of anti-trust authorities in any economy.
In Indian context, we have Competition Commission of India (CCI) that attempts to
NOTES regulate the activities of such firms that may be exercising excessive monopoly power
and consumer may be suffering due to such activities.
8.7. Summary
Monopoly is one of the extreme market structures where there is a single seller in
the market. In this case there is no distinction between firm and industry. As in the case
of perfectly competitive firm, monopoly firm also decides its best level of output at
which MR=MC, but not producing at the lowest part of the AC curve. The firm facing
a downward sloping demand curve indicates the necessity of price reduction in order
to sell more units of output. A monopolist enjoys monopoly power for its product. The
real monopoly power may depend upon variety of factors and may vary for different
industries. There is no doubt that a perfectly competitive industry is better for consumers
instead of a monopoly. Thus, the government also makes effort to ensure that competition
is maintained in various industries and no single producer is able to exploit the
consumers.
8.8 Key Terms
Monopoly : A situation where a particular individual or enterprise is the only supplier

of a product.
Monopsony : A market with only one buyer of a product.
Barriers to Entry : Conditions that prevent or greatly impede a likely competitors

ability to enter in a market.
Monopoly Power : The ability of a producer to increase the products price above its
marginal cost.
Lerner Index of Monopoly Power : It is calculated as the difference between price

(P) and marginal cost (MC) divided by price to quantify the monopoly power
of a firm.
Rent-seeking : Efforts made by producers including the amount spent to acquire and
maintain monopoly position in any industry.
8.9. Question and Exercise
Economics for 1. Consider a demand function P = 10-Q; calculate TR, MR and AR for different
Managers : 136 levels of price ranging from 1-10.
2. What are the characteristics of monopoly? Monopoly
3. Show diagrammatically a case of loss-making monopolist.
4. How is monopoly different from perfect competition?

NOTES
5. Do you think it is justified that government intervene in industries to ensure that
they remain competitive? Justify your answer.
6. What is the social cost imposed if in a particular industry there is a single seller.
8.10 Further Reading & References
1. C.H. Petersen, W. C. Lewis and S. K. Jain. 2009. Managerial Economics, fourth

Edition.
2. Dominic Salvator.2009. Managerial Economics-Principles and worldwide

3. W.B. Bruce Allen, K.Wieght, N.Doherthy and E. Mansfield.2011. Managerial

Economics- Theory, Application, and Cases,seventh edition.
Economics for
Managers : 137
Cost Analysis
UNIT 9 MONOPOLISTIC COMPETITION
NOTES Structure
9.0 Introduction
9.1 Unit Objectives
9.2 Characteristics of Monopolistic Competition
9.3 Equilibrium under Monopolistic Competition
9.4 Summary
9.5 Key Terms
9.0 Introduction
In the last two units, we studied two benchmark market structures namely perfect
competition and monopoly. As mentioned earlier, in real world most of the industries
may exit with a market structure in between these two extreme forms. One such structure
is a monopolistic competition which is a type of imperfect competition. The word
"monopolistic competition" is an oxymoron which means putting together words that
are contradictory. In case of monopolistic competition, many firms exist and entry is
not restricted for new firms. Thus it is close to perfect competition and the use of the
word "competition". However, each firm has differentiated product that gives such
firm a monopoly over the product and accordingly the use of word "monopolistic". We
will have more discussion on differentiated products later in the text. The theory of
monopolistic competition was propounded by E. H. Chamberlin in his pioneering book
"Theory of Monopolistic Competition". Examples of monopolistic competition include
industries for products like soaps, toothpaste, detergent, packaged tea etc.
This unit is organised as follows: Section 9.2 discusses characteristics of

monopolistic competition. Section 9.3 enumerates equilibrium under monopolistic
competition including both short-run and long-run. Section 9.4 provides the summary
of the unit and section 9.5 brings together the key terms used in the unit.
9.1 Unit Objective

* To understand the structure of market under monopolistic competition.
Economics for
Managers : 138 * To understand differentiated products and non-price competition.
* To know the price and output determination of monopolistic firm in the short Cost Analysis
run and long run.
9.2 Characteristic of Monopolistic Competition NOTES
Monopolistic competition has following characteristics:
1. There are many producers and many consumers in the market, and no firm
has total control over the market price.
2. Consumers perceive that there are non-price differences among the

competitors' products.
3. There are a few barriers to entry and exit.
4. Producers have a degree of control over price i.e. they are price makers.
5. A central feature of monopolistic competition is that products are

differentiated.
9.2.1. Product Differentiation

Products that sell in case of monopolistic competition are differentiated from one
another such that though these products may satisfy similar want of consumer yet these
are not perfect substitutes of each other. Consider for instance market for toothpastes
where one may find Colgate, Close up, Pepsodent and many such brands. Note that
each product is used for oral hygiene but how each is different from another.
Differentiated products are similar but not identical, however, satisfies the same needs.
As these products satisfy the same need of consumers there is competition but as each
firm distinguishes its product from other firms' there is monopoly. For instance, think
about the campaign of Colgate which says "mere toothpaste mein namak hai" (my
toothpaste has salt). The salt becomes the differentiating characteristics of the product
creating monopoly for Colgate in that product space. You can think of many such
examples as companies attempt to differentiate their product from that of another firm.
There are four main types of differentiation:
1) Physical product differentiation: where firms use size, design, colour, shape,
performance, and features to make their products different. For example,
consumer electronics can easily be physically differentiated. In this case,
products can be either horizontally or vertically differentiated by firms. In
case of horizontal differentiation, firms create space for their product through
its features where as in case of vertical differentiation, the quality of product
and thus performance varies.
2) Marketing differentiation: where firms try to differentiate their product by

distinctive packaging and other promotional techniques. For example,
Economics for
breakfast cereals can easily be differentiated through packaging.
Managers : 139
Cost Analysis 3) Human capital differentiation: where the firm creates differences through
the skill of its employees, the level of training received, distinctive uniforms,
and so on. It has relevance in service industry. Consider for instance, retail
NOTES shopping industry where in each store the special attention received by
customer from the store attendant can be a differentiating factor.
4) Differentiation through distribution: including distribution via mail order or

Check Your Progress
through internet shopping, such as Amazon.com, which differentiates itself
1. Explain how a firm
from traditional book-stores by selling online.
operating in
monopolistic 9.2.2 Non price competition : Advertising and selling expenditure
competition industry
Evidently, firms under monopolistic competition make extensive efforts to
has monopoly and still
differentiate their products from another. It may lead to non-price competition among
the industry is
the firms where instead of competition with each other in terms of price, firms may
competitive.
2. Like the Colgate s involve in extensive advertising and selling costs to establish the distinguishing factor
salt example, write the of the product in the minds of the consumer. Firms can increase its expenditure on
factors used by firms product variation and selling efforts in order to increase its demand. Product variation
to distinguish their is the characteristic change made by the firm on their product in order to make the
products in bathing product more attractive to consumers. Selling expenses on the other hand, incurred by
soap, detergent soap, the firm to advertise their product. Both the expenses increase firm's sale and profit.
shampoo and washing
powder category of
9.3 Equilibrium under Monopolistic Competition
products.
Under the monopolistic competition, we cannot derive the market demand curve
and market supply curve of the product as in the case of perfect competition. Since
each firms in the market sells differentiated product, we do not have a single equilibrium
price, rather we would have a cluster of prices. Unlike in perfectly competitive firm,
monopolistic firm can decide the characteristic of their product and the selling price. In
the short run, supernormal profits are possible, but in the long run new firms are attracted
into the industry, because of low barriers to entry, good knowledge and an opportunity
to differentiate.
9.3.1 Monopolistic Competition in the Short-Run

As firms in monopolistic competition produces differentiated product, the demand
curve they face is downward sloping, but highly price elastic. It is highly elastic as
many other substitutes of the product are available in the market. The conditions for
arriving at profit maximizing output and concomitantly the price for each product of a
firm is similar to monopoly. As in the case of monopoly, the marginal revenue (MR)
curve is below its demand curve. Take note of Figure 9.1 where we equate for profit
maximization, MC = MR, and achieve output as Q and price P. Given that price (AR)
is above ATC at Q, supernormal profits are possible as shown in Figure 9.1, area PABC
Economics for is the supernormal profits enjoyed by the firm. The condition to check whether or not
Managers : 140
profits are being made can be summarized as follows: - (i) if Price > ATC, the firm Cost Analysis
makes a profit, (ii) if Price < ATC, the firm makes a loss and (iii) If Price = ATC, the
firm will break-even.
Figure 9.1 NOTES
9.3.2 Monopolistic Competition in the Long-Run

Now, in long run new firms may be attracted to market considering that existing
firms are enjoying supernormal profits. As new firms enter the market, demand for the
existing firm's products becomes more elastic and the demand curve shifts to the left,
driving down price. Eventually, all super-normal profits are eroded away. New entrants
continue until only normal profit is available. At this point, firms have reached their
long run equilibrium. This condition is shown in Figure 9.2.
Figure 2
Noticeably, any manufacturer under monopolistic competition benefits the most

in the short-run and therefore, they will try to stay in the short run by innovating, and Economics for
Managers : 141
Cost Analysis through further product differentiation.
In monopolistic competition, a firm takes the prices charged by its rivals as given
and ignores the impact of its own prices on the prices of other firms. Monopolistic
NOTES competition differs from perfect competition in that production does not take place at
the lowest possible cost. An individual firm's demand curve is downward sloping, in
contrast to perfect competition, which has a perfectly elastic demand schedule. Each
firm also exercises some amount of influence over the market; because of differentiated
product and brand loyalty. Thus, it can rise its' prices without losing all of its customers.
In a monopolistically competitive market, firms can behave like monopolies in the
short run, including using market power to generate profit. In the long run, however,
other firms enter the market and the benefits of differentiation decrease with competition;
the market becomes more like a perfectly competitive one where firms cannot gain
economic profit. In practice, however, if consumer rationality/innovativeness is low
and heuristics are preferred, monopolistic competition can fall into natural monopoly,
The long-run characteristics of a monopolistically competitive market are almost

the same as a perfectly competitive market. However, differences between these two
are that monopolistic competition produces heterogeneous products and involves in
non-price competition, which is based on subtle product differentiation.
9.4 Summary
A monopolistic competitive industry has characteristics of both perfect competition

and monopoly. A key aspect is product differentiation and extensive efforts made by
firms to differentiate their products from others firm to retain their monopoly position
over the product. A firm makes profits in the short run will nonetheless only break even
in the long run because demand will decrease and average total cost will increase. This
means in the long run, a monopolistically competitive firm will make zero economic
profit.
9.5 Key Terms
Monopolistic Competition : A market structure where many firms exist and entry is
not restricted for new firms. However, each firm has differentiated product
that give such a firm a monopoly over the product.
Differentiated Products : Products that may satisfy similar want of a consumer but
are not perfect substitutes of each other.
Non-price Competition : Competition among the firms where instead of competing
with each other in terms of price, firms involve in extensive advertising and
Economics for selling costs to distinguish their product from other firms product.
Managers : 142
Cost Analysis
1. What are the characteristics of monopolistic competitive industry?

NOTES
2. What are the similarities and dissimilarities between monopolistic competitive
industry and perfect competition?
3. What is the source of monopoly for a firm in a monopolistic competitive industry?

Give examples from the shampoo industry.
4. Explain using diagram how a firm that earns supernormal profit in short-run in
monopolistic competitive industry will earn only normal profit in long run.

Edition.
2. Dominic Salvator. 2009. Managerial Economics-Principles and worldwide

3. W.B. Bruce Allen, K. Wieght, N. Doherthy and E. Mansfield.2011. Managerial

Economics- Theory, Application, and Cases, seventh edition.
Economics for
Managers : 143
Oligopoly
UNIT 10 OLIGOPOLY
NOTES Structure
10.0 Introduction
10.1 Unit Objectives
10.2 Oligopoly and its Characteristics
10.3 Oligopoly Models
10.4 Summary
10.5 Key Terms
10.0 Introduction
Continuing with our discussion on market structure, we now move on to Oli-

gopoly. The word "Oligopoly" has Greek roots in words "oligos" meaning few and
"polis" implying sellers. If you closely observe industries like communication, avia-
tion, and automobile, you will find very few players in these industries. For instance, in
telecommunication in India you have firms like Airtel, Vodafone, and BSNL with a
few other small players but with a large number of buyers. With small number of firms,
the key features of such a structure are the interdependence among the firms for price
and output decisions and also the interactions among these firms. A small group of
firms can behave either extremely competitive or come together to behave like a mo-
nopoly. Thus, not the simple but strategic interactions among the firms are the interest
of study for many economists in case of oligopoly. In this unit, we will study the oli-
gopoly models to understand price and output determination by firms under specific
assumptions of those models.
This unit is organized as follows: Section 10.2 discusses characteristics of oli-

gopoly firm. Section 10.3 elucidates oligopoly models. Section 10.5 provides a sum-
mary for the chapter and key terms, questions and exercise are discussed in sections
10.6 and 10.7 respectively.

Economics for * To understand the structure of market under oligopoly.
Managers : 144
* To understand the models of oligopoly. Oligopoly
* To understand market concentration and measures used to quantify it.
NOTES
10.2 Oligopoly and its Characteristics
Oligopoly is one of the market structures prevalent in most of the manufacturing

sector, including India. In terms of few sellers, if there are only two sellers it is called as
duopoly. If the product in the market is homogeneous, we have pure oligopoly (for
example aluminum, steel etc.) and if producers sell differentiated products, we have
differentiated oligopoly (for example tablets, smart phones etc.). As mentioned earlier,
since there are only few sellers in the market, the action of a firm affects the action of
its competitor. In case of telecom industry, when Airtel introduced tariff reduction to
their customers, Idea cellular or Vodafone may immediately follow the tariff policy.
10.2.1 Price Competition versus Non-price Competition

The firms under oligopoly may compete with each other in form of either price or
non-price competition. Price competition refers to counter strategy of a firm with re-
sponse to their competitor would be in terms of price. For instance, when Maruti intro-
duced a price cut in the sale of certain model, TATA Motors also responds in the same
manner by reducing the price of certain model, called price competition. Since compe-
tition often leads to harmful price war, oligopolies prefer to compete through product
differentiation and other strategies like advertising. These types of competitions refer
to as non-price competition. To sum up, rivalry is the main feature of oligopoly which
arises from the few sellers. Thus there is a possibility of price war among the firms that
may occur as:
1. New producer/seller sells at a lower price than the existing one to establish
itself in the market.
2. Existing producer/seller wants to revive lagging sales by reducing the price.
3. There are surplus stocks and limited storage capacity with firms.
10.2.2 Collusive and Non-collusive Oligopoly

An important factor influencing a market structure is the degree of cooperation
among the firms. When firms cooperate completely, they engage in collusion. This
term denotes a situation in which two or more firms jointly set their prices or outputs,
divide the market among them or make other business decisions jointly. Cartel is the
best example of collusion, where firms in cartel work together, restrict output and or
supply and artificially keep the prices as high as possible. A non-collusive oligopoly
can be seen where firms act independently and consider themselves as normal business
unit. When it comes to the pricing policy, they may become interdependent.
Economics for
Managers : 145
Oligopoly 10.2.3 Sources of Oligopoly
Difficulties encountered in entering an industry are often referred to as barriers to
entry. We had discussion on barriers to entry in the unit covering monopoly. These
NOTES barriers also play a key role in oligopoly by restricting the number of sellers in an
industry. Thus, we enlist the sources of oligopoly as follows:
1. Economies of scale: the operation of economies of scale over a large range

of output leaves few firms in the market that can make profit given the size
of market.
2. Free but limited entry: though the entry to the industry is free, but it limited
because of the requirement of huge infrastructure or capital investment.
3. Established firms: new firms find it difficult to establish themselves in the

market because of the loyalty of the customers to established firms' products.
4. Government policies: government may give franchise or licenses to only

few sellers.
5. Control over input: few firms in the industry may own or control the entire
Check Your Progress supply of raw material for their production.
1. Define oligopoly and
explain its sources. 6. Product differentiation: an established firm that has already convinced its
2. Identify two customers that their product is significantly better than new entrants will not
oligopolistic have an advantage over others.
industries in Indian 7. Patent: having a patent as an exclusive right to commercialize a product in
context and list the the market will also restrict new entrants.
major firms operating
in those industries. It is very important for industry level analysis to understand the origin of these
3. Considering that barriers. You must have noticed that some barriers exist because of the nature of indus-
there are few firms in try like those that require massive initial capital requirements where as in some case
oligopolistic incumbent or existing firms have deliberately taken action to restrict the entry. Accord-
industry, what kind ingly, economists differ in their opinion regarding the constituents of barriers to entry.
of interaction can According to Bain (1956), advantages that existing firms have over potential competi-
take place among the tors constituted entry barriers whereas Stigler (1968) argued that only entry costs faced
firms? by new entrants are part of these barriers. Clearly, Bain's explanation is broad and
encompasses the action that the existing firms might undertake to raise barriers to
entry.
10.3 Oligopoly models
In case of oligopoly, there is no general theory of oligopoly as it is difficult to

ascribe a single type of interaction among the firms. Thus, a number of models of
various degrees of realism have evolved over a period of time with different behavioral
Economics for
assumptions regarding the interactions among firms. Some of these models have be-
Managers : 146
come standard and are explained below. Oligopoly
10.3.1 The Cournot Model

The French economist Augustin Cournot introduced the concept of Oligopoly
NOTES
model in 1838 highlighting the interdependence of existing firms in such an industry.
For simplicity the model assumes that (i) there are only two firms, (ii) firms sell ho-
mogenous product and (iii) firms make decision about the quantity of output to be
produced. The key feature of the model is that each firm tries to maximize its profit by
assuming that other duopolist holds its output constant at the existing level.
The output determination in Cournot model is given in Figure 10.1 with output
on X axis and price on Y axis. For simplicity, we consider that both firms have same
marginal cost. As earlier, equilibrium output decisions are based on point where MC =
MR. In Figure 10.1 where P is price and Q output, D1 is the initial market demand
curve in an industry. When firm A is operating in the market alone it will face the
market demand curve D1 and respective marginal revenue curve MR1. The cost is
given by MC1 curve which is parallel to X axis as cost is assumed to be constant.
Under these conditions the firm maximizes profit by producing F0 units of output.
When firm B decides about the output to be produced, it consider the level of output
already being produced by firm A. Accordingly, B faces a market demand curve D2,
which is drawn on the basic of unproduced quantity (it is left of D1 by units F0 that are
already being produced by firm A) and MR2 is the corresponding marginal revenue
curve on the belief that firm A will continue to produce F0 units of output. As in the
previous case, firm B will produce half of existing demand curve (based on MR=MC).
Now firm A realizes that, in the market still there is unproduced quantity, and it will
face new demand curve based on subtracting from the market demand curve units
supplied by the firm B. Firm A now maximizes the profit by producing F2 units. This
action and reaction continues until each firm produce and supply one-third of the mar-
ket demand and one-third remains unsupplied.
The reaction of one firm to the output produced by another firm is the key aspect
of Cournot model. Clearly, there is an inverse relationship between the output pro-
duced by one firm and that of another firm. It implies that as the output produced by
firm A increases firm B will produce lesser amount. This aspect of the model is cap-
tured through reaction curve. A reaction curve of firm A gives its profit-maximizing
output based on the different levels of output of another firm. Each firm has its reaction
curve and final equilibrium is attained where reaction curves of both firms intersect
each other. This analysis is given in Figure 10.2 with X axis representing output of firm
B and Y having output of firm A. The reaction curves of both the firms are also given
that intersect at point E. Based on this point one can arrive at equilibrium output under
Cournot Model such that each firm is producing profit maximizing output based on
what other firm is producing.
Economics for
Managers : 147
Oligopoly Figure 10.1

P
NOTES
D1
MR1
MC1
D3
MR3 MR2 D2
F2 F1F0Q
Figure 10.2
QA
FirmsBreactioncurve
E FirmsAreactioncurve
QB
10.3.2. The Kinked Demand Curve Model

As mentioned earlier, there is no standard model that explains oligopoly com-
pletely. Each model assumes a particular behavior or witness the existence of some-
thing peculiar. Price rigidity is one such instance that has been observed in oligopoly
whereby firms may follow a firm in case it reduces prices but not in case of price
increase. Thus price becomes rigid for upward movement. Paul M. Sweezy in 1939
introduced the concept of kinked demand curve model as an attempt to answer the
price rigidity in the oligopolistic model. When an oligopolist raised it price, it will lose
its customers as other oligopolist would not follow them. On the other hand, when an
Economics for oligopolist reduces its prices in order to increase its market demand other also follow
Managers : 148
them by another price cut. As a result, firm in the oligopoly market facing demand Oligopoly
curve with a kink at the existing price level. The demand curve will be highly price
elastic above the kink, while less elastic below the kink. Figure 10.3 explains the mar-
ket mechanism with price (P) on Y axis and output (Q) on X axis. ABC is the market NOTES
demand of oligopolist where there is a kink at point B. The MR curve for the firms on
the other hand has two segments. AQ is the portion corresponds to the AB portion of
the demand curve whereas RS is the segment corresponds to the BC portion of the
market demand curve. QR portion of the curve is discontinuous part of the curve. The
oligopolist produces best level of its output when MC curve passes through the discon-
tinuity segment of the MR curve. It shows that as long as MC passes through the
segment, the price and quantity remain the same. As shown in figure the actual output
produced will depend on the cost consideration that is if the marginal cost is given by
MC, MC1 or MC2.
The main feature of oligopoly is that it highlights the interdependence of firms in

the market. The major contribution of this model is that the market demand curve each
oligopolist faces is determined by the output and price decision of the other firms in the
oligopoly. One of the major criticisms that the kinked model facing is that the theory
fails to explain how the oligopolist finds the kinked point in its market.
P Figure 10.3
A MC2
MC
B
MC1
QQ
R
SS C
C
Q
10.3.3 Cartel Arrangement

In the first two models that we studied, we find that firms are competing with
each other in an interdependent environment. Considering that there are few firms
there is always a possibility for these firms to come together or collude explicitly or
tacitly. If the firms in an industry either all or some decides to collude they can drive up
the price. Note that such collusion need not involve all the firms, in case a set of pro-
ducers are involved they can influence the price. Such collusion may lead to creation
of a cartel as an agreement of producers and manufactures to fix prices, market and
Economics for
output. Thus there can be two types of cartels, (i) market sharing and (ii) centralized
Managers : 149
Oligopoly cartel. Market sharing cartels are those where firms may divide the market such that
each producer operates in a particular geographical region. Centralized cartel on the
other hand, agrees to set the monopoly price, output and profit distribution among the
NOTES members. In the world, Organization of Petroleum Exporting Countries (OPEC) is the
best example of centralized cartel.
Cartels are illegal in most countries of the world like U. S and India. And most
cartels exist at international level as territorial law of one country need not apply on
foreign companies or countries. Once again OPEC is the case in point.
Interestingly, cartels are inherently unstable. As one or another firm will have the
motivation to cheat and earn some stealth profits. For instance, in case of centralized
cartel a firm that has been allocated a particular amount of output to sell in the market
may like to sell little more and earn extra profits. This can go on as long as others firms
of the cartel do not notice. However, sooner or later excessive supply in the market
may drive down the price and others may take action against the errant firm. If all
members disband it may lead to competitive behavior among them and price may come
closer to perfectly competitive market. Thus, the fear of reduction in price to competi-
tive levels can be major incentive for firms to not cheat. Moreover, the stability of a
cartel depends upon the organizational structure of the cartel and its capability to handle
errant firm. Furthermore, as we already know the extent to which a cartel can raise the
price also depends upon the elasticity of demand for the product. Recall our discussion
from the monopoly unit where we showed that monopoly power of a firm is higher in
case the product has inelastic demand. In case of elastic product, cartel may have less
monopoly power and may not earn enough profit to share among the member firms
that may once again lead to instability of the cartel.
10.3.4 Price Leadership

Price leadership is the fourth model of oligopoly that ensures less price war and
less collusion. Price leadership is a kind of unorganized collusive oligopoly. Under the
price leadership, the leader in the sector determines the price of goods or services. This
can leave leader's rivals with little choice but to follow its lead and match these prices
if they are to hold on to their market share. Price leadership often takes several forms
as; i) Price leadership by low-cost firm, ii) Price leadership by dominant firm and iii)
Barometric Price Leadership.
Price leadership by low cost firm implies that a low cost firm in industry sets a
lower price than the profit maximizing price. Under this condition, a high cost firm
will not be able to sell their product at the higher price than that of low cost firm;
therefore they are forced to agree with the lower price set by the low cost firm.
Price leadership may arise from dominant firm in the industry as well. One of the
few firms may produce a very large proportion of the total production in the industry
Economics for and therefore dominates in the industry. On the other hand, other relatively small firms
Managers : 150
would not be able to make any impact on their own. As a result, the dominant firm Oligopoly
estimates its own demand curve and fixes the price accordingly.
Finally, price leader ship may be in the form of barometric price leadership. An
old, experienced, largest and most respected firm takes over as the custodian of the NOTES
market and protects the interest of all other firms in the industry. The firm will make
any changes in the industry while considering the market and cost condition after con-
sidering all the firms.
10.4 Summary
This unit provides an idea of the oligopoly models, where the market is character-
ized by few sellers and price rigidities. Based on the product that sells in the market,
oligopoly is either characterized as pure oligopoly or differentiated oligopoly. As there
are only limited sellers in the market; firms need to take in to account the likely re-
sponses from other participants in the market. Depending on the nature of the product,
sellers may agree to collude with each other and may take the form of cartel.
In order to understand the behavior of firms in an oligopolistic market, econo-

mists have given different models. As the interdependence and interactions between
the firms are very important in oligopoly, these models consider different types of
interactions among the firms. Accordingly, these models attempt to study the behavior
and predict the firms' actions.
10.5 Key Terms
Duopoly : A market structure with two sellers.
Oligopoly : A market structure with few producers selling either homogenous or

differentiated goods.
Collusion : A situation in which two or more firms jointly set their price or output,
divide the market among them or make other business decisions jointly.
Reaction Curve : A curve of one firm that gives its profit-maximizing output based
on the different levels of output of another firm.
Kinked Demand Curve : A demand curve faced in the oligopoly market that has a
kink at the existing price level. It is price elastic above the kink (as other
firms will not raise price if one firm increases the price), while less elastic
below the kink (as other firms will follow any price decline).
Market Sharing Cartel : A cartel where firms may divide the market such that each
producer operates in a particular geographical region.
Economics for
Managers : 151
Oligopoly Centralized Cartel : A cartel where firms may agree to set the monopoly price,
output and profit distribution among the members.
NOTES 10.6 Questions and Exercises
1. What are the behavioral assumptions of the Cournot Model?
2. Why an oligopolist faces a kinked demand curve?
3. Why firms in oligopoly market decide to agree on collusion?
4. What conditions ensure that a cartel is stable?
5. What do you understand from price leadership? Can you think of some examples
of price leaders in Indian market for some products like Salt.

Edition.
2. Dominic Salvator. 2009. Managerial Economics-Principles and worldwide ap-

plications, sixth edition.

Economics for
Managers : 152
Pricing under Different
UNIT 11 PRICING UNDER DIFFERENT Structures- Pricing Practices
STRUCTURES-PRICING PRACTICES
NOTES
Structure
11.0 Introduction
11.2 Cost Oriented Pricing
11.3 Strategy Oriented Pricing
11.4 Customer Oriented and Other Pricing Practices
11.5 Summary
11.6 Key Terms
11.0 Introduction
A firm can use a variety of pricing strategies when selling a product. Producers
may benefit from lowering or rising prices, depending on the need and behavior of
customers and clients in particular markets. Finding the right price strategy is an
important element in running a business. The immediate effect of price strategies is
reflected in short run profit. But it also affects future profit. Indeed price strategies are
a major force which determines firms' long run profit. This unit provides a broader
perspective for pricing decisions. A manager always tries to develop the system which
contains optimum prices and this system must be consistent with opportunities and
constraints. In this unit we will study the pricing strategies of firms with broad
classification of those into three categories. Firstly, cost based strategies where the
main basis of devising prices is the consideration of cost. Secondly, the strategic
consideration of monopoly power in oligopoly and monopoly is the basis of pricing
strategy. Lastly, the customer characteristics and tastes become important for firms.
Note that in case of all these pricing practices; their classification in to three categories
need not be water tight. The classification is broad based to highlight the key concern
along with other considerations. For instance, cost consideration will play a role while
devising a pricing practice based on customer taste.
The unit is organized as follows: Section 11.1 delineates unit objectives. In 11.2,
11.3 and 11.4 we will study cost oriented pricing, strategy oriented pricing, and customer
oriented and other pricing practices respectively. Section 11.5 provides summary with Economics for
Managers : 153
Pricing under Different key terms and questions and exercises given in 11.6 and 11.7.
Structures- Pricing Practices

NOTES
* To study cost oriented pricing practices.
* To understand strategy oriented pricing practices.
* To understand customer oriented and other pricing practices.
11.2 Pricing Decisions and Strategies
A manager always tries to develop the system which contains optimum prices
and this system must be consistent with opportunities and constraints faced by the
firm. A firm can improve profits by (i) cutting costs, (ii) selling more, or (iii) pricing
strategy. Merely raising prices is not always the answer, especially in an economy.
Where customers income is low. Many businesses have been lost because they priced
themselves out of the market place. On the other hand, many businesses leave "money
on the table". One strategy does not fit all, so adopting a pricing strategy is a learning
curve while studying the needs and behaviors of customers. Now we discuss various
pricing strategies that are used by producers.
11.2 Cost Oriented Pricing
11.2.1 Cost-plus pricing

Cost-plus pricing is the simplest pricing method and many firms use it. In this
method, producer set the price that cover cost of producing the product plus enough
profit to allow the firm to earn its target rate of return. This is very popular method.
Cost-plus pricing is used primarily because it is easy to calculate and requires little
information. Information on demand is not easily available, managers have limited
knowledge as far as demand is concerned. The process of obtaining this information is
expensive. Therefore, cost-plus pricing is often considered the most rational approach
in maximizing profits. Basically there are two steps involved in cost-plus pricing. First,
we determine the cost of production of good (both fixed cost and variable cost). In the
second step we determine the markup over costs.
Cost-plus pricing has some advantages like, this method provides a justification
for price change, the formula used in this method is very simple, it may also contribute
Economics for to price change and it require little information. However, many people criticize this
Managers : 154
method as it takes into account only cost of production and there is no role of demand Pricing under Different
in this method. This shortcoming is compounded by the fact that cost data used may be Structures- Pricing Practices
the wrong cost.
11.2.2 Absorption Pricing NOTES
This is one of the forms of cost-plus pricing. In this method of pricing, all costs
are recovered. The price of the product includes the variable cost of each item plus a
proportionate amount of the fixed costs. Absorption cost pricing is especially used in
industrial sectors. It is not applicable for retail or service pricing. The calculation of
absorption pricing for an individual unit is to divide total overhead and administrative
costs by the number of units produced, and add the result to the variable cost per unit.
This method is not acceptable for deriving the price of a product that is to be sold in a
competitive market, because it does not account for the pricing of competitors, nor
does it factor in the value of the product to customers.
11.2.3 Marginal-Cost Pricing

Marginal-cost pricing is the practice of setting the price of a product equal to the
additional cost of producing an extra unit of output. By this policy, a producer charges,
for each product unit sold, only the addition to total cost resulting from materials and
direct labour. Businesses often set prices close to marginal cost during periods of poor Check Your Progress
sales. Under marginal cost pricing, the business would first decide how much to produce 1. Explain different
and then set its price based on the marginal cost of the last unit it produces. If, for considerations that
example, an item has a marginal cost of $1.00 and a normal selling price is $2.00, the will be important for
firm selling the item might wish to lower the price to $1.10 if demand has waned. The firms to devise price
of the product.
business would choose this approach because the incremental profit of 10 cents from
2. Discuss the problem
the transaction is better than no sale at all.
with marginal-cost
From the perspective of economics theory, marginal-cost pricing leads to the most pricing.
profitable prices in any type of market. However, it can be difficult for a business 3. What are the
owner in the real world to calculate marginal costs, because owners and managers tend advantages of cost-
plus pricing?
to conflate marginal costs with other types of costs, such as fixed costs and sunk costs.
11.3 Strategy Oriented Pricing
11.3.1 Limit Pricing

In limit pricing method, producers sell the product at a price which is lower than
the average cost of production. In limit pricing, the price set by a monopolist to
discourage economic entry into a market, and is illegal in many countries. The limit
price is the price that the entrant would face upon entering as long as the incumbent
firm does not decrease output. The limit price is often lower than the average cost of
Economics for
production or just low enough to make entering not profitable. The quantity produced
Managers : 155
Pricing under Different by the incumbent firm to act as a deterrent to entry is usually larger than would be
Structures- Pricing Practices optimal for a monopolist, but might still produce higher economic profits than would
be earned under perfect competition.
NOTES For example, two companies are competing for a market segment. Both companies
have perfect information. Company A is already in the market and is making a
monopolistic profit. Company B is considering entry into the market segment to take
some of the profits from company A. Company A is not keen on the idea. So, to
discourage company B from entering the market, company A begins to sell its products
below the monopolistic price (or threatens to sell its products below the monopolistic
price if company B decides to enter the market). This action would reduce or eliminate
any potential future profits company B would make if it enter the market segment.
Ultimately company B decides the profit margins are low and does not enter the market
segment. Company A continues making profit. This practice is most commonly
undertaken by oligopoly firms seeking to expand their market shares and gain greater
market control.
11.3.2 Price Discrimination

It is a pricing strategy in which a producer charges customers different prices for
the same product or service. There are three necessary conditions for price discrimination:
(i) Firm must have come control over the prices. A monopolist is in appropriate
position to exercise price discrimination.
(ii) Firm must be possible to categorize different markets according to price

elasticity of demand.
(iii) Products cannot be purchased in one market for reselling in another market.
Broadly, there are three forms of price discrimination:
(i) First-degree price discrimination: This involves charging maximum possible

prices for each unit of product. This is an extreme form of price discrimination
and most profitable from firm's point of view. For instance, in case of auction
people bid for the highest price they are willing to pay for a product. In this
way, seller can elicit as much as possible from the customer.
(ii) Second-degree price discrimination: This is an imperfect form of first-degree

price discrimination. Instead of setting different price for each unit, it involves
pricing based on the quantities purchased by consumer. This is most common
in utility pricing. Second-degree price discrimination plays an important role
in the schedule of rates charged by many public utilities like gas, water and
electricity. For instance, first 100 units of electricity consumption have
different charge as compare to next slab of say 100-300 units.
(iii) Third-degree price discrimination: This is most common form of price

Economics for
discrimination. It involves separating the market or consumer in terms of
Managers : 156
their price elasticity of demand. Three condition must hold for this price Pricing under Different
strategy; demand must be heterogeneous, manager must identify and segregate Structures- Pricing Practices
the different segments, and market must be successfully sealed. In this case,
producer will charge high price in a market where demand is inelastic as NOTES
compare to market with elastic demand.
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 different prices for a show that is price of ticket may vary if you visit the
movie hall on weekdays as compare to weekends depending upon elasticity of demand.
11.3.3 Predatory Pricing

Predatory pricing, also known as aggressive pricing or undercutting intend to
drive out competitors from a market. Predatory pricing is an act of setting prices low in
an attempt to eliminate the competition. Predatory pricing is illegal under anti-trust
laws, as it makes markets more vulnerable to a monopoly. Companies may engage in a
variety of activities that intend to drive out competitors, such as create barriers to entry
for new competitors or unethical production methods to minimize costs.
A sign of predatory pricing can occur when the price of a product gradually
becomes low which can happen during a price war. This is difficult to prove because it
can be seen as a price competition and not a deliberate act. In the short term, a price war
can be beneficial for consumers because of the lower prices. In the long term, however,
it is not beneficial as the company that wins a price war, effectively putting its competitor
out of business, will have a monopoly. If predatory pricing leads to an increase
in monopoly power, then it will harm the public interest because it leads to higher
prices in the long term. However, predatory pricing could be confused for a very
competitive market as well. Consumers can benefit if prices fall and all the firms stay
in business.
11.3.4 Penetration Pricing

Penetration pricing is the pricing technique of setting a relatively low initial entry
price, usually lesser than the intended established price, to attract new customers. The
strategy aims to encourage customers to switch to the new product because of the
lower price. In short term, penetration pricing is likely to result in lower profits than
would be the case if price were set higher. However, there are some significant benefits
to long-term profitability of having a higher market share, so the pricing strategy can
often be justified. For example, penetration pricing is commonly used by utilities,
Economics for
especially phone and cable or satellite services, although it is sometimes found in
Managers : 157
Pricing under Different competitive gas and electricity markets as well. Many home phone, cellphone, cable
Structures- Pricing Practices and satellite providers offer a discounted rate for a period of time, such as your first six
months of service, to get you to switch to their service. After your discount period has
NOTES ended, the price increases significantly, but the company hopes you have become used
to its service and won't go through the trouble to change to a different company
Penetration pricing is often used to support the launch of a new product, and
works best when a product enters a market with relatively little product differentiation
and where demand is price elastic so a lower price than rival products is a competitive
weapon. Penetration pricing includes setting the price low with the goals of attracting
customers and gaining market share. The price will be raised later once this market
share is gained. There are certain advantages of using penetration pricing, it can be
based on marginal cost pricing, it discourages the entry of new firms, and it is useful to
control the cost of production. Price penetration is most appropriate where; economies
of scale is available, demand is price elastic, enough demand for product and the product
face high competition soon after entering into market.
11.3.5 Price Leadership

You may recall this as one of the models of oligopoly. In this model, one firm is
more powerful compare to another. This firm set the price and rivals follow it. The
leading firm that initially sets the price is called the dominant firm. The firms that use
the price set by the dominant firm are typically smaller in size and are called followers.
Markets for steel and agricultural implements have been observed to operate in this
manner. This is called price leadership strategy. For example, in retail sector when
Wal-mart come to town, the small shopkeepers and other small retailer become victims
of the price charged by big stores. Now they follow the prices of big guys. Manager of
a dominant firm alone determine the price of the product. Because manager at a small
firm are price takers, they act as if they are in a competitive market, taking the price as
given. If there is strong competition in a market, customers are faced with a wide
choice of who to buy from. They may buy from the cheapest provider or perhaps from
the one which offers the best customer service. But customers will certainly be mindful
of what is a reasonable or normal price in the market.
11.3.6 Competitor Based Pricing

Most of the firms in a competitive market do not have sufficient power to be able
to set prices above their competitors. They tend to use "going-rate" pricing - i.e. setting
a price that is in line with the prices charged by direct competitors. This is a method of
determining the price at which a particular product is sold based on the prices of
competing products rather than on the cost of production or the amount of demand
from customers. The advantages of using competitive pricing is that selling prices
should be line with rivals, so price should not be a competitive disadvantage and its
Economics for main advantage is the ease of use. Extensive marketing research and statistical analysis
Managers : 158
are also not required to design the pricing strategy. The main problem with this practice Pricing under Different
is that the business needs some other way to attract customers. It has to use non-price Structures- Pricing Practices
methods to compete in the industry - e.g. providing distinct customer service or better
availability. NOTES
11.3.7 Freemium Check Your Progress
In the knowledge economy with open source software becoming popular, the 1. What are the
word "freemium" is a combination of the words "free" and "premium." Freemium is a conditions for price
discrimination?
business model that works by offering a product or service free of charge (typically
2. Can a small firm be a
digital offerings such as software, content, games, web services or other) while charging
price maker in
a premium for advanced features, functionality, or related products and services. Less
presence of dominant
common examples of freemium can be found in design, education, manufacturing,
firm? Why or why
publishing, music, movies and even the manufacture of window gardens. One of the
not?
most well-known examples of a freemium business model is Skype, which provides 3. Is predatory pricing
free computer-to-computer calling but sells voicemail, calls to landlines and other legal? Is it beneficial
products. for consumers?
11.4 Customer Oriented and Other Pricing Practices
11.4.1 Market Skimming Pricing

Market skimming is a product's pricing strategy by which a firm charges the
highest initial price that customers will pay. As the demand of the first customers is
satisfied, the firm price to attract another, more price-sensitive segment. Therefore, the
skimming strategy gets its name from skimming successive layers of "cream," or
customer segments, as prices are lowered over time.
Skimming involves setting a high price before other competitors come into the
market. This is often used for the launch of a new product which faces little or no
competition - usually due to some technological features. Such products are often bought
by "early adopters" who are prepared to pay a higher price to have the latest or best
product in the market and are therefore the target market when such policy is adopted.
Skimming is usually employed to reimburse the cost of investment of the original

research into the product: commonly used in electronic markets when a new range,
such as iPhone, are firstly dispatched into the market at a high price. This strategy is
employed only for a limited duration to recover most of the investment made to build
the product. To gain further market share, a seller must use other pricing tactics such as
economy or penetration. Innovative electronic products, such as the Apple iPad and
Sony PlayStation are good example of such a pricing policy. Generally firms use this
technique to recover the cost of development. Skimming is a useful strategy when
Economics for
lowering the price has only a minor effect on increasing sales volume. The high price is
Managers : 159
Pricing under Different interpreted as a sign of high quality, high price does not attract more competitors and
Structures- Pricing Practices lastly there are enough customers willing to buy the product at high prices. There are
some problems and challenges with this approach that are:
NOTES 1. Skimming encourages the entry of competitors. When other firms see the
high margins available in the industry, they will quickly enter and such a
strategy cannot last for long, as competitors soon launch rival products which
will put pressure on the price (e.g. the launch of rival products to the iPhone
or iPod).
2. If producer lower the prices of product very fast than some time it creates
negative publicity because consumer feel that it would better to wait and
purchase the product at a much lower price. This negative sentiment also
affects the brand of company.
3. A final problem is that by price skimming a firm may slow down the volume
growth of demand for the product. This can give competitors more time to
develop alternative products ready for the time when market demand
(measured in volume) is strongest.
This method is useful only when the market demand curve is inelastic. If demand
schedule is elastic than market equilibrium can be achieved by quantity change rather
than price change.
11.4.2 Market Oriented Pricing

Market oriented pricing includes setting a price based upon analysis and research
compiled from the target market. This means that marketers will set prices depending
on the results from the research. For instance, if the competitors are pricing their products
at a lower price, then it's up to them to either price their goods at same level or below,
depending on what the company wants to achieve. In this method, price is based on
current market conditions. For example, if a car company engages in market orientation,
it will research what consumers want and need in a car rather than produce models
meant to follow the trends of other manufacturers. Such pricing is often used in equity,
bond and commodity exchanges. Market orientation focuses more on customers and
less on developing complex, convincing sales tactics.
11.4.3 Psychological Pricing

Psychological pricing uses the customer's emotional response to encourage sales.
By pricing products strategically, a company may increase sales without significantly
reducing prices. In some cases, a higher price is actually more likely to increase sales.
Pricing designed to have a positive psychological impact on the buyer to ensure that he
buys the product is called Psychological pricing. Selling a product at $3.95 or $3.99,
rather than $4.00 is said to be psychologically more appealing. There are certain price
Economics for points where people are willing to buy a product. If the price of a product is $100 and
Managers : 160 the company prices it as $99, then it is called psychological pricing. In most of the
consumers mind $99 is psychologically 'less' than $100. A minor distinction in pricing Pricing under Different
can make a big difference is sales. The company that succeeds in finding psychological Structures- Pricing Practices
price points can improve sales and therefore, maximize revenue. The psychological
pricing method helps you build an impression of your brand without making significant NOTES
changes to the product.
11.4.4 High-Low Pricing

High-low pricing involves alternating between high and low prices. Initially, the
product is offered at a high price, which establishes the value of the item in the minds
of consumers and later it sell to consumer at discount rate means low pricing. High-low
pricing is extensively used in fashion industry. The lower promotional prices are designed
to bring customers to the organization where the customer is offered the promotional
product as well as the regular higher priced products. When this method is properly
implemented, the high-low technique can yield substantial profits; but only if customers
buy multiple additional items that are fully priced. The high-low pricing method is
widely used, but discerning shoppers in the internet era are more capable of spotting
lower-priced items elsewhere, and so will only buy the low-price items and will avoid
the high-price items.
11.4.5 Value Based Pricing

The setting of a product or service's price, based on the benefits it provides to
consumers. According to this method, pricing of a product is based on the value the
product has for the customer and not on its costs of production or any other factor. This
strategy is normally used where the value to the customer is many times the cost of
producing the item or service. Value price means that you get great value for money i.e.
the price that you pay makes you feel that you are getting a lot of product. In many
ways, it is similar to economy pricing. One must not make the mistake to think that
there is added value in terms of the product or service. Reducing price does not generally
increase value. A good example of value pricing is the cost of producing a software
CD. The cost of producing a software CD is about the same independent of the software
on it, but the prices vary with the perceived value the customers are expected to have.
There are some benefits of using value-based pricing for instance it provides real
willingness to pay data and helps in developing higher quality products.
11.4.6 Seasonal Pricing

This pricing technique is often used where the product or services are seasonally
demanded. Some common examples are woolen garments, umbrella, air conditioners,
room heaters etc. This does not necessarily means that the demand for the product
ceases after season is over but it reduces drastically. In such cases, the pricing of the
product is done in a manner where the products price is increased during on season and
reduced during off season to promote sales and reduce the inventory carrying costs
along with disposal of products which might not make it to the next season or may lose Economics for
Managers : 161
Pricing under Different their value drastically as is the case for consumer products which have a limited shelf
Structures- Pricing Practices life. In the case of manufacturing industry if the product is medium or high quality and
if the off season is very long then product have very high inventory carrying cost
NOTES which can be avoided by reducing price during the off seasons. In some cases the
product run risks of getting spoiled e.g., woolen garments may get spoiled by the insects
and also may go out of fashion in next season. Thus producer would benefit by adopting
off-season pricing for such products.
11.4.7 Geographical Pricing

Geographical pricing sees variations in price in different parts of the world.
Geographic pricing is considered a form of variable pricing. For example oranges grown
in Nagpur will typically sell at a lower price in the state's capital city of Mumbai, but
will cost more when sent to Kashmir for sale. In some countries there is more tax on
certain types of product which makes them more or less expensive, or legislation which
limits how many products might be imported again raising price. These factors also
make difference in price of same product.
11.5 Summary
The question faced by most of producers is how to set prices and output when
they have market power. This unit provides broader perspectives for pricing decisions.
There are various pricing strategies that are used by producers. Managers always try to
maximize the profit of firm. For this they follow large number of pricing methodologies.
These pricing methodologies are helpful for different producer to maximize their profits
in different situations.
11.6 Key Terms
Cost-plus Pricing : A situation where producer set the price that covers cost of
producing the product plus enough profit to allow the firm to earn its target
rate of return.
Marginal-cost Pricing : It is the practice of setting the price of a product to equal the
additional cost of producing an extra unit of output.
Limit Pricing : A situation where producers sell the product at a price which is lower
than the average cost of production.
Price Discrimination : A pricing strategy in which a producer charges customers

different prices for the same product.
Predatory Pricing : It is a pricing strategy intended to drive out competitors from a

Economics for market.
Managers : 162
Penetration Pricing : A pricing technique of setting a relatively low initial entry Pricing under Different
price, usually lesser than the intended established price, to attract new Structures- Pricing Practices
customers.
Market skimming : A pricing strategy by which a firm charges the highest initial NOTES
price that customer will pay.
1. Distinguish between price discrimination and limit pricing. How these pricing
practices can be used by firms as a strategy?
2. In case of seasonal pricing, why producers do not intend to wait for next year for
selling the product and sell it at off season low price?
3. What are the problems with market skimming pricing strategy?
4. Suppose you are a monopolist and find that the demand elasticity of your product
is different in two markets. What would be your pricing strategy?
5. In case of open source software, what pricing strategy can help companies to
generate revenue?

Edition.
2. Dominic Salvator. 2009. Managerial Economics-Principles and worldwide


Economics for
Managers : 163
New Theories of Firm
UNIT 12 NEW THEORIES OF FIRM
NOTES Structure
12.0 Introduction
12.2 Baumol's Theory of Sales Revenue Maximisation
12.3 Williamson's Model of Managerial Discretion
12.4 Marris's Model of the Managerial Enterprise
12.5 The Behavioural Model of the firm
12.6 Summary
12.7 Key Terms
12.0 Introduction
The theory of the firm, as discussed in Units 7-11, has evolved from representing
the firm involved in profit maximising. Central to the neoclassical view of the firm is
the objective of profit maximization that determines the behaviour of the firm. This
mechanical approach to the behaviour of firms does not provide much flexibility in the
decision making process within the firm. As long as the assumption holds, firm as a
profit maximiser will set MR=MC. Considering that some of the assumptions could be
very restrictive and firms may not have complete information and knowledge about
industries another set of theories evolved to understand the functioning of firms.
The models discussed in this unit, consider a firm as a complex organisation

where control and ownership are distinct particularly in case of joint stock companies.
And it is a nexus of different activities, composed of diverse constituents. Particularly
of interest in these theories is a large firm which is a joint stock company. The owners
in such a firm are the shareholders who are involved in appointment of the board of
directors which then appoints the top management of the firm. Clearly, shareholders
have less power or involvement in the decision making of the firm. Even in case of
shareholders mostly shares are held by large institutions like insurance companies or
financial institutions (domestic or foreign) which may not be involved in the decision
making process of firms. Further, small investors rarely attend the annual general
meetings of such firms. Such a structure of a large firm leads to separation between
Economics for owners and managers and accordingly provides an opportunity to management to pursue
Managers : 164 objectives that may be different from that of owners. This distinction is the hallmark of
the theories discussed in this unit as each one of them highlights the different goals that New Theories of Firm
manager may pursue instead of mere profit maximization that may be preferred by the
owners. We will focus on four models in this unit providing comparison with traditional
theories along with the critique of these models. NOTES
The unit is organized as follows: In section 12.2 we will study Baumol's theory of
sales revenue maximisation followed by Williamson's model of managerial discretion
in section 12.3. Marris's model of the managerial enterprise is given in section 12.4 and
behavioural model of the firm is elaborated upon in 12.5. It is followed by summary
and key terms.

* To study Baumol's theory of sales revenue maximisation.
* To study Williamson's model of managerial discretion.
* To study Marris's model of the managerial enterprise.
* To study the behavioural model of the firm.
12.2 Baumol's Theory of Sales Revenue Maximisation
W. J. Baumol in his seminal work in 1959 suggested that for managers sales
revenue maximisation is an alternative goal to profit maximisation as propounded by
neo-classical theory of firm. The key reason for the difference in firm's goals is separation
of ownership and management whereby managers are free to pursue different goals.
Baumol dealt with oligopolistic and imperfect market and presented two models with
and without advertising. Further, he presented two models (i) static single-period model
and (ii) multi period dynamic model of growth. As mentioned earlier, each model has
two versions, one without and one with advertising activities. His work is known as
"Theory of Sales Revenue Maximisation".
In this theory, sales maximisation is the most plausible goal of managers. Following
reasons explain the motivation of top management to pursue sales growth:
(i) High correlation between salaries and other earning of manager with sales.
(ii) Banks and other financial institution are willing to finance firms with large
and growing sales.
(iii) Personnel problems can be handled more easily when sales are growing.
(iv) Sales growth is considered more prestigious.

Economics for
(v) Growing sales provide more bargaining power to firms in a competitive
Managers : 165
New Theories of Firm environment vis-a-vis their competitors.
In this unit, to understand the basic model of sale revenue maximisation we discuss
only static single-period model. The basic assumptions of this static model are:
NOTES
(i) Single time period.
(ii) The objective of the firm is to maximise sale revenue subject to profit
constraint.
(iii) The profit constraint is exogenously determined by the demand and

expectation of the shareholders, the bank and other financial institutions.
(iv) Demand curve of the firm is downward sloping.
(v) Cost curves are U-shaped.
12.2.1 Single Product Model- No Advertising

Sales maximization implies optimization of total revenue. Recall that total revenue
equals number of units X price per unit. Using different prices and concomitant demand
as per the demand curve we derive total revenue curve as we have discussed earlier in
unit 8. In Figure 12.1, TR curve shows the total revenue curve. Note that due to downward
sloping demand curve TR curve reaches its peak for output level Q3 where change in
revenue due to one more unit of sale of output is equal to 0, that is, slope of the curve
is zero. Anymore sale beyond this point leads to reduction in TR. TC represents total
cost curve. The difference between TR and TC is the profit which is represented below
in profit curve. Note at output level Q1 and Q4 profit is 0 as TR=TC at both those
levels of output. The profit curve reaches its peak at Q2 where the difference between
TC and TR is highest and the slopes of both curves are same as evident from parallel
line drawn at point L and M. At this level of output, firm earns P1 level of profit.
In Baumols model, the firm is a sale maximiser, but it must also earn a minimum
level of profit. The firm needs minimum profits to finance future sales. Further, these
profits are essential for a firm for paying dividends on share capital and for meeting
other financial requirements. Thus minimum profits serve as a constraint on the
maximisation of a firm's revenue. Maximum sale revenue depends on minimum
acceptable level of profit. If the firm acceptance profit is P2, the firm will produce Q3
which maximize sales revenue. And at this level firm earn P2 level of profit. If minimum
acceptance level of profit increase and it is P3, in this case firm is not able to earn
maximum sales revenue because at this level firm will produce Q5 level of output
which is less than Q3 that maximizes total revenue. From Figure 12.1, it is clear that
profit maximizing level of output is Q2. And sales maximizing firm will produce higher
level of output compare to profit maximizer. The sale maximizer will sell the product at
lower price as compare to the profit maximizer. The sale maximizer will earn lower
profit as compare to profit maximizer.
Economics for
Managers : 166
Figure 12.1 New Theories of Firm
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/ NOTES
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12.2.2. Single Product Model-With Advertising

Baumol has further shown that the profit constraint under sales maximisation is
also effective in advertising and thereby increases the firm's revenue. One key assumption
of the model is that revenue always increases with advertising expenditure. Therefore,
it is not possible to attain sales maximizing equilibrium without profit constraint as
firm can always increase its sales by increasing advertising. In Figure 12.2 as earlier,
expenditure on advertising is taken on the horizontal axis, and total revenue, costs and
profit on the vertical axis. TR is the total revenue curve and TC is total cost curve. A
reprresents advertising expenditure.
An oligopolist will prefer to increase its sale by advertising rather than by a cut in
prices. Increased advertising always increase sales of a firm as per the assumption of
the model. Sale maximizer always has higher advertising cost in compare to profit
maximiser. For simplicity assume that production costs are constant and are given as
C1C. Thus, TC contains costs plus advertising cost. Profit curve is the curve which is
obtained from subtracting TC from TR. The profit-maximisation firm will spend A1 on
advertising. On the other hand, given the profit constraint P1 the sales- maximisation
firm will spend A2 on advertising. Thus the sales-maximisation firm spends more on
advertising than the profit-maximisation firm, and also earns higher revenue than the
latter at the profit constraint P1. Economics for
Managers : 167
New Theories of Firm Figure 12.2
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NOTES
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Check Your Progress

1. Why top management & &
pursue sale
maximization instead 3
of profit
maximization?
2. Does sales $ $
maximizing implies $GYHUWLVLQJ
profit maximizing?
Why there is a
difference? Baumol's model was criticized on the following points. Firstly, it does not address
3. Which firm produce the period of time over which sales are to be maximized. It is possible that the managers
more output profit of the firms in question may have wanted to maximize their short run sales, to gain
maximizing or sales
market share in order to maximize their long run profits. Secondly, it does not show the
maximizing?
industry equilibrium where all firms maximize sales. Thirdly, firm in an industry has
market power and control over price and expenditure and it misses out the strategic
reaction of the managers.
12.3 Williamson's Model of Managerial Discretion

O. Williamson in his seminal article "Managerial Discretion and Business
Behaviour" in 1963, presented model of managerial discretion. As earlier, there is a
distinction between ownership and management of large firms. Williamson argues that
profit maximization is not the objective of the manager of an organization. According
to this model, utility maximization is the sole objective of the manager. Managers are
concerned about their own utility rather than maximising the shareholders' utilities.
The basic assumptions of this model are:
1. Imperfect competition in the markets.
2. Dissociation of ownership and management.
Economics for 3. A minimum profit constraint exists for the firms to be able to pay dividends
Managers : 168 to their shareholders.
The basic argument of this model is built on managerial utility function. According New Theories of Firm
to Williamson, the managerial utility function includes variables like salary, security,
power status, prestige, and professional excellence. In order to present the utility in
money terms it is important that quantifiable variables are used. Accordingly, Willimson NOTES
identified three variables that could replace the qualitative aspects of manager's utility
function. These variables are: (i) staff expenditure, (ii) managerial emoluments and
(iii) discretionary investments.
Staff expenditure represents the staff working under a manager and an increase in
staff represents promotion of a sort as it increases the gamut of activities over which a
manager has control. Being in charge of large staff is a symbol of prestige and
professional success of a manager. Managerial emoluments include various types of
fringe benefits received by managers in form of luxurious offices, house, and car etc.
Interestingly, these emoluments do not influence the productivity of the manager but
are associated once again with prestige and to some extent tax benefits as well. Lastly,
discretionary investment is the extent of flexibility and amount allowed to a manager
to undertake investment beyond the requirements of day to day running of the business.
A large amount represents the faith higher authorities have in the capabilities of the
manager.
The model was developed from a profit maximizing frame; price and output were
determined by the intersection of the marginal revenue and marginal costs curves. Total
costs increase as the mangers waste money, therefore, the profits left to be paid, as
dividends to shareholders, are less than they would be under profit maximization. The
managerial discretion model was a development of the classical model, and shares
many of the same traits. The model developed by Williamson is a mathematical equation
that seeks to explain managerial behaviour. Three new variables (staff expenditure,
managerial emoluments and discretionary investments) are added to the marginalist
model.
Based on the mathematical calculation, the model shows that at equilibrium, the
managerial firm will employ administrative staff beyond the optimal point. The optimal
point is one where marginal cost of staff is equal to its marginal revenue. As the result,
a managerial firm has a tendency to over staff and thus indulges in wasteful expenditure.
Similarly, managerial slack that is the emoluments and discretionary investment spending
is larger for a managerial utility maximizing firm as compare to profit maximizing
firm.
The empirical evidence on this model is limited but it explains a few situations
existing in the real world. For instance, firms increase managerial emoluments and
staff expenditure during the boom and similarly reduce the same in recession. Many a
times when new management takes over they reduce staff expenditure without
influencing the productivity of firms.
Economics for
The model fails to describe how businesses take their price and output decisions Managers : 169
New Theories of Firm in a highly competitive set up. The relationship between better performance of managers
and the increasing amounts spent on manager's utility by the firm is not always true.
The model does not apply in a dynamic set up like changing demand and cost conditions
NOTES during booms and recessions. As it is impossible to model human behaviour in the
most complex equation, it is also impossible with a simplified equation. The managerial
discretion model, like profit maximization, fails if it is taken to literally tell how
businesses set price and output, but it may still be valid at the level of managers'/
businesses' objectives.
12.4 Marris's Model of the Managerial Enterprise
R. Marris in his work titled, "A Model of Managerial Enterprise," presented the
Managerial Enterprise in 1963. He argues that the difference between the goals of
managers and owner is not as wide as other theories claim because most of the variables
appearing in both functions are strongly correlated with the size of a firm. The goal of
firm is the maximisation of balanced growth rate, which is maximisation of growth of
demand for the products of the firm and growth of its capital supply. In initial model,
there are two constraints (i) the managerial constraint and (ii) job security constraint.
The managerial constraint implies the limitation on growth of the firm set by the
capacity of its managerial team. Further, research and development (R&D) team also
play a significant role in setting this constraint. R&D department as a source of new
ideas and products affects the growth of demand for the product of the firms. These
managerial constraints thus limit both rate of growth of demand and rate of growth of
capital supply.
The job security constraint implies manager's want for certainty in job. This need
for security leads to risk-averse behaviour of the manager. As any risky venture may
lead to financial failure of the firm and accordingly job loss for manager. Further, the
need for job security also implies that manager will follow prudent financial policies.
In terms of balance sheet of a firm this behaviour leads to low debt ratio, optimal
liquidity ratio (neither too high nor too low) and retained profit. These three ratios
determine the financial security constraint of the managers. This financial security
constraint set a limit to the growth of the capital supply.
12.4.1 Equilibrium of the Firm

According to the model, when rate of growth of demand of product of firm (gd) is
equal to rate of growth of capital supply (gc) the firm is in equilibrium with balanced
growth rate (g*)
gd =gc =g* maximum
gd depends on diversification rate (d) and percentage of successful new products

Economics for (k);
Managers : 170
gd = f1(d, k) New Theories of Firm
Diversification rate is number of new products introduced per time period. The
firm prefers to launch new products in market.
NOTES
K=f2 (d, P, A, R & D, intrinsic value)
Here, k depends on d, Price (p), advertising expense (A), R & D expenditure and
intrinsic value of the product. According to Marris, gd depends on diversification (d)
and average profit margin (m).
gd = f1(d, m)
where gd is positively correlated with d and negatively correlated to m.
Rate of growth of capital supply: gc
gc depends on level of profit(): gc = ()
Here, is financial security coefficient and is constant.
gc = [f3 (m, d)]
Where m= rate of profit and d= k/x is capital output ratio
So and m are positively correlated which indicate that an increase in the average
profit margin results is an increase in the total profit.
?/?m=0
Equilibrium of the firm
The firm decides its financial policy denoted by ?. It next chooses subjectively a
value for either m or d and with this decision taken the firm can find its maximum
balanced growth rate.
g*= f1(m*, d*)= ?[f4(m*, d*)]
The balanced growth rate gives optimal policy level of m* and d*.
While comparing Marris's Model with Baumol's Model we find that in Baumol's
model managers are interested in their own utility, while in Marris model focus is on
maximisation of manager's utility and owner's utility. Baumol measures growth of
demand in term of change in sales revenue, while Marries measure in terms of
diversification rate. In Baumol's model growth of capital is not goal, while marris model
growth of capital is an explicit goal of the firm.
While comparing Marris's Model with Profit Maximization Model we find that a
advertising and R & D expenditure will be higher for growth maximiser than for a
profit maximiser. In growth maximiser there will be slack payment to the administrative
staff, while slack is zero for profit maximiser. The profits of growth maximiser are
smaller than profit maximiser.
Marri's model has been criticized as it is not true in recession or tight market. It Economics for
Managers : 171
New Theories of Firm does not justify the preferences of owner and has excessive focus on manager's
preferences. It focuses on restrictive assumption that firms have their own R&D
department but actually most firm's do not have such department. Marris also assumes
NOTES given production cost and price structure whose determination is not explained by
him. Oligopolistic interdependence is not satisfactorily dealt within Morris model.
Check Your Progress The assumption that the continuous growth is possible by creating new market, that is
1. What constitutes by developing product whole sales grow at the expense of total demand in the economy
managers utility at large is highly questionable.
function?
2. What are the
assumptions of the
12.5 The Behavioural Model of the Firm
Williamsons model
of managerial Behavioural theories of the firm were developed by various authors at the start of
discretion? the second half of the last century. Simon in 1955 developed a model in article "A
3. What do you Behavioural Modal of Rational Choice", published in the Quarterly Journal of
understand from Economics. According to the model, firms consist of a number of decision makers,
financial security many of whom will have different objectives. Individuals within an organization may
constraint? be interested in profits, sales, market share, inventory and production. Organizations
4. What factors influence are involved in resolution of conflicts (due to different goals), uncertainty avoidance,
job security of a problematic search and organizational learning. Simon (1959), Cyert and March (1963)
manager in the firm? developed similar models based on the interaction of individual managers within an
organization. The outcome of these models was that firms would aim for a satisfactory
level of profits and pursue other objectives at the same time. In this unit we will discuss
the model of Cyert and March.
According to the model, a firm is a coalition of groups with conflicting interests.

The firm is not treated as singe-goal and single-decision unit. It is treated as a multi-
goal, multi-decision organisational coalition. According to Cyert and March, different
groups participate in setting goals and making decisions. These groups include managers,
workers, shareholders, customers, suppliers, bankers, and so on. But manager, worker
and shareholders are the most active groups in the framework. And each group has its
own goal. Most importantly, priorities and information may vary by groups.
The goal of the firm depends on demand of the member of coalition that may
change over time. The demands of different members are determined by aspirations of
member, past achievements, their expectation, achievements of other members and so
on. There is continuous conflict between different groups of firm. There is strong relation
between demands and past achievement. Demand take the form of aspiration levels. The
aspirations levels-demand at time depends on the previous history of the firm.
Goals of the firm are set by the top management. There are five main goals of the
firm namely production goal, inventory goal, sales goal, share-of-the market goal and
profit goal. A brief discussion on these goals follows:
Economics for
Managers : 172 1. Production goal: This originates from production department. Smooth running
of production process, avoid excess capacity, management of waste raw New Theories of Firm
material, lay-off of workers at some time, are some goals that comes under
production goal.
2. Inventory goal: This originates from inventory department or from sales and NOTES
production department. Sales department wants sufficient stock of output in

market for customers. While production department wants the sufficient stock
of raw material for further production.
3. Sales goal and share-of-the market goal: Both of these originate from sales
department. This department set the sale strategy and decide about advertising
campaigns, the market research programme and so on.
4. Profit goal: This goal is set by the top management to satisfy the demands of
shareholders and the expectations of bankers and other financial institutions.
The firm in behavioural theory is a satisficing organisation rather than a maximising

entrepreneur. These firms seek to attain a satisfactory performance as defined by
aspiration level. As mentioned earlier, each group has its own goal and priorities and
information may vary by groups. This may lead to conflict among different groups and
therefore there is a need to devise means to resolve the conflict. The conflict and
bargaining between different groups should not lead to chaotic unstable situation. And
it is required that goals and the functioning of firm shows the remarkable stability.
There are different ways to resolve the conflict between different groups. The most
important ways to resolve the conflict are:
1. Money payment: Money payment is major means for satisfying the demands
for various groups of the coalition firm. A large part of demand is satisfying
by money payment e.g. workers and employees are getting their wages and
salaries, shareholders are getting their dividends and so on.
2. Slack payment: Slack payment defines as payment to various groups of the

coalition over and above that requirement for efficient working of the firm.
There are different kinds of slack payments organisational slack, managerial
slack, etc.
Furthermore, through decentralisation of decision making conflict is partly avoided

if the decision area of each member or group is well defined. The top management,
depending of the urgency of the different demands, attaches priority and satisfies first
the demands that seems more important in any one period and postpone the demand of
other period for future. The process of decision making includes decision making at
two levels:
1. The decision making process at the level of top management: Top-level Economics for
managers include boards of directors, presidents, vice-presidents, CEOs, Managers : 173
New Theories of Firm general managers, and senior managers, etc. They develop goals, strategic
plans, company policies, and make decisions about the direction of the
business. The main role of top management is allocation of resources.
NOTES 2. The decision at low level of managements: The lower level management
informs the worker about the decisions which are taken by managements.
Lower level of management directs the workers and employees. The top
management has the budget and the balance sheet of each section and uses
these as controlling devices for lower management.
A comparison with the traditional theory: The behavioural theory differs from
traditional theory from many aspects.
1. Firm in traditional theories has single goal, that is profit maximisation. But
in the case of modern behavioural theory firm has multiple goals.
2. The traditional theory consider firm as synonymous with the entrepreneur.
The firm in behavioural theory is conceived as a coalition of groups with
conflicting interest.
3. In traditional theory, there is no conflict of goal between members but in the
case of behavioural theory there in conflict among members.
4. The behavioural theory is basically a short-run theory. In short-run there is
adaptive process of learning where as in traditional theories we do long-run
planning.
12.6 Summary
Profit maximization as an objective requires firms to set MC = MR, the conclusion

is based on various assumptions including complete information available to firms and
no distinction between the ownership and management of the firms. In the context of
large joint stock companies, it is observed that owners may not be directly involved in
decision making process providing flexibility to managers to pursue separate goals.
We discussed various such goals under different models in this unit. These goals included
sales revenue maximization, managerial utility maximization, and balanced growth
rate. We also elaborated on the behavioural model where the process of resolving conflict
among various groups is very important. Further, it looks at the decision making process
at top and low levels of management.
12.7 Key Terms
Sales Maximization : It implies optimization of total revenue.

Staff Expenditure : It represents the staff working under a manager and an increase in
Economics for
staff represents promotion of a sort as it increases the gamut of activities
Managers : 174
over which a manager has control.
Managerial Emoluments : These include various types of fringe benefits received by New Theories of Firm
managers in form of luxurious offices, house, and car etc.
Discretionary Investment : It is the extent of flexibility and amount allowed to a

manager to undertake investment beyond the requirements of day to day NOTES
running of the business.
Managerial Constraint : Such a constraint implies the limitation on growth of the

firm set by the capacity of its managerial team.
Job Security Constraint : It implies managers want for certainty in job.
1. Explain sales revenue maximization model given by Baumol and the role of profit
constraint in determining the output under this model.
2. Explain manager's utility function, its constituents and how mangers attempt to
achieve it?
3. How behavioural model of managerial decision making differs from traditional

neo-classical model? Critically evaluate behavioural model.
4. According to the behavioural theory, name the different groups active in a firm.
What are the different goals that may be pursued in a firm?
5. What is the reason for conflict among different interest groups of a firm? How
such a conflict is resolved?
6. Explain attainment of equilibrium under Marri's model.
1. Baumo, W.J., Business Behaviour, Value and Growth, Harcourt and Brace, 1962.
2. Williamson, O.E., "Managerial Discretion and Business Behaviour", American

Economic Review, 1963
3. Marris, R., "A Model of Managerial Enterprise", Quarterly Journal of Economics,

1963.
4. Simon, H.A. "A Behavioural Modal of Rational Choice", Quarterly Journal of

Economics, 1955.
5. Cyert, R.M. and J.G. March, A Behavioural Theory of the Firm, Prentice-Hall,
1963.
Economics for
Managers : 175
Project Evaluation
UNIT 13 PROJECT EVALUATION
NOTES Structure
13.0 Introduction
13.2 Project Evaluation
13.3 Project Appraisal Techniques
13.4 Summary
13.5 Key Terms
13.0 Introduction
Units 13 through 17 in Book IV will address contemporary issues that concern

the modern managers. These issues include project evaluation, risk and uncertainty,
technological change, externalities and environmental issues and information asymmetry
and game theory applications for managers. You may find that units of this book are
not related to each other and covers mutually exclusive units. You may read them
separately as per convenience.
In unit 13, we will focus on project evaluation as a firm may plan to undertake
new projects for various reasons and also learn some of the techniques used to evaluate
the projects. This unit is organized as follows: In 13.2 we will introduce project evaluation
and in 13.3 we will learn different project evaluation techniques. It is followed by
summary, key terms, question and further references in section 13.4, 13.5, 13.6 and
13.7 respectively.

* To understand the reasons behind firms new projects.
* To learn techniques to decide on which project to undertake in case a manager
has to make a decision.
13.2 Project Evaluation

Economics for
Managers : 176 A manager and his team are expected to undertake various projects for the firms.
There is a need to evaluate such projects and check if a project is technically feasible, Project Evaluation
economically feasible, socially desirable and politically desirable. As evident from the
name, technical feasibility concentrates on technological aspect of the project and
confirms that project will perform. Economic feasibility of the project requires ensuring NOTES
that cost is not over the revenue generated and the project will give positive returns to
firm over a period of time. The project should be desirable socially and should not have
any opposition from various stakeholders. Moreover, political desirability is also
significant for the running of the project.
The long-run planning for projects is undertaken in firms and is called as capital
budgeting. Capital budgeting means a process of planning expenditure that give rise to
revenue over a period of time. A firm may undertake projects for various reasons that
may involve expenditure and revenue generation over a period of time. These reasons
include (i) replacement, (ii) cost reduction, (iii) output expansion of traditional products
and markets, (iv) expansion into new products and/or markets and (v) investments to
meet government regulation. As firm ages its technology may become old and obsolete
that may not be able to provide competitive edge in view of new techniques. Thus a
firm may undertake new investment that is likely to give returns over a period of time
by replacing older machines, equipments and instruments with newer ones. New
technology may also be preferred as it may include some cost reduction aspects that
may help a firm in increasing its margin. It may also include movement of production
facilities to places where the cost of production is less. It is possible that firm may be
willing to enhance its capacity to meet the growing market demand. Such an expansion
may happen for the output to be sold in the same region. Such projects like earlier one
entail making investment to generate returns in longer period. Most importantly, a firm
may be interested in undertaking R&D to develop, produce and sell new products in
existing markets or finding of new markets for older product in other geography within
or outside a nation. Lastly, as government changes various regulations companies may
be required to undertake investment to meet those regulations. For instance, government
may change the emission norms and accordingly a firm has to use new technology to
meet the new requirements. Such regulations may be related to health, pollution, and
safety.
13.3 Project Appraisal Techniques
It is important to learn different project appraisal techniques so that such projects

can be evaluated and compared for rational decision making. These techniques are
divided into two main categories namely non-discounted cash flow techniques and
discounted cash flow techniques. We will now discuss these techniques.
Economics for
Managers : 177
Project Evaluation 13.3.1Non-discounted Cash Flow Techniques
Non-discounted cash flow techniques include (i) pay-back period method and (ii)
average annual rate of return on investment method.
NOTES
Pay-back Period Method: As the name suggests in this method we focus on time
period involved in which a firm will recover the amount invested in the project initially.
The process involves comparing the net cash flow from the project and time duration
involved in the same. Net cash flow refers to difference between cash receipts and cash
expenditure over the life of the project. As cash flows occur over a period of time there
are some general guidelines regarding calculation of these flows. For instance, cash
flows should be calculated on after-tax basis. Cash expenditure includes variable costs
and fixed costs. As depreciation is a non-cash flow it is not considered for calculation
of net cash flows. Table 13.1 shows the payback period of six projects with same initial
outlay. Clearly, firm will prefer the project with lesser pay-back period.
Table 13.1 : Ranking of Various Project Using Payback Method
Project Initial Outlay Net Cash Inflows (Rs.) Pay-back Rank

(Rs.) period (years)
Year 1 Year 2 Year 3
A 10,000 10,000 500 500 1 1
B 10,000 5,000 5,000 5,000 2 3
C 10,000 2,000 4,000 12,000 2.33 4
D 10,000 10,000 3,000 3,000 1 1
E 10,000 6,000 4,000 5,000 2 3
F 10,000 8,000 8,000 2,000 1.25 2
This method is a very simple way to evaluate various projects. It does not involve
complicated process to take into consideration discounting factor that is discussed later
in the unit.
Average Annual Rate of Return Method: According to this method, the net income
from a project is divided by the period over which the income is earned. Then, average
annual return on investment is calculated as a percentage of initial investment made.
Consider Table 13.2, where total income is sum of net cash flows over the time duration
of the project. Refer back to Table 13.1, for project A: 11000 = 10000+500+500 and
similarly for all the projects. Further, net income is calculated as 11000-10000 and net
average annual income equals 1000/3 where 3 is the duration over which cash flow is
realized from the project. Further, to get average annual return on investment calculate
(333/10000)*100. Using this method average annual return on investment is calculated
Economics for for each project and raking is done accordingly.
Managers : 178
Table 13.2: Ranking of Various Project Using Average Annual Rate of Return Method Project Evaluation
Project Initial Total Net Net Average Average Annual Rank

Outlay Income Income Annual Return on
(Rs.) Income Investment (%) NOTES
A 10,000 11,000 1,000 333 3.33 4 Check Your Progress

B 10,000 15,000 5,000 1,667 16.67 3 1. What do you
understand from net
C 10,000 18,000 8,000 2,667 26.67 1
cash flows?
D 10,000 16,000 6,000 2,000 20.00 2 2. What is the difference
E 10,000 15,000 5,000 1,667 16.67 3 between net cash flow
and net income from a
F 10,000 18,000 8,000 2,667 26.67 1
project?
This is also a simple method that does not take into consideration discounting factor. 3. How net average
annual income is
13.3.2 Discounted Cash Flow Techniques different from average
The value of money changes over a period of time that is there is time value of annual return on
money. It implies that 100 Rs that you may have in your pocket is worth more today investment?
than it would be worth tomorrow. This is so because you can keep 100 Rs in bank and
earn interest on the amount for over a period of one year. Accordingly, if a firm makes
investment in time t that will generate revenue stream from next year onwards for few
years, there is a need to know today's value of the stream of revenue to be generated in
future. Discounting is the method used to find the worth of future payments in present
day value. The key factor in discounting process is to determine discount rate that is
the rate at which the future payments should be discounted to calculate present day
value. Most of the times risk adjusted discount rate is used. This could also be the cost
of capital for the project to the firm. In case, evaluators cannot decide on a particular
rate, they can try with various rates to calculate the present value. We will call this rate
as r for further discussion. Using discount rate firm may use net present value (NPV)
method or internal rate of return (IRR) method as project evaluation technique.
Net Present Value (NPV) Method: This is one method used by firms to decide if
it should invest in a particular project. NPV equals to sum of the present value of
stream of net cash flows from the project over a period of time minus the initial cost of
investment. In this method, NPV is calculated using the following steps:
STEP 1 :
Present Value (PV) of revenue earned in a particular year = Net Cash Inflow in t
period/ (1+r) t
Where r is discount rate and t is the year in which cash flow will be realized.
Consider project A given in Table 1 and its net cash flows that we calculated as Economics for
10,000, 500 and 500 in year 1, 2 and 3 respectively. Present value (PV) is thus calculated Managers : 179
Project Evaluation for r at 10% as:
PV1 = 10000/ (1+.01)1 = 9091;
PV2 = 500/ (1+.01)2 = 413;

NOTES
PV3 = 500/ (1+.01)3 = 376
STEP 2 :
Then, sum the present values for all the years over which a firm will realize cash
flows.
PV= 9091 + 413 + 376 = 9880. Similarly you can notice that in Table 3 for all
other projects as well sum of present values is given.
STEP 3 :
Further, Net Present Value (NPV) is calculated as
NPV = PV - I; where I is initial cost of project
For project A NPV = 9880 -10000 = -120. Similarly you can notice that in Table
3 for all other project as well NPV is given and accordingly each project has been ranked.
Table 13.3 Net Present Value and Profitability Index Method
Project Present Value (Rs.) = Sum of NPV = PI = Rank

Net Cash Inflow/(1+r)t Present PV - I PV/ I
Values (Rs.) (Rs.)
Year 1 Year 2 Year 3
A 9091 413 376 9,880 -120 .99 6

B 4545 4132 3757 12,434 2,434 1.24 5
C 1818 3306 9016 14,140 4,140 1.41 2
D 9091 2479 2254 13,824 3,824 1.38 3
E 5454.5 3305.8 3756.6 12,517 2,517 1.25 4
F 7272.7 6611.6 1502.6 15,387 5,387 1.54 1
NPV Index Method (Profitability Index (PI)): In case a firm uses NPV method, it
does not take into account the initial size of investment made and in comparative analysis
of project of unequal size this limitation may pose problem. In that case, a firm can also
calculate profitability index which is calculated as:
PI = PV/ I
PI for different projects is given in Table 13.3 along with NPV and you can find
that rank of different projects remain same using PI as well as initial investment is
Economics for same in all the projects. However, this may not be the case always. It goes without
Managers : 180 saying that firm will undertake projects highest NPV and PI. In case of PI, it should be
greater than 1 for firm to consider a particular project. Project Evaluation
If NPV Method is being used to evaluate a project then interest and depreciation
should not be deducted from the cash inflows (i.e. should not be added to Expenditure).
Interest is part of the cost of funds and is accounted for in arriving at the discount rate. NOTES
Initial investment is being deducted to get NPV.
13.3.3 Internal Rate of Return

Internal Rate of Return (IRR) is that rate of discount at which NPV equals Zero.
In other words, IRR is the discount rate that equates the present value of the net cash
flow from the project to its initial cost of capital. It is helpful in ranking of projects
without knowing 'r' or when a manager cannot decide about the discount rate.
[Net Cash Inflow in t period/ (1+r*) t] = I
Here the objective is to calculate r* for different projects. In order to decide whether
or not to accept a project, we need to compare IRR with a minimum acceptable rate of
return.
13.3.4 Comparative Study

In Table 13.4, we give ranking of different projects based on different methods
discussed above. It is clear that each method has its pros and cons. For instance pay-
back and ARR methods are very simple and easy to calculate. However, these methods
do not take into account the time value of money which is considered in NPV and PI
methods. The problem with these two is to determine appropriate discount rate as the
evaluation of the project will vary with the discount rate used. In our case as all projects
have same initial cost NPV and PI gives same rank. But if a firm is planning to undertake
project with varying initial cost it may be useful to look into PI instead of merely NPV.
Table 13.4: Ranking of Projects under Different Methods
Project Pay Back ARR Method NPV Method PI

Period Method
A 1 4 6 6
B 3 3 5 5
C 4 1 2 2
D 1 2 3 3
E 3 3 4 4
F 2 1 1 1
13.4 Summary
Economics for
In this unit, we focus on the need of firms to undertake various projects. Further, Managers : 181
Project Evaluation as these projects involve initial capital investment and revenues are generated over a
period of time; there is a need to evaluate these projects. The requirement is not only to
evaluate individual project but perform comparative analysis in case a firm has more
NOTES than one project in which it can invest. We learn different techniques for evaluation
along with the advantages and disadvantages of these methods.
13.5 Key Terms
Pay-back Period : It refers to the time period involved in which a firm will recover
the amount invested in the project initially.
Net Cash flow : It refers to difference between cash receipts and cash expenditure
over the life of the project.
Average Annual Rate of Return Method : In this method, net income from a project
is divided by the period over which the income is earned.
Discounting : It is a method used to find the worth of future payments in present day
value.
Net Present Value : It equals to sum of the present value of stream of net cash flows
from the project over a period of time minus the initial cost of investment.
Profitability Index : It equals to sum of the present value of stream of net cash flows
from the project over a period of time divided by the initial cost of investment.
Internal Rate of Return : It is that rate of discount at which NPV equals Zero.
1. Why firms undertake different projects?
2. Explain the need for discounting.
3. Explain pay-back period method and its major disadvantage.
4. Explain the steps involved in calculation of Net Present Value.
5. How profitability index is different from net present value? Which method you
will use in case you have 5 projects with different level of initial investment?

Edition.
Economics for 2. Dominic Salvator. 2009. Managerial Economics-Principles and worldwide

Managers : 182 applications, sixth edition.
Risk and Uncertainty
UNIT 14 RISK AND UNCERTAINTY
Structure NOTES
14.0 Introduction
14.2 Risk and Uncertainty
14.3 Risk Preferences
14.4 Risk management
14.5 Summary
14.6 Key Terms
14.0 Introduction
A manager during the course of his decision making faces different situations.
The outcome of these situations may be certain or uncertain and it has a bearing on the
decision making process of the manager. For instance, a manager of soft drink company
might have to decide about launching a new product in the market with more fizz and
less sweetness depending upon new market research on changing tastes of the new
generation. Now the consumer may or may not accept the new product. Therefore, the
outcome of the decision is not certain. Now, suppose in order to introduce that product,
the firm has to set up new production plant. Once again, the profitability from setting
up the new plant is questionable as the manager does not know if the new product will
be accepted by the consumers. The demand, product and cost analysis that is covered
in the previous units implicitly assumes that manager knows about the outcome of his
decisions very clearly. However, this may not be the case most of the time. Thus, in
this unit we deal with the problem of uncertainty and risk that is faced by a manager
during the course of job. In this unit, we will define and quantify risk and further look
at different means available to the manager to mitigate the risk.
This unit is organized as follows. Section 14.2 distinguishes between risk and
uncertainty and explains different statistical means available for measuring risk. Section
14.3 describes different risk preferences of a manager and its implications on the decision
making. Section 14.4 discusses issues related to risk management.
After studying this unit, you should be able to- Economics for
* To introduce the readers to the problem of uncertainty and risk faced by a Managers : 183
Risk and Uncertainty manager during the course of job.
* To learn the quantification and measurement of risk for efficient decision making.
* To discuss different means available to the manager to mitigate the risk.
NOTES
14.2 Risk and Uncertainty
Risk and uncertainty are two words that economists used interchangeably. Frank
Knight1 in his famous book on risk, uncertainty and profit draws a distinction between
risk and uncertainty. An uncertain situation is one where firm is not aware of the possible
outcome in the future or it cant quantify the same. Risk is a situation where a manager
knows all the possible outcomes from a particular decision as well as the probability of
the occurrence of each outcome. In other words, in case of risk we do not know what
any future outcome will be, but we know the probability distribution of all the possible
outcomes. Consider an example of a person who throws a dice and do not know the
result from throwing that dice. However, it is clear that out of the six possibilities there
is a 1/6 chances of each option. Therefore, risk means an unknown outcome out of well
defined possible outcomes like in case of throwing a dice. Contrary to this, uncertainty
occurs when we have no idea of what the possible outcome might be. For instance, if
you do not know whether it will rain tomorrow, then we call it as a state of uncertainty2.
For instance, a manager who is deciding about the introduction of new cold drink will
look at research results. Let say, the report says 63% people want a new product with
more fizz and less sweet. Thus, the probability of success of new product is 0.63 and
failure is 0.37. The manager, therefore, is able to quantify the situation and will be able
to decide about the future. Take another situation, where a firm does not know what
kind of economic situation will prevail at national and international level for next two
years. At national and international level there is a forecast of an upcoming boom in the
world economy. Based on the previous reports of the forecasting agencies a firm gets
to know that boom will occur with 75% probability and normal situation with 20%
probability and there is only 5% probability that recession may occur. Thus, a firm
faces the risky situation but it is not uncertain as it is aware of the possible options and
their probabilities.
Measurement of Risk
Quantitative evaluation of risk depends on the possible outcomes of a particular
event as well as the likelihood that each outcome will occur. For instance, a manger has
to take a decision on a particular investment that involves certain kinds of risk. It
requires two kinds of information: probability distribution of different outcomes
associated with risky situations and possible outcome from each situation. Probability
is the likelihood that a particular outcome will occur. For instance, as mentioned earlier,
75% chances that a boom will occur in the world economy. The probability calculation
of a manager can be based upon market research report or the reports of the analysts
Economics for
about different situations like stock market or could be subjective. The subjective
Managers : 184
calculation imply that it depends upon the perception of the manager regarding the Risk and Uncertainty
outcome based upon his/her past experience.
The second set of information required by manager is the possible payoff associated
with each outcome. Continuing with the earlier example, revenue generated if the good NOTES
is successful and if it is a failure and the probability of each occurrence along with the
outcomes are given in Table 14.1.
Table 14.1: Introduction of New Product by a Firm
Outcome Probability Revenue Potential Payoff
Success 0.63 100 cr. 63 cr. (100*0.63)
Failure 0.37 -10 cr. -3.7 cr. (-10*0.37)
Net result: 59.3 cr. (63 + (-) 3.7). Thus, in a risky situation the decision is based
on the expected value of the possible outcomes. Expected value is the weighted average
of the values associated with the all possible outcomes where weights are the associated
probabilities. Suppose a company plans to make investment. If the investment is
successful, the companys stock price will increase from Rs.500 to 800 per share; if it
is not successful the price will fall to Rs 300 per share. Additionally, the manager has to
see the probability associated with each outcome. Assume that as it is a risky investment
the probability of success is 1/4 and the probability of failure would be 3/4. Note that
when all the possible outcomes of an event are known along with respective probabilities,
then the sum of all the probabilities is 1.
Now lets see how the manager calculates the expected value.
Expected value = Probability of success (value associated with success) +
Probability of failure (value associated with failure)
= (Rs 800 per share) + (Rs 300 per share)
= 200+225
= 425 Rs.
From the example, it is clear that after the particular investment the stock price of
shares of the company will reduce by 75Rs. The company should not go for the particular
investment.
In the above example, we see that how the manger react to the investment decision
under risky situation. It doesnt mean that all managers react in the same way. To see
how, we have to go through another example. Suppose a person got selected in two
different companies as a manager with an expected income of Rs 25000 per month.
Company A offers job based on the performance; a sum of Rs 30000 for successful
performance and Rs 20000 for unsuccessful performance with equal probabilities.
Economics for
Company B on the other hand offers a fixed amount of salary of Rs.25200 with a
Managers : 185
Risk and Uncertainty probability of 0.99. The 0.01 probability is that company may shut down in that case he
will earn a dismissal wage of Rs.5200. The manger has to choose a job among this two
alternative available to him. In this case, the expected income derived from both these
NOTES jobs is same.
Expected income from job A = pr (success)x(salary)+pr(unsuccessful) x (salary)

= 0.5(30000)+0.5(20000)
= 15000+10000
= Rs.25000/
Expected income from job B = pr (stay alive) x (fixed salary)+ pr(shut down) x
(dismissal wage)
= 0.99(25200) +0.01(5200)
= 24948+52
= Rs. 25000/
Since the expected value is same for both jobs, the variability tells which job is
risky and which is not. The simplest way to calculate variability is to find the squares
of deviation of each outcome from their respective expected values and add them together
with probabilities.
Table 14.1: Variance and Standard Deviation of Job A and Job B
Job A Job B
1 Salary (successful) 30000 Rs. 25200Rs.
2 Deviation from expected value 5000 200
3 Deviation square(probability) 25000000 (0.5) 40000 (.9)
4 Salary (unsuccessful) 20000 Rs. 5200Rs.
Check Your Progress 5 Deviation -5000 19800

1. What is the difference 6 Deviation square (probability) 25000000 (0.5) 392040000 (.99)
between risk and
uncertainty? Explain in 7 Variance (3+6)* 25000000 3960000
detail with the help of 8 Standard deviation 5000 1989.98

an example.
2. What are different * Variance = Deviation Square of successful event * probability + Deviation square
methods of risk of unsuccessful event* probability
measurement? Explain. Table 14.1 shows that job in company A is riskier than job in company B as
standard deviation is higher in case of A. The selection of the job now depends upon
the risk preferences of the person. That is if he/she is a risk averse, lover or neutral.
Economics for
Managers : 186
Risk and Uncertainty
14.3 Risk Preferences
A study by MacCrimmon and Wehrung in 1984 found that managers vary in their
NOTES
preferences towards risk. Risk presences, in other words, mean willingness of the people
to bear the risk. Some can be risk loving, some risk neutral and others may be risk
averse. The study found that 40% of the executives were relatively risk loving and
20% risk neutral and 20% risk averse with no response from other 20%.
A person is said to be risk averse if he/she chooses a certain income instead of

risky income even when the expected value of both is same. A person is said to be risk
neutral when he is indifferent between certain and uncertain prospects. A person is said
to be risk loving is he/she chooses a risky income prospect instead of certain income
with the same expected value.
In order to quantify the preferences, economists use the concept of expected utility.
Expected utility is sum of all utilities associated with all possible outcomes, weighted
by the probability that each outcome will occur. If an individual has a given level of
wealth denoted by W, then preferences of risk can be formally defined as follows:
An individual is said to be risk averse if, when faced with a risky situation, the
utility of expected wealth is greater than the expected utility of wealth, that is;
U[E(W)] > E[U(W)] = Risk aversion
An individual is said to be risk seeking if, when faced with gamble, the utility of
expected wealth is less than the expected utility of wealth, that is;
U[E(W)] < E[U(W)] = Risk seeking
Finally, if the utility of expected wealth is equal to the expected utility of wealth,
the individual is said to be risk neural, that is;
If we establish relationship between money and utility then we can say that for
risk averse people utility increases as money increases but at a decreasing rate. Figure
14.1 (a) shows the utility curve for the risk averse people which is concave to the origin
showing increasing utility at a decreasing rate. For a risk neutral person expected value
of utility for a certain prospect is equal to the expected value of utility for an uncertain
prospect. The utility curve for the same has been shown in figure 14.1 (c). Figure 14.1
(b) shows the utility curve for a risk seeking person which is convex to the origin
showing with additional rupee, utility increases at an increasing rate.
Economics for
Managers : 187
Risk and Uncertainty )LJ
D E
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NOTES

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14.4 Risk management
Having understood the presence and measurement of risk, the pertinent issue is to
know about managing the risk. Bad risk management can lead to disastrous effects. For
instance, many argue that the recession in 2008 was largely caused by the loose credit
risk management of financial firms. Risk management is the identification, assessment
and prioritization of risk followed by coordinated and economical application of
resources to minimize, monitor and control the probability and impact of unfortunate
event. Simply we can say that risk management is a two step process- (1) determination
of risk and (2) handling the risk. Risk management occurs everywhere in the financial
world. It occurs when an investor buys a low-risk government bonds over high-risk
corporate and a bank performs a credit check on an individual before issuing them a
personnel credit.
Identification of risk: Identifying the potential risk is the main component of risk
management. Hence, risk identification can start with either from the source or from
the problem. Source of the risk may either be internal or external. Problems related
Economics for with employees of a company belong to internal risk and business cycles related
Managers : 188
problems are external to the company. Problem analysis refers to identifying the potential Risk and Uncertainty
threat; threat of losing money, threat of human errors and threat of accident and casualties.
Reducing the risk: All the three categories of people; risk lovers, risk averters
and risk neutrals- when they are involving in more important decisions, they are generally NOTES
risk averse. Basically, through the following ways we can minimize the risk:
diversification, insurance, collecting more information and hedging.
a. Diversification: Diversification is the practice of reducing risk by allocating
resources to a variety of activities whose outcome are not closely related.
This practice of reducing risks is common in market: different product under
same brand name and variety of same product under same brand names are
the best examples of the type. For example from the renowned economical
car Nano to the luxury car Aria has comes from the manufactures of TATA.
The manufactures has a variety of cars in between them which are more or
less close substitutes. The strategy behind the diversification is that any re-
duction in profit due to low sale in any model will offset by alternative in-
crease in sales of another model. Apart from this, TATA has investments in
other areas also whose outcomes are not closely related. Hence, the prin-
ciple of diversification is that as long as you can allocate your resources
towards a variety of activities whose outcomes are not closely related, you
can eliminate some kinds of risk.
b. Insurance: An individual with economic security is certain that he/she can
satisfy his/her needs in the present and in the future. Insurance is an agree-
ment where, one party (insurer) agrees to pay to the other (policy holder)
upon the occurrence of a specific loss. For instance, insurance on your resi-
dence or factory will pay toward repairing or replacing your home or factory
in case of damage from a covered perils. Risk averse people are willing to
pay to avoid any kind of risks as long as the cost of insurance is equal to the
expected losses. This is because buying insurance assures a person of hav-
ing the same income whether or not there is a loss.
More clearly a person will go for insurance only after carefully analyzing the
wealth situation with and without insurance. Lets clarify the situation. Suppose an
owner of a factory believes that there is a 10% possibility of robbery in his factory
which will cause him a loss of 10 cr from his total wealth of 100 cr. He may ready to
pay up to 1 cr as insurance premium to cover the risk. Table 14.2 shows the mechanism
of insurance. Note that in both the cases expected wealth is same. Remember a risk-
averse person count losses more than the gains. Therefore, if he does not have insurance
his property valued at 90cr at the risk of robbery. But in insurance both outcome will
equate to the expected wealth. Therefore, definitely the owner will go for insurance.
Economics for
Managers : 189
Risk and Uncertainty Table 14.2: Expected value of wealth with and without insurance
Pr of robbery(0.1) Pr. of no robbery(0.9) Expected wealth
NOTES With insurance 99cr 99cr 99cr
Without insurance 90cr 100cr 99cr
c. Hedging: Hedging is a position that is being taken in the market in order to

offset or balance against any risk. In other words, it is an investment position
that is taken to offset any potential losses/gains that may be incurred by
companion investment. There are many instruments available in the finan-
cial market for hedging like : forward contracts, options, futures, insurance,
stocks etc. Future is also one of the most effective instruments which is used
to provide hedge against any future prices fluctuations. Futures involve en-
tering into a contract to buy or sell a specified quantity of commodity of
given quality at a future specified time and specified price. A wheat pro-
ducer may also enter into a future contract that is an agreement to deliver a
certain number of bushels of wheat to a specified place on a certain date in
the future for a certain fixed price. In this way, he has hedged his exposure to
wheat price fluctuations. Contracts in this market trades continuous and the
value of the contract goes up and down in inverse relationship to the price of
wheat in the market. If price of wheat in the market increases then it become
worthless to exercise the contract and if the price of wheat goes down then it
is profitable for the farmer to exercise the contract.
d. Complete Information: Finally, more information could help to reduce the
risk. Value of information is the difference between the expected value of an
outcome when there is complete information and when there is incomplete
Check Your Progress
information. If the value of information is more than the cost of attaining the
1. What do you mean by
same individual may colect such information and reduce the risk.
expected value? How is
it helpful in defining
risk preferences of 14.5 Summary
managers?
2. What do you Risk is a situation where all the possible outcomes from a particular event are
understand by risk known along with the probability of the occurrence of each outcome whereas uncertainty
management? Why is it refers to a situation where there are more than one possible outcome from a particular
important for a event and the probability of the occurrence of each outcome is not known.
manager?
A risk averse person is one who chooses a certain income instead of risky income
even when the expected value of both is same. A risk neutral is a person who is
indifferent between certain and uncertain prospects. Lastly, a risk lover is a person
who chooses a risky income prospect instead of certain income with the same expected
Economics for value.
Managers : 190
For a manger there are different ways to manage risk. It begins from identification, Risk and Uncertainty
assessment and prioritization of risk followed by coordinated and economical
application of resources to minimize, monitor and control the probability and impact
of unforeseen events. NOTES
14.6 Key Terms
Risk: a situation where all the possible outcomes from a particular event are known
along with the probability of the occurrence of each outcome.
Uncertainty: a situation where there are more than one possible outcomes from a
particular event and the probability of the occurrence of each outcome is not
known.
Probability: likelihood that a particular outcome will occur.
Expected Value: the weighted average of the values associated with the all possible
outcomes where weights are the associated probabilities.
Risk Averse: a person who chooses a certain income instead of risky income even
when the expected value of both is same.
Risk Neutral: a person who is indifferent between certain and uncertain prospects.
Risk Lover : a person who chooses a risky income prospect instead of certain income
with the same expected value.
Risk Management: identification, assessment and prioritization of risk followed by

coordinated and economical application of resources to minimize, monitor
and control the probability and impact of unforeseen events.
Questions
1. Explain the risk preferences of different individuals.
2. How is standard deviation helpful in decision making in a risky situation.
3. Is risky situation similar to uncertain situation? Give examples.
4. Explain different ways through which a manager can manage risk.
5. Suppose that two investments have the same three types of payoffs, but the
probability associated with each payoff differs, as illustrated in the table
below. Find the expected return and standard deviation of each investment.
Economics for
Managers : 191
Risk and Uncertainty Payoff Probability Investment A Probability Investment A
Rs. 300 0.10 0.30
NOTES Rs. 250 0.80 0.40
Rs. 200 0.10 0.30

1. Knight, Frank H. 1921, Risk, Uncertainty and Profit. Boston : Houghton
Mifflin.
2. Macrimmon, Kenneth R. and Donald A. Wehrung (1984), `The Risk In Bas-
ket, Journal of Business, 57 (3), 367-387.
3. R. S. Pindyck and D. L. Rubinfeld, Microeconomics (7th Edition), Pearson
Economics for
Managers : 192
Technological Change
UNIT 15 TECHNOLOGICAL CHANGE
Structure NOTES
15.0 Introduction
15.2 Defining Technology
15.3 Factors contributing to technological change
15.4 Summary
15.5 Key Terms
15.0 Introduction
A manager operates in a changing socio-economic enviornment that is witnessing

extensive technological changes. It is pertinent that a manger should keep abreast with
these changes. In this unit we will focus on the definition of technology and its
characteristics. The technological change is not brought in an economy as manna from
heaven. There are various factors that contribute to the same. The latter half of the unit
is devoted to the role of market structure and intellectual property rights in bring the
change.
This unit is organized as follow. Section 15.2 discusses the definition and
characteristics of technology. Section 15.3 elaborates on market structure and intellectual
property rights.

* To introduce readers to the concepts related to technological change.
* To learn about the influence of the market structure on innovation by firms
and the role of intellectual property rights in incentivizing such innovation.
15.2 Defining Technology
Technology refers to the application of scientific knowledge to the practical aims

of human life or, as it is sometimes phrased, to the change and manipulation of human
environment (Britannica Encyclopedia). Technology is the making, usage and Economics for
knowledge of tools, machines, techniques, crafts, systems, or methods of organization Managers : 193
Technological Change in order to solve a problem or perform a specific function. In simple terms, technology
is the way of doing things. The information available is increasing at a sharper rate
since last two centuries and the same rate of information will be available during next
NOTES decades. See the example of mobile hand set producers; they are double in power now
and halve in price. This says that the information year of twentieth century has
experienced an explosion of knowledge creation and has had a major impact on the
rate of technological change. Technological change is considered as the major driving
force for the economic development of a nation, which is primarily determined by
public and private research and development.
Classification of Technology
Technology based on their nature and content can be classified in several ways:
New Technology versus emerging technology
A technology is said to be new when it is introduced first time in a new situation.

However, it is not necessary that the technology should be new to the world; it may
only to the particular company. For instance, a pharmaceutical company develops a
process to make a certain kind of drugs; the process may be new to the company however,
it may use by any other manufactures elsewhere in the world. On the other hand, a
technology is said to be emerging that is not yet fully commercialized but will become
so in the next few years. For instance: 3D printing in manufacturing which is in the
status of commercial production which rapidly prototyping and producing plastic objects
and multi material items.
High-technology versus low- technology

A technology refers to as high-tech that uses highly sophisticated equipment and
advanced engineering techniques; for example, genetic engineering and
telecommunication. Usually a company with certain characteristics uses the high-
technology components in their production process. A technology that does not involve
highly advanced or specialized systems or devices are known as low technology
industries. The technology most widely used by firms that are producing the goods
satisfying basic human needs. A technology that falls between high and low technology
refers to as medium technology.
Codified versus tacit technology

Tacit knowledge is a type of knowledge, which is not captured through language
or mathematics and therefore, not easy to transfer as well. It is type of knowledge
component that is widely held by individuals but not able to be readily expressed which
includes skills, experiences, intuitions and judgments. Normally the sharing or
transferring of tacit knowledge occurs through discussions, personal interactions and it
is difficult to represent or capture in explicit form. In the field of management the
Economics for concept of tacit knowledge refers to knowledge which is only known by an individual.
Managers : 194 Knowledge that is put in diagrams, blueprints or in technical manuals is codified
knowledge. Codified knowledge otherwise known as explicit knowledge is formal and Technological Change
systematic. It can be easily communicated and shared. Typically, it has been documented
as either words, numbers, codes, formulas or musical notations.
Concept of Neutrality of Technical Progress NOTES
Technical progress boosts output directly through the production function and
also by increasing the steady state of capital stock. A production function tells us that
we can increase output in three ways: by increasing capital, by increasing labor or by
boosting total factor productivity (TFP). There is a problem with first of these two
methods is that by increasing capital, consumption has to be reduced at least in the
short-run and by increasing employment, the leisure time has to be reduced. However,
if we can increase the TFP, we can produce more output with same level of capital and Check Your Progress
employment. The concept of neutral technical progress indicates that it is a growth 1. What do you mean by
model where the balance between capital and labor leave unchanged and so permits a Technology? Also give
steady growth. Hicks defined the neutral technical progress as the one which keeps its different
labor-capital ratio (L/K) constant, where L is number of labor employed and K is the classification.
physical unit of capital unit used in the production. On the other hand, a technical 2. What is neutral
progress is said to be capital-saving where marginal product of labor raises more than technical progress? In
that of capital and it is labor saving if marginal product of capital rose more than that of which situations
capital. technical progress
become capital-saving
15.3 Factors contributing to technological change and labour-saving?
Market structure
Schumpeter started a debate on market structure and Research and Development
(R&D) and innovation by manufacturing firms. According to him, firms in a concentrated
market active in R&D activities because R&D activity requires huge fixed invest and
can take years before they yield some benefit on it. Small firms in a competitive market
may not have sufficient fund to undertake such a huge investment. Therefore, large
firms in a concentrated market are conducive for such a research.
Contrary to this, some economist argue that large firm in a concentrated market
have freedom from the competition and may cause firms to be inefficient, which further
leads to inefficiency because of setting up of price above the marginal cost. Firms in a
competitive market may well suit for bringing technological progress. The case is that
small firms are more likely to provide an investment friendly environment and can
flourish ideas also, while large firm may impose bureaucratic rule which delays the
progress of innovation. For a competitive firm the possible gains are very large and
will tend to do the innovation at the maximum speed. It wants to capture as much as
profit from the industry before its competitor move in. Making profit is not the sole
objective of modern firms; they want to capture large market share thereby create a Economics for
reputation in the market, which is possible only through continues innovation. Therefore, Managers : 195
Technological Change competitors undertake innovation activity up to the socially optimal level. However,
firms in a monopoly market capture all the value of invention in its industry because of
its monopoly nature. The monopoly firm therefore applies the restrictive nature of
NOTES invention. The debate remains unsettled in empirical studies.
Intellectual Property Rights

Intellectual property (IP) refers to creations of the mind: inventions, literary and
artistic works, and symbols, names, images, and designs used in commerce, according
to World Intellectual Property Rights Organization. Intellectual property rights (IPRs)
are legal and institutional devices to protect such creations of the mind. IPRs protection
is not restricted to industrial property that is product and process patents. IPRs encompass
creative works of artists, musicians, performers etc. under the protection of copyrights.
These creative works of art are also motivated by economic incentives. These rights
over IP give right holder an exclusive control for limited time period over the commercial
use of a creation. All these ownership rights are territorial in nature, so that the level
and conditions of protection are determined by the national laws and enforcement
institutions.
Why IPRs?
Arrow has discussed the economic characteristics of information as a commodity
and, in particular, of invention as a process for the production of information. The basic
characteristics of information, indivisibilities, inappropriability, and uncertainty, are
the classic reasons for the failure of perfect competition to achieve optimality in resource
allocation and utilization. Non rivalry and partial excludability have been identified as
the defining characteristics of knowledge by Romer. These characteristics render
knowledge goods - goods whose main market value is derived from the knowledge
they contain- as impure public goods. A non rival good has the property that its use by
one firm or person in no way limits its use by another for example, spectrum available
for running the telecom services. Excludability that depends upon technology and the
legal system implies that the goods owner cannot prevent others from using it. For
instance, if a public park is built one cannot refuse someone from entering the same.
However, means can be devised for exclusion like building toll on expressways or
flyovers. Owing to these features, the marginal cost of providing additional unit is zero
or minimal once fixed costs have been incurred to produce these goods. Therefore,
according to the marginalistic principle of optimization the price of the knowledge
good must be zero. However, the initial costs of generating these knowledge goods are
quite extensive. As the result, market fails in providing efficient output of knowledge
goods and necessitates state intervention.
State intervention by means of intellectual property regime makes knowledge

based products or processes excludable. This excludability is limited to the commercial
Economics for use of the products that is for making, using, offering for sale, selling, or importing of
Managers : 196 these products. Disclosure requirements in patent laws ensure that knowledge is available
to other researchers for research purpose. Thus, approbability of knowledge depends Technological Change
upon the intellectual property regime of a country and in the present context that of
globe for it will define the extent to which innovators are able to recoup their investments
in research and development (R & D hereinafter). Note that the existence of non patent NOTES
barriers, substantial natural imitation lags, first mover advantage, oligopolistic market
structure are important factors that reduces the importance of IPRs as the mechanism
to appropriate returns from R & D investments. Moreover, state can also reward
innovators to recognize their contribution to the society and make the innovations
available to public.
Producers of knowledge goods facing competitive markets deal with the threat of
imitation. Research shows that for products and process, the odds are better than 50-50
that a development decision leaks out in less than 18 months. Personnel turnover,
informal communication networks among engineers and scientists working at various
firms, professional meetings, input suppliers, and customs are different channels through
which information leaks out. These information leaks out however, does not imply that
imitation of the product also takes place immediately as the ratio of imitation costs to
that of innovation cots and the ratio of the imitation time to the innovation time are
high. The extent of imitation is determined by industry specific characteristics, tacitness
of the technology, circumstantial sensitivity of industry technology, and R & D
undertaken by competitors that affects the absorptive capacity of firms. The benefits of
the original producers from the commercialization of new knowledge product fall
considerably due to imitation.
We explain the reason for providing intellectual property rights protection

following Scherer. In Figure 15.1, let b (t) represents the potential benefits from the
commercialization of the knowledge good. Assume that these expected benefits are
constant over a period of time; it is represented by the solid horizontal line in Figure
15.1. These potential gains are not realized immediately after the introduction of the
new good. Time is required for penetrating and cultivating the market. In case of state
sponsored monopoly the time trajectory of the benefits realization is likely to be
approximated by the dotted line labeled monopoly in Figure 15.1. However, if
competitive imitation occurs at time T2, the second firm in the market may realize a
benefits stream shown by the dashed trajectory labeled imitator in Figure 15.1. The
monopolists benefits are eroded accordingly, as described by the dot-dash line branching
off from the monopolist benefit stream.
The impact on society of the reduction in the potential benefits of the original
producers of the knowledge goods is reduction in the R & D expenditure by the firms.
This aspect is made clear by Figure 15.2. Following Scherer, let the expected benefits
from the new knowledge good be b(t) these are shown on the vertical axis of Figure
15.2. The horizontal axis shows the development time that is time required for the
development of new product. C = C (TO , TE , t), where C is the discounted total cost of Economics for
Managers : 197
Technological Change development, TO is the time at which development begins, TE is the expected date of
successful completion and t is a running time. There is a time cost trade off involved
that is by incurring more cost firms can reduce the development time. To maximize its
NOTES profits, producer maximizes the difference between the discounted private benefits
from the innovation and development costs. As evident from the figure, competition
steepens a firms discounted expected benefit function and also shifts it towards the
origin that is b(t). This causes problem when shift is sufficiently large so that the
benefit function lies below and left of the discounted development cost function. Thus,
development of the new knowledge good is perceived as unprofitable and no resources
are allocated for the same. Excessive imitation in an economy will therefore, lead to
reduction in the R & D expenditure by the firms as these firms will not be able to
recoup the investments made by them for the same. Thus, there is a need for provision
for the intellectual property rights like patents.
Figure 15.1
Y
Annual
b (t)
benefits
Monopoly
Imitator
O X
T1 T2
Running Time
Figure 15.2
Present
Money
Value
(Benefits
(Benefits
and cost) C (T)
b (t) (intense
competition) b(t) (Monopoly)
O
T1 X
Economics for
Development Time
Managers : 198
The patent application has a disclosure recruitment that implies that an applicant Technological Change
must disclose the working of the subject matter of patent. The disclosure requirements
of the patent application ensure that ample information is made available to other
researchers for carrying further research. Moreover, it has been argued that but for NOTES
IPRs most of the inventions would not have been made known to public as imitation
threat would have made inventors to keep information secret. Thus, these rights are
trade off for such information. Note that disclosure requirements are important as the
inventor cannot exploit all the possible uses of the invention. IPRs by facilitating
contractual agreements between the original right holder and other innovators help in
wider dissemination and use of intellectual creations. Therefore, IPRs provide option
to the innovator to fearlessly advertise the invention and at the same time technological
information is provided to further the research and technological process of the economy.
The state sponsored monopoly by making provisions for these rights generate
static losses in an economy. The patent system causes under production of the newly
invented product and that output is not Pareto optimum for it is possible to make society
better off without making inventor worse off. Scherer has given the diagrammatic
explanation of the economic costs involved in providing patents. Following Scherer
(1972, 1980), Figure 15.3 portrays the case of a process innovation by a firm located in
a competitive industry. It is assumed that the industry faces a linear demand curve and
has constant costs. The process innovation results in a downward shift of the cost
function from C1 to C3. This is the case of run of the mill innovation. If innovator
wants to enjoy monopoly profits price he has to charge price OP4. This price is higher
than OP1 charged in competitive market. A patent in this case only allows the innovating
firm to choose between two strategies. On the one hand, the firm can license its
innovation or sell it to other firms. Given the competitive nature of the industry, the
maximum royalty per unit of output that the innovating firm can charge to its competitors
is P1P3. It can also set price slightly less than OP1 and drive other firms out of the
market. The innovating firm will alter its pre-invention profit-maximizing price-output
decision only in the case of inventions which imply major cost reductions to the extent
of OC2 that is drastic inventions.
Economics for
Managers : 199
Technological Change The crucial assumption, for the abovementioned analysis, is an economy that is
static where efficiency is measured at a moment in time. In an alternative world, when
we consider the dynamics of investment and growth, efficiency takes on a radically
NOTES new meaning. As mentioned above, investments made for the development and
commercialization of any new product or processes are quite extensive. In order to
recoup these investments and further the process of R & D exclusive rights over the
products or processes are needed. Monopoly power granted via these rights ensures
that innovators do not suffer losses due to the imitation of the products by their
competitors. Thus, the policy makers face the daunting task of finding an optimal mix
of the IPRs policies to balance the static losses against the dynamic gains.
Strategic management of IP by firms can alter the market structure in favor of the
IPRs holder. Such management practices create incumbency advantage, raise entry
barriers, and create power with suppliers. How far these maneuvers are successful in
altering market structure in favor of the IPRs holder in long run needs to be empirically
examined. There exist ample literatures which have studied the impact of R & D, and
technical progress on the market structure, not much empirical work is done on the
impact of IPRs on the same. Study by Mansfield et al. shows that contrary to the
popular belief of creating monopoly patent protection does not make entry impossible
as 60% of the patented successful innovations were imitated with in the span of 4
years. Mansfield has studied the impact of product innovations in the chemical, drug,
petroleum and steel industries on the market structure. The results show that in the
petroleum and steel industries, the concentration-increasing product innovations greatly
Check Your Progress
outnumbered the concentration decreasing product innovations. But in the chemical
1. Give your view on the
industry, there were almost as many concentration increasing innovations as
role of large firms and
small firms in concentration decreasing innovations. Empirical results have not shown that
continuous innovation concentration increasing innovations were more important than concentration decreasing
in different market innovations.
structure. One very important aspect of these rights is the conflict between the competition
2. What is IPRs? What policy and IPRs regime. The purpose and objective of both the state policies contradict
are different causes of each other, and there is considerable need for establishing harmony and avoid
market failure that contradictions. The issues involved are extremely complex and vast for the present
necessitates state study.
intervention in the
Apart from these indirect costs involved in creating and maintaining IPRs there
market?
are direct costs involved. These costs are legislating costs, administrative costs, and
enforcement costs. Administrative costs are extensive for these require skilled technicians
to ensure the newness and innovativeness of the creations. Enforcement costs are also
extensive; it requires coordination among the police, the judiciary, and the customs
machinery of the economy.
Economics for
Managers : 200
15.4 Summary
Technology is the application of scientific knowledge to the practical aims of

NOTES
human life. On one hand, new technology implies the introduction of a technology for
the first time in a new situation. On the other hand, emerging technology means the
one that is not yet fully commercialized but will become so in the next few years.Tacit
knowledge refers to the knowledge component of a technology that is widely held by
individuals but cannot be readily expressed. It is difficult to codify such knowledge in
formal and systematic waythrough diagrams, blueprints or in technical manuals.
Intellectual property rights (IPRs)are legal and institutional devices to protect

creations of the mind. These rights play role in incentivizing innovation by firms.
15.5 Key Terms
Technology: is the application of scientific knowledge to the practical aims of human

life.
New technology: introduction of a technology for the first time in a new situation.
Emerging technology: one not yet fully commercialized but will become so in the
next few years.
Tacit knowledge: knowledge component of a technology that is widely held by

individuals but not able to be readily expressed which includes skills,
experiences, intuitions and judgments.
Codified knowledge: also known as explicit knowledge is formal and systematic, and
is put in diagrams blueprints or in technical manuals.
Intellectual property rights (IPRs): are legal and institutional devices to protect such
creations of the mind.

1. Distinguish between tacit and codified technology.
2. What is neutrality of technical progress?
3. Discuss the role of different market structures in technological change.
4. What do you mean by intellectual property rights?
5. Discuss both the pros and cons of patent system.
6. What do you mean by public goods?
Economics for
Managers : 201
1. Arrow K. J., 1962, `Economic Welfare and the Allocation of Resources for
NOTES
Invention. In The Rate and Direction of Innovative Activity : Economic and
Social Factors, ed. R. Nelson. Princeton, NJ: Princeton University Press.
2. Scherer F. M. 1980, Industrial Market Structure and Economic Performance.
Houghton Mifflin : Boston.
3. Watal J., 2001, Intellectual Property Rights in the WTO and Developing
Countries. New Delhi : Oxford University Press.
4. Shepherd W. G., 1997, The economics of industrial organization. 4th Edi-
tion, Prentice Hall.
5. Schumpeter J. A., 1942, Capitalism, socialism and democracy, New York :
Harper.
Economics for
Managers : 202
Externalities and
UNIT 16 EXTERNALITIES AND Environmental Issues
ENVIRONMENTAL ISSUES
NOTES
Structure
16.0 Introduction
16.2 Externalities and Inefficiencies
16.3 Externalities and Environmental issues
16.4 Summary
16.5 Key Terms
16.0 Introduction
In unit II, we studied market mechanism and learned how the forces of demand
and supply lead to price determination. In other words, consumers choices and
preferences that are captured by the demand curve along with the technology, production
and cost considerations of the suppliers lead to market transactions and price
determination. However, it is not always possible for the market price to represent the
cost associated with the production of the goods. In such case, price is not an indicator
of the social cost of producing the good. Take for instance, a case of leather tannery
that throws the waste in the river. A village that might be located downstream is
negatively influenced by the water pollution as it cannot use water. The producers of
leather are going to sell the product in the market without considering the cost imposed
on the villagers and market price will not capture the social cost. In order to understand
the economics behind such phenomenon we will study the concept of externalities in
this unit. These are extremely significant for a manger as a firm cannot operate in
isolation. A manger needs to be aware about the direct and indirect impact of the
operations of the firm in order to rule out the possibilities of any kind of dispute.
This unit is organized as follows: Section 16.2 explains the concept of externalities
and market failure. Section 16.3 discusses the different means to correct the market
failure along with a brief discussion on the issue of climate changes and the measures
used to mitigate the environmental damage.

* To introduce readers to the concept of externalities and market failure. Economics for
* To discusses means to correct the market failure along with a brief discussion Managers : 203
Externalities and on the issue of climate change and the measures used to mitigate the
Environmental Issues environmental damage.
NOTES 16.2 Externalities and Inefficiencies
In case of externalities the activity is not directly reflected in the market, because
of this it can be a source of economic inefficiency or market failure. This implies that a
market cannot capture the effect of production and consumption activities. An action
of a producer or consumer has an impact on another producer or consumer and market
price does not account for the same. For instance, as mentioned earlier, when a firm
throws industrial waste in the river market price of the final good does not capture the
cost imposed by the production activity on the villagers. Alternately, if someone puts
an electric bulb out-side their home for their convenience and a poor kid use the light to
study for exams, the benefit will not include the gains to the kid. These are the examples
of negative and positive externalities respectively. Thus, negative externality is a situation
when the action of a party imposes costs on another party. Positive externality is when
the action of a party benefits another party. Both types of externalities lead to market
failure.
Before analyzing the inefficiencies of externalities let us look at some of the basic
concepts that is used later in the unit. Marginal private cost (MPC) refers to the direct
cost of a production when a firm increases their output by one unit. Marginal external
cost (MEC) is the cost imposed on the society when the firm increases their output by
one unit. Marginal social cost (MSC) is the total marginal costs of the firms production
activity. Thus;
MSC=MC+MEC 16.1
Marginal private benefit (MB) is the benefit assessed by the firm while increasing
their output by one unit. It is measured through the individual demand curve. Marginal
external benefit (MEB) is the benefit to the external party that is not a part of the
production. Lastly, Marginal social benefit (MSB) is the total benefit to society.
MSB= MB+MEB 16.2
Negative externalities and market failure

Negative externalities lead to market failure a situation in which unregulated
competitive market is inefficient as prices fail to provide proper signals about the benefit
and cost imposed of a good. The concept can be explained by an example with the help
of the following example. Suppose there are two neighbors and one owns a cattle farm
and other has a farm land. Cattle sometimes wander into the neighboring farm and
create a negative externality in terms of crop loss. This is refers as negative externalities
which cause an economic inefficiency that is explained in Figure 16.1 that shows the
Economics for
production decision of cattle farm in a competitive market. On X axis, we have the
Managers : 204
number of cattle that a framer should raise and on Y cost of production and price of Externalities and
milk (final product that a farmer sells using the cattle in the farm). Based on the market Environmental Issues
demand and supply price is fixed at p. Recall that it is a competitive market where a
farmer will take the price of milk as given. The MC curve in the figure gives the NOTES
marginal cost of production for the farmer for raising cattle. The firm maximizes it
profit by having q number of cattle such that the marginal cost of raising those cattle
is equal to price of milk. The firm, however, does not take in to account the external
cost imposed on the farmer whose farm is razed by cattle that is MEC. Since the output
of cattle farm increases, the external cost imposed by the firm (in terms of crop loss)
also increases. Therefore, MEC curve is also upward sloping. Hence, the new cost
curve, MSC (MC+MEC) equates with price at q1. From a social point of view, the
firm produces too much output. The efficient level of output is therefore determined by
the intersection of MEC with price at q1.The same analysis can be applied to a firm that
produce output along with pollution. The firm will consider only MC and produces
output level q whereas after taking note of the external cost of pollution imposed on the
residents in the nearby area only q1 should be produce. The low price of output or
excessive production thus reflect on the market failure.
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1. What is positive and
negative externality?
Explain with the help
; of an example.
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2. What do you understand
Positive externalities and market failure by MSC and MSB?
How do they create
An externality may generate positive outcome as well. For example, look at the
externality in the
above example once again from another perceptive. Now we are in crop firm. In Figure
market? Explain in
16.2, the horizontal axis measures the farms production level and vertical axis measures
detail through an
the values generated from each level of output. It is assumed that farmer enjoys
example.
economies of scale therefore, at initial levels of production the marginal cost is constant
and it is horizontal to X axis. The demand curve DD measures the marginal private
benefit (MB) of the production to the farmer and he decides to produce at the level of
Economics for
q at which his marginal cost curve and demand curve intersect. But the production
Managers : 205
Externalities and generates external benefit to the cattle farm as it can use the cattle feed from the
Environmental Issues neighboring farm (the wastage from the farm). The marginal external benefit (MEB)
curve indicates this benefit. The MEB curve is downward sloping because this benefit
NOTES is large for a small amount of production.
Marginal Social Benefit (MSB) curve is obtained by adding MB curve to MEB

curve at each levels of output. The efficient level of output q1 is found at the intersection
of MSB with MB. This inefficiency arises because the farmer does not capture all the
benefits of his investment. As a result the price p is too much to encourage his investment
in the socially desirable level. A lower price p* is required to encourage the efficient
level of production. The similar analysis can be extended to a person who maintains a
well manicured garden. All the neighbors also benefit from good surrounding. If we
put time devoted on X axis in Figure 16.2 you find the similar result. That is if a person
considers only the benefit accruing to him he will devote less time to gardening as
compare to a situation when he will take into account the marginal external benefit to
the neighbors.
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16.3 Externalities and Environmental issues
The above example explains the problem of externality in a simple way. Now we
take a look at the most common type of externality-the existence of air and water
pollution. The Environment (Protection) Act, 1986 defines environment to include
water, air and land and the interrelationship that exists among and between water, air
and land, and human beings, other living creatures, plants, microorganisms and property.
Economics for Due to population growth and rapid industrialization environmental resources become
Managers : 206 scarce. Negative externalities arises when exhaustible resources are depleted and when
renewable resources are used at a rate greater pace than its re-generation rates. Market Externalities and
failure and government failure are the reason for these environmental issues, further, Environmental Issues
this externality occurs when property rights are not well defined. Markets can exist and
function efficiently only when property rights on the actions are well defined and NOTES
transaction cost of exchanges are small.
For environmental resources such as clean air, water and atmosphere property
rights are not well defined. Users of these resources consider them as free goods.
Therefore, they consider zero prices for these goods while using them. Think about a
case where a village man makes his living from catching and selling fish from a river.
Now, if a chemical plant open nearby the river, and decides to discharge chemical
waste into the river, then the fish all die and fisher man lose his ability to make a living.
In this case, the chemical plant is not being forced to cover all of the costs of its operation.
If it was required to dispose of hazardous waste in some way that did not involve
dumping it into a river, then it would be faced with higher costs, and if it has higher
costs, then the price of its products will be higher. If the price is higher, then consumers
will purchase less. In the above example, the property rights are not defined in either of
the cases. The fisherman do not know how much he can fish per day and factory owners
do not have enough idea on how much they can pollute the river.
Dealing with externalities

The best way to deal with this externality is to ask the firm to reduce the waste by
reducing the output. But in a modern competitive world, firms having different
technological combination, the idea may not work properly. However, it is possible to
fix an efficient level of pollution by equating marginal social cost (MSC) with marginal
cost of abating the pollution (MCA). MCA measures the additional cost to the firm of
installing a pollution control instruments. It means that the firm can reduce the amount
of pollution but only at a cost, known as MCA. Consider the above example, can be
explained through Figure 16.3. The curve labeled MSC represents marginal social cost
of pollution, which slopes upward, because as production increases the level of hazardous
pollution also increases. The curve MCA represents marginal cost of abating the pollution
which slopes downwards because, the marginal cost associated with high level of
pollution is low.
The efficient level of pollution is decided at point E where the MSC is equal to
the MCA. Only at this point the firms cost of abating the pollution and social cost are
minimum. Any point to the left of E the pollution is too low and any point to the right
the pollution is too high. Having decided that this much of emission level is acceptable,
a government can induce a firm to produce efficiently in three ways; emissions standards,
emissions fees, and transferable emission permits.
Economics for
Managers : 207
Externalities and )LJ
Environmental Issues
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Emission standard
An emission standard is a legal limit on how much pollutant a firm can emit
whereas an emission fee is a charge levied on each unit of firms emissions. Consider
Figure 16.4, where both the issues are simultaneously dealt. An emission standard of
10 units is fixed at the efficient level of E. If the firm exceeds the limit it can face either
monetary penalties. The standard of emission ensures that firm will produce efficiently.
Emission fees
Suppose, emission fee of Rs 5 is set for each unit of production based on the
efficient level of production E. From Figure 16.4, it is clear that firm can reduce its cost
by reducing its output at 10 units. Note that for all levels of output beyond 10 units the
marginal cost of abatement is less than the emission fee, so it will be producing emission
up to 10 units and paying the fees for the same. If it plans to produce more it can use the
Check Your Progress
abatement mechanism as MCA is less than 5.
1. Explain various ways
through which Transferable emission permits
government Transferable Emission Permits (TEP) creates transferable property rights to emit
intervention can reduce a specified amount of pollution. The property rights consist of a permit to emit pollutant.
market failure. Each permit holder has a right to emit the specified amount of pollution mentioned in
2. How does emission the permit. Specifically, permit holders usually have a number of such permits subjects
trading system under to transferable among the firms; can be bought and sold among the anybody allowed to
Kyoto protocol helps in participate in the permit market. However, the total number of such permits held by all
reducing environmental sources puts an upper limit on the total quantity of emission. In a competitive market
pollution? Explain in situation a market for the permits is likely to develop. Gradually market equilibrium
detail. will be reached at the point where the price of permits equates with cost of abatement
for all firms. Those firms whose cost of abatement is low certainly reduce emission the
most and those firms with relatively high marginal cost of abatement will purchase the
Economics for permits.
Managers : 208
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Kyoto Protocol
One such mechanism is attempted under Kyoto Protocol (KP). KP is an
international agreement linked to the United Nations Framework Convention on Climate
Change (UNFCCC), adopted in Kyoto, Japan, on 11 December 1997 and entered into
force on 16 February 2005. KP provides an elaborate mechanism to reduce the GHGs
emission globally including emissions trading, clean development mechanism and joint
implementation. An Emission Trading (ET) system involves setting an aggregate
emission target for an industry e.g. steel industry. Accordingly, individual firm in the
industry is allocated tradable permits or allowances that entitle each firm to emit a
specified amount of CO2. The regulatory authority either allocates or auctions allowances
in the market. Market players that have to meet their emission targets buy these
allowances and trade it in the market.
Emission trading is an efficient way to reduce CO2 emission at least cost as can be
shown by the following example. Consider two companies A and B and each emit
100,000 tonnes of CO2 per year. The government gives each of them 95,000 emission
allowances. One allowance represents the right to emit 1 tonne of CO2. At the end of
each year, the companies have to surrender a number of allowances corresponding to
their emissions during the year, whatever the emissions of the individual company are.
If they fail to do so, they face a fine. Companies A and B do not want to pay the fine and
both have to cover 5,000 tonnes of CO2. They can either reduce their emissions by
5,000 tonnes, or purchase 5,000 allowances in the market. In order to decide which
option to pursue, they will compare the costs of reducing their emissions by 5,000
tonnes with the market price for allowances. Lets say that the allowance market price
is Rs10 per tonne of CO2. If company As reduction costs is Rs 5 it will reduce its
emissions. Company A may even reduce its emissions by more than 5,000 tonnes, say
Economics for
10,000 tonnes. For Company B, the situation may be the opposite: its reduction costs
Managers : 209
Externalities and are Rs 15 so it will prefer to buy allowances instead of reducing emissions. Company
Environmental Issues A spends Rs 50,000 on reducing 10,000 tonnes at a cost of Rs 5 per tonne and receives
Rs 50,000 from selling 5,000 tonnes at a price of Rs 10. Company A fully offsets its
NOTES emission reduction costs by selling allowances, whereas without the Emissions Trading
it would have had a net cost of Rs 25,000 to bear. Company B spends Rs 50,000 on
buying 5,000 tonnes at a price of Rs 10. In the absence of trading, B would have spent
Rs 75,000. Under the trading scheme, the company that has low reduction costs will
choose to reduce its emissions. It is evident from the example that the prices of emission
reduction opportunities among the market participants will finally drive the market
price of allowances. This emission trading mechanism is also referred to as cap-and-
trade mechanism as it involves putting a cap on the carbon emissions and at the same
time allowing for trade in the same.
16.4 Summary
Externality is an action of a producer or consumer that has an impact on another

producer or consumer and market price does not account for the same. In case of
negative externalitythe action of a party imposes costs on another party whereas in
case of positive externality such an action benefits another party. Due to presence of
the negative externality, we find that marginal private cost that is the direct cost of a
production when a firm increases their output by one unit is lesser than marginal
external cost that is imposed on the society. Such a situation leads to market failure
necessitating government intervention.
16.5 Key Terms
Externality: an action of a producer or consumer has an impact on another producer

or consumer and market price does not account for the same.
Negative externality: when the action of a party imposes costs on another party.
Positive externality: when the action of a party benefits another party.
Marginal private cost (MPC): the direct cost of a production when a firm increases
their output by one unit.
Marginal external cost (MEC): cost imposed on the society when the firm increases
their output by one unit.
Marginal social cost (MSC): the total marginal costs of the firms production activity;
MSC=MC+MEC.
Marginal private benefit (MPB): benefit assessed by the firm while increasing their
Economics for output by one unit.
Managers : 210
Marginal external benefit (MEB): benefit to the firm which are not a part of the Externalities and
production Environmental Issues
Marginal social benefit (MSB): total benefit to the society; MSB= MB+MEB.
NOTES
Emission standard: a legal limit on how much pollutant a firm can emit.
Emission fee: a charge levied on each unit of firms emissions.
Transferable Emission Permits (TEP): creates transferable property rights to emit a

specified amount of pollution.

1. Explain the concept of externality by giving different examples.
2. What is market failure? Show the case of market failure in case of negative exter-
nality.
3. Compare and contrast the following three mechanisms for treating pollution ex-
ternalities (a) an emissions fee, (b) an emissions standard, and (c) a system of
transferable emissions permits.

Delhi.
Economics for
Managers : 211
Information Asymmetry and
Game Theory Applications UNIT 17 INFORMATION ASYMMETRY
for Managers
AND GAME THEORY
NOTES APPLICATIONS FOR MANAGERS
Structure
17.0 Introduction
17.2 Information Asymmetry and its Implications
17.3 Game Theory
17.4 Basic Concepts
17.5 Summary
17.6 Key Terms
17.0 Introduction
In unit II, we studied market mechanism and learned how the forces of demand
and supply lead to price determination. Such markets work efficiently when there is
symmetric information i.e. consumers and producers both have the same level of
knowledge. However, this may not be a realistic assumption to make regarding the
market mechanism. For instance, if you go to market to buy a second hand car in all
likelihood the seller has more information about the car than you. In case of insurance,
an individual knows better about his health as compare to the insurance agents. In such
instance, either seller or buyer has better information as compare to the other. And this
asymmetric information occurs when one party in a contract knows better than others
in the market. The presence of such asymmetry made lead to market failure. For example,
as in the health insurance market, buyers know more about their health than the insurance
providers and they have an incentive to conceal the health problems to get a lower
insurance premium. This information asymmetry affects the market and causes market
failure. In this unit we will study about information asymmetry, the ensuing market
failure and various means available to address the market failures. The second half of
this unit is devoted to understanding game theory and its applications for managers.
The organization of this unit is as follows: Section 17.2 describes information

asymmetry in detail along with its implications like adverse selection and moral hazard.
The later sub-section discusses a few means available to deal with the problems caused
Economics for by the presence of information asymmetry in market. Section 17.3 onwards we will
Managers : 212 discuss game theory. Please note that these units are introductory in nature and interested
readers can get more detailed information from microeconomics textbooks. Information Asymmetry and
Game Theory Applications
for Managers
NOTES
* To introduce readers to the basic concepts of information asymmetry and
ensuing market failure.
* To discusses principle agent problem and possible solutions available in the
literature.
* To discusses game theory.
17.2 Information Asymmetry and its Implications
In a market, two parties come together to enter into transaction. These two parties
may have equal information about the product or it is possible that the seller knows
best about the product and buyer is aware about his/her intentions to enter into contract.
In such a case, the information distribution is not symmetric. Consider following cases,
in a market of used goods- seller would always have better information about product,
health insurance- buyers know better about his/her health, labor market- employee
knows about his/her skill and motivation level, and technology market- seller is aware
about the machine or working of patent better. In such instances, there are two important
implications of information asymmetry:
Adverse selection
Adverse selection is a situation when sellers and buyers are not able to determine
the quality of the product given the information and as the result products of different
qualities sell at the same price. For instance, in a used car market a buyer will thinks
that there are his/her chances of getting a good cars is 50%. And he/she will view all the
cars as medium quality cars and accordingly will be willing to pay low price. This will
drive good cars out of market. As the quality of cars in the market fall, buyers will
adjust their expectations of getting a good car further lower. This process will continue
in such a way that only low quality cars will be available in the market. George Akerlof,
a Nobel laureates in 2001, shows that how adverse selection affects the used car market.
The sellers of used car always want to sell bad quality cars (or lemons) and want to
keep good car; therefore, buyers usually wary about the quality of the car. This
consideration drives the price of used car down in the market and reduces the number
of good car owners willingness to sell. In some cases owners of lemons are willing to
sell their cars regardless of their prices; however, owners of good car will sell the cars
only if the price is good enough. Therefore, fraction of lemons in the market increases,
hence price of the used cars reduces further downs. As a result of the vicious circle, Economics for
prices of used cars go down to the low level and no good car is offer to sell. Managers : 213
Information Asymmetry and Similarly, in the above example of insurance, the buyer of the insurance will be
more willing to make contract with the insurance company when his health is in a
for Managers
critical condition. He knows better about his health, but the insurance company does
NOTES not. Similarly, when a firm is hiring an employee it needs to consider the skills and
quality of the employee. Appointing a poor performing employee can be an adverse
selection. Adverse selection can make these market for insurance and market for labor
problematic. Because when uninformed parties realize that they are facing adverse
selection, they may become reluctant to trade, causing poor performance of market or
market failure.
Moral hazard
Moral hazard is present when one party to a transaction takes action that another
partner cannot observe and is negatively affected by the same. In other words, when
the actions of one party are not observable and such actions influence the gains or loss
to the other party associated with the transaction. For example, a manger of a software
company assigned a work to the team of three members. All members may not have
same spirit to work as the final result will reflect on the team work. Definitely, the
quality of work degrades as a result of moral hazard by any of the team members. The
same case may happen in case of insurance also. Owner of a property, who have insured
against the fire, do not put sufficient fire extinguisher to prevent the fire. Here the
owners attitude changes because he has insured his property as an example of moral
hazard. An employee may shirk work that may not be in best interest of the employer.
A person with health cover may behave recklessly that may affect the probability of
illness and/or accidents. Note that in case of moral hazard, both the parties have already
entered into transaction. It is the behavior of one party after getting into contract that is
leading to the problem of moral hazard. However, in case of adverse selection, there is
no transaction to begin with. The asymmetry of information in market leads to situation
where the parties do not enter into agreement.
With respect to large firms/incorporation/pubic limited companies, specific moral

hazard problem occurs that is studied with principle-agent model. In case of large
firms, there is a dichotomy between the owners and managers. The owners in a public
limited company may be spread across the country and the management board is
responsible for looking after the company. In such a case, there is a possibility that a
manager need not function in a manner that is in the best interest of owners as the
overall objective of managers and owner may vary. For instance, owner may be interested
in long-term growth and prospects of a company whereas a manager may be interested
in large salaries, permanent position and reputation.
Dealing with asymmetric information

Signaling
Economics for Signaling occurs when an informed individual undertakes an activity to convince
Managers : 214
others of particular fact. In market the sellers and buyers may deal with asymmetric Information Asymmetry and
information through market signaling; where sellers send signals to buyers conveying
for Managers
information about product quality and buyer send signal about the intention to make
purchase. In case of employer-employee situation where it is very difficult for an NOTES
employer to asses moral hazard, education is considered as a best example of market
signaling. As more productive peoples are more likely to attain high level of education
in order to signal their productivity and thereby obtain better-paying job.
Screening
Uninformed parties can also initiate the transfer of information by testing either
the informed parties or the goods those parties seek to trade. Screening occurs when a
uniformed party establishes a test that induces informed parties to self-select, thereby
revealing what they know. In some cases the uninformed party may a passive participant.
For e.g. the potential buyer of a used car can learn about the quality of the car by a
complete evaluation by a mechanic. In some cases, the uninformed party may be an
active participant for example an employer who wants to hire a certain type of workers
suitable for a particular position, sets the application such a way that attract the applicant
with desired qualities and repels others.
Guarantees and warranties
As the role of signaling in labour market, guarantees and warranties play an

important role in product market. Guarantees and warranties offered by durable goods
producer is considered as an example of dealing with asymmetric information.
Consumers value the quality of product through its guarantees and warranties because
the extensive guarantees will be always costly for a low quality producer than high
quality producer. Thus, consumer can correctly view guarantees and warranties as a
signal of high quality product. Check Your Progress
Payment schemes 1. What is information
asymmetry and its
In case of moral hazard, particularly in the principle-agent framework, it is possible
implication in decision
to devise payment structure in such a way that the problem can be eliminated. For
making? Explain
example, a firm can overcome problem from mangers by offering big bonuses for
various ways of
long-term performance rather than short-term. In sales, usually incentives are given
reducing information
based on the sales figure to ensure that the salesperson take interest in the selling of the
asymmetry.
product.
2. What do you understand
Review of Key Concepts by adverse selection?
(Asymmetric information) : a situation when one party in a contract knows How does it lead to
better than others in the market. market failure?
(Moral hazard) : when the actions of one party are not observable and such
actions influence the gains or loss to the other party associated with the transaction.
Economics for
(Signaling) : where sellers send signal to buyers ensuring the quality of
Managers : 215
Information Asymmetry and the product.
for Managers (Screening) : occurs when an uniformed party establishes a test that induces
informed parties to reveal what they know.
NOTES
17.3 Game Theory
Game theory is a science of strategy. In modern world, firms often compete

aggressively in some markets and collude in some other market. Why do firms behave
in different manner in different conditions? Game theory is a tool that explains the
strategy of firms. Von Neumann in 1928, who developed the theory of twoperson zero
sum game, began an application to modern business field. Further, in 1944 along with
Oscar Morgenstern, Neumann published their classic book Theory of Games and
Strategic Behavior that extended the previous work and started a cooperative game
theory. John Nashs work on non-cooperative games made seminal contribution to the
theory. Robert Luce and Howard Raiffa book Games and Decisions: Introduction and
Critical Survey in 1957 made game theory popular. And in 1970s, there was a spurt in
further research work in the game theory, methodologies and new applications in other
social sciences.
Game theory helps firms to better access their own negotiating position as well as
allow them to change the strategy they follow. To know the application of game theory
into economics and business, we should clarify the basic concepts of the theory.
17.4 Basic Concepts
Game theory is a formal methodology and set of techniques to study the interaction
of rational agents in a strategic setting. Rationality implies that each firm has a well
defined objective for instance profit maximization. The nature of optimization remains
as either minimizing (cost) or maximizing (profit, sales revenue). A game is a situation
where two or more participants, known as players challenge each other in pursuit of
certain objectives that may put these players in conflicting position with respect to
each other. During the game some of the players are the winners and some are losers. It
means that not all objectives are simultaneously materialized. At the end of each game,
an outcome will be generated and the reward is known as payoffs. The winners
payoff will be positive and the losers will be negative. The key objective of the game
theory is to set an optimal strategy for each player. A strategy is the plan of action for
playing the game. For example a profit maximizing firm A, will think of keeping the
price of a product high as long as the competitor follows the same. But once the
competitor shows the sign of lowering the price, the firm A might think of lowering the
price even more. Therefore, every action of a player depends on the anticipated strategy
Economics for
of its competitor. Finally, all players in the game will reach an optimal strategy. An
Managers : 216
optimal strategy is the one which maximizes the players expected payoffs. Information Asymmetry and
Non-cooperative Games for Managers
Game theory comprises of cooperative game theory and non-cooperative game
NOTES
theory. According to the Palgrave Encyclopedia of Strategic Management, cooperative
games models how agents compete and cooperate as coalitions in unstructured
interactions to create and capture value. Non-cooperative game theory models the actions
of agents, maximizing their utility in a defined procedure, relying on a detailed
description of the moves and information available to each agent. Note that cooperative
and non-cooperative are technical terms and are not an assessment of the degree of
cooperation among agents in the model: a cooperative game can as much model extreme
competition as a non-cooperative game can model cooperation.
Payoff Matrix
A payoff matrix is a decision analysis tool that summarizes pros and cons of a
decision in a tabular form. It lists payoffs (negative or positive returns) associated with
all possible combinations of alternative actions (under the decision makers control)
and external conditions (not under decision makers control). Below explains an example
of two players (firm A and B) game that are involved in non-price competition like
advertising. Both firms have two strategies, to advertise and do not advertise. As
mentioned, payoffs are interactive such that the consequences of a firms decision
depends upon its action as well as its competitors action. The possible outcome is
illustrated as a payoff matrix in Table 17.1. First number in the cell shows firm As
payoff and second number is the payoff of firm B. Suppose both firm decides to advertise
then A will earn a profit of Rs.9 and B a profit of Rs.6. Similarly, if both firms do not
advertise then A earns a profit of 8 and firm B a profit of 3. Now suppose firm A
decides to advertise but firm B does not. Then firm A earn a maximum profit of Rs.15
and 0 will be the profit of firm B. In case firm B decides to advertise and firm A does
not to advertise then firm B earns profit of Rs.8 and firm A of 6.
Table 17.1: Payoff matrix of two firms
Firm B
Advertise Do not advertise
Firm A Advertise (9,6) (15,0)
Do not advertise (6,8) (8,3)
From the above payoff matrix can you imagine what strategy each of these firms
will follow? Consider the decision making process of firm A. The manager will see
what will be the payoff if firm B advertise, depending upon their decision to advertise
or not. So if B advertise firm A will either get 9 or 6 as payoffs. Clearly, 9 is better and
Economics for
it is best for A to advertise when B is advertising. Now consider the situation when B
Managers : 217
Information Asymmetry and is not advertising. In that case, depending upon if A advertise or not the firm will
receive 15 or 8 as payoffs. Thus, it is clear that whatever the strategy of firm B follows,
for Managers
firm A will definitely advertise. Because, while advertising it will maximize its payoff
NOTES irrespective of firm Bs strategy. Therefore, advertising is the dominant strategy of
Firm A. The same is the case of firm B whatever strategies firm A follows advertising
is the dominant strategy of firm B. A dominant strategy is one that is optimal no matter
what others follow. In our example, both firms have a dominant strategy- to advertise.
Therefore, the outcome will be equilibrium in dominant strategy. Suppose any of the
firm does not have a dominant strategy then its optimal decision depends on what
opponents do.
Nash Equilibrium
Dominant strategy equilibrium is a stable equilibrium . What action will be chosen
by players in a game where there is no dominant equilibrium? A rational decision
maker player chooses the best action available to them. In a competitive game the best
action of any player depends on the other players action. Therefore, while making a
decision every player must keep others action in mind. Even if there is no dominant
strategy, there is an optimal choice for each player given the strategy of others. The
optimal choice is called Nash Equilibrium. A Nash equilibrium is a situation a with
the property that no player can do better by choosing an action other than a given
other players strategy.
Twoperson zero sum game

This is a category of game where there are two players who confront each other
to attain a particular solution. At the end of the game, the sum of the payoffs to both
players is equal to zero. This implies that one players gain is the other players loss.
Consider there are two firms A and B in a duopolistic market and are competing to lure
each others customers. You may think about two small cafes that are located in close
vicinity to each other. Considering that the total population of the area is limited each
cafe owner attempts to lure each others customer. Suppose firms A and B have to
choose between advertising and not advertising in the street then their payoff matrix is
given as Table 17.2. You can notice that in the table, when we add together each firms
payoff the net benefits are equal to zero.
Table 17.2 : Zero sum game
Firm B
Advertise Do not Advertise
Firm A Advertise (0,0) (5,-5)
Do not Advertise (-5,5) (0,0)

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A game where payoffs at the end of the game are added up to a fixed numbers Information Asymmetry and
whatever strategies chosen by the players is known as constant sum game. The above
for Managers
example is the special case of constant sum game because the payoffs at the end of the
game are equal to zero in all the cases. It is not necessary that the constant number NOTES
always be zero. For example in case of two firms operating in market where fixed
number of customers, suppose the total sale will always equal to 100 which will be
shared by two firms. Consider the payoffs of two firms in four cases (60, 40), (50, 50),
(40, 60) and (30, 70). In case first, firm A attains 60 units of sale and firm B earn 40
units of sale both added to sum of 100. In all the four cases the payoffs are added to
100. This is known as constant sum game. The examples explained above treated only
two players are participant. However, it may be extended up to n number of players.
Maximin and Minimax strategy

The selection of an optimal strategy by each player without the knowledge of the
competitors strategy is the basic problem of playing games. If all the players mutually
know their opponents strategies also, then selection of a strategy is not a problem. But,
now the question is how these players elect their strategy so that they optimize their
payoffs. Such a decision making criteria in game theory is known as maximin and
minimax strategy.
Maximin Criteria
The maximizing player lists the minimum gains from each strategy and selects
the strategy which gives the maximum out of these minimum gains.
Minimax Criteria
The minimizing player list all the maximum losses from each strategy and select
the strategy which gives the minimum loss out of these maximum losses.
In a two person zero-sum game we know that there are two players, firm A and B.
If we look from As perspective, we assumes that A wish to maximise his payoffs while
as counter strategy B would like to minimize the loses. Consider the following example
where firm A has three strategies A1, A2 and A3 and B counter react with two strategies
B1 and B2, given in Table 17.3 that shows payoffs of only B. Each strategy has a
payoff value equal to 10 so the balance will be payoff for A. Suppose firm A starts with
strategy A1 and firmly believes that firm B will adopt those strategy which will give
minimum losses for it. In Table 17.4, B2 is the strategy which minimizes the loss of
firm B. The raw minima in action A1 will be a value equal to 4. Similarly, if A chooses
A2 then firm B will select strategy B2, which will again minimize firm Bs loses. The
raw minima in this case will a value equal to 5. Finally, if firm A decides to play A3,
this time firm B will elect strategy B2, with a raw minima 3, which minimizes his loss.
Firm A then considers the maximum of raw minima (circled in the table) as the strategy
to play.
Economics for
In case of firm B, it has two strategies to follow, B1 and B2. Suppose firm B Managers : 219
Information Asymmetry and select strategy B1, while considering firm As strategies, A1, A2 and A3. Firm B now
thinks that firm A will adopt a strategy which will be worst for him, which is the
for Managers
strategy A1 in the table. Similarly if firm B adopt strategy B1, keeping the same belief
NOTES firm A may follow A2 in the game. Hence, firm B try to minimize his loses while
selecting the minimum of the maximum loses, which is 5. From this example, it is be
clear that A would go for maximizing his minimum gain while B would strive for
minimizing the maximum losses. In our case both raw minima (maximum gain for firm
A) and column maxima (Minimum loss for firm B) are same. When maximin value and
minmax value are same, the value is known as saddle point. A saddle point may therefore
be defined as a position in the payoff matrix where the maximum of row minimas
coincides with the minimum of the column maximas. The payoff at the saddle point is
called the value of the game.
Table 17.3 : Defining saddle point
Firm B
B1 B2 Raw Minima
A1 10 4 4
Firm A A2 8 5 5
A3 2 3 3
Column Maxima 10 5
A game may or may not have a saddle point. A game with saddle point is known
as pure strategy game, whereas a game with no saddle point is known as mixed strategy
game. Where saddle point does not exist in game firms uses different method to solve
the problem.
Repeated versus non-repeated games

The discussion so far is focused on the games that are played once. However, in
a real world situation, firms interact with each over a period of time. They tend to
formulate opinions about each others behavior through repeated interactions. Such a
situation warrants analysis of repeated games. Repeated games involve many consecutive
and counter moves by players in a game. Tit-for-tat is the main strategy for a player in
a repeated game. Tit-for-tat means do the same what the opponents done to you. It
means that you are behaving in a same manner what the opponents behave to you. If
your opponents cooperate with you continue to cooperate until the rivals cooperate
with you. It the opponent starts to betray, the next moment you also betray him back.
Though the tit- for- tat strategy seems to be the best practice for every firm (resulting
best result), it works efficiently only under certain condition. The players must be
Economics for stable and number must be small. The game is assumed to repeat indefinitely, because
Managers : 220
in finite number of games, the chance of noncooperation will be higher towards the end Information Asymmetry and
of the game.
for Managers
In the repeated games, firms interaction with each other over a period of time
leads to understanding of the behavior of each other. It is also possible that firms may NOTES
send each signals regarding their future action to ensure that the rival behaves in a
manner that is beneficial to each other. These signals could be in the form of threats,
credibility and commitment. Now we will see how the three things- threats-credibility
and commitments works in the game theory.
In an oligopolistic market, firms often threaten their rivals to lower their prices if
the rivals lower it, even if the move reduces the profit of their own. The threat may be
either credible or non credible to others. By assuring a lower price than any other
company in the market, firms can make it credible. In Table 17.5, where there are two
players firm A and firm B and their payoff matrix is given. Suppose firm A has a
dominant strategy of charging higher prices and firm B does not have a dominant
strategy. The reason is that firm A earns a better profit while charging a higher prices
regardless of firm Bs action. It is clear from the matrix that while charging a higher
price firm A earns a profit of 6 when firm B charging a lower price and earns a profit of
when firm B charges a higher price. In both the cases, firm A is better off charging a
higer price. Now it turns to be the decision of firm B, it decides to charge a lower price
which makes him more profitable (4 instead of 3). Now firm A threaten to firm B that
it may lower its price, however, firm B does not believe this threat because by lowering
the price firm A now earns only a profit of 5 instead of 6 while charging a higher price.
Therefore, firm B keeps following the strategy of low price.
Table 17.4 : Payoff matrix under threat Check Your Progress

3. What is the relevance
Firm B of game theory in
Higher price Lower price strategic decision
making? Explain
Firm A Higher price (7,3) (6,4) through an example.
Lower price (5,1) (4,2) 4. What is pay-off

matrix? Draw a payoff
To maintain a high profit, firm A has to make its threat credible. One way to doing matrix of a zero sum
so is to create a reputation for carrying out its threat that is likely to influence firm B game.
and it may raise the prices. So in the longer time period both will charge a higher price 5. What is Nash
and make a profit of 7 and 3 for A and B respectively. By doing so, remember that firm equilibrium and
B now earns a profit of 3 slightly lower than what he could earn while charging a lower repeated Vs. non-
price 4. But the point is that still it may be better off than charging a lower price with repeated games?
the threat low prices by firm A (3 instead of 1).
Economics for
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Information Asymmetry and
Game Theory Applications 17.5 Summary
for Managers
Asymmetric information is a situation when one party in a contract knows better

NOTES
than other in the market. In such situations, sellers and buyers are not able to determine
the quality of the product given the information leading to selling of different qualities
of the same product at the similar price. This is a case of adverse selection. Further, in
case of asymmetric information, the actions of one party may not be observable and
such actions influence the gains or loss to the other party associated with the transaction.
Game is a situation where two or more participants, known as players challenge

each other in pursuit of certain objectives that may put these players in conflicting
position with respect to each other. Each player needs a strategy that is the plan of
action for playing the game.
17.6 Key Terms
Game: a situation where two or more participants, known as players challenge each
other in pursuit of certain objectives that may put these players in conflicting
position with respect to each other.
Strategy: the plan of action for playing the game.
Nash Equilibrium: a situation when player do the best what they can given what the
competitors do.
Dominant Equilibrium: a situation when players do the best what they can regardless
of what competitors do.
Two-person zero sum game: category of game where there are two players who
confront each other to attain a particular solution and at the end of the game,
the sum of the payoffs to both players is equal to zero.
Maximin criteria: the maximizing player lists the minimum gains from each strategy
and selects the strategy which gives the maximum out of these minimum
gains.
Minimax criteria: the minimizing player list all the maximum losses from each strategy
and select the strategy which gives the minimum loss out of these maximum
losses.
Repeated games: involve many consecutive and counter moves by players in a game.

Economics for 1. What is information asymmetry?
Managers : 222
2. What is the difference between moral hazard and adverse selection. Information Asymmetry and
3. What is the difference between a cooperative and a non-cooperative game with for Managers
example.
4. What do you mean by dominant strategy and Nash equilibrium? NOTES
5. Two computer firms, A and B, are planning to market network systems for office
information management. Each firm can develop either a fast, high-quality sys-
tem (High), or a slower, low-quality system (Low). Market research indicates that
the resulting profits to each firm for the alternative strategies are given by the
following payoff matrix:
Firm B
High Low
Firm A High 50,40 60,45
Low 55,55 15,20
i) If both firms make their decisions at the same time and follow maximin
(low-risk) strategies, what will the outcome be?
ii) Suppose that both firms try to maximize profits, but that Firm A has a head
start in planning and can commit first. Now what will be the outcome? What
will be the outcome if Firm B has the head start in planning and can commit
first?
1. R.S. Pindyck and D.L. Rubinfeld.Microeconomics (7th Edition), Pearson

2. George A. Akerlof, 1970. The Market for Lemons: Quality Uncertainty and
the Market Mechanism. Quarterly Journal of Economics: 488-500.
3. E.F. Fama, 1980. Agency Problems of the Theory of Firm, Journal of Political
Economy.288-307.
4. James W. Friedman. (1990). Game Theory with Applications to Economics.

New York: Oxford University Press.
5. Avinash Dixit and Susan Skeath.(2004). Games of Strategy. (2nd Edition)

New York: Norton.
Economics for
Managers : 223
Measuring National Income
and Concepts UNIT 18 MEASURING NATIONAL
INCOME AND CONCEPTS
NOTES
Structure
18.0 Introduction
18.2 National Income Accounting
18.3 Method to calculate GDP in India
18.4 Other national income accounting measures
18.5 Statement of National product and Related Aggregates of India
18.6 GDP growth in India
18.7 Summary
18.8 Key Terms
18.0 Introduction
Large number of goods and services are produced each day in India. How do we
measure all this economic activity? The question of measurement comes under the
heading of national income accounting. To improve the performance of economy, it is
essential to quantify and understand the measurement of the major macroeconomic
variables. The standard techniques developed by the economists and statisticians to
measure the performance of modern economy are collectively known as methods of
national accounting.
In this unit we shall define and learn to calculate the values of these important
macroeconomic variables. The two principal measures of economic activity (national
income) are gross domestic product (GDP) and real GDP. In section 18.2 of this unit
defines and explains the concept, methods to measure GDP and other major
macroeconomic indicators that provide overall picture of the economy. It is useful to
understand (and measure) these concepts because they depict the present status of an
economy, help to analyze the changes over a period of time and also helpful to forecast
on the basis of available data. It is also critical in the sense that, policy makers can
gauge the changes taking place in different sectors (primary, secondary and tertiary);
then, frame and tweak the policies accordingly. We discuss briefly the method suitable
for calculating GDP in India in section 18.3. After discussing various methods to
Economics for calculate national income and other important macroeconomic variables in section 18.4
Managers : 224 we shall present a statement showing Indias national product and related aggregates
for year 2010-11 in section 18.5 and conclude with a brief mention of changes happened Measuring National Income
and Concepts
in growth level of GDP since 1950s in section 18.6..
18.1 Unit Objectives NOTES

* To develop an understanding of concepts and basic measures (GDP, NGP
etc.) to calculate national income.
* To characterize economy with the help of a few ball park numbers (With the
help of values calculated for various national accounting measures)
18.2 National Income Accounting
The single most important concept in macroeconomics is gross domestic product

(GDP); it measures the total value of goods and services produced in a country during
a year. GDP is part of the national income and accounts (or national accounts), that
enables policymakers to determine whether the economy is contracting or expanding
and whether there lies a threat of inflation or recession. In brief, GDP is a yardstick of
economic performance of an economy.
Gross Domestic Product

During any given year, people in India produce certain amount of goods and
services. It includes industrial goods, agricultural output and other services. Have you
ever wondered; what is total value in dollars of all these goods and services? In 2012,
it was $1.824 trillion. In other words, in 2012, people living and working in India
produced $1.824 trillion worth goods and services. The dollar amount - $1.824 trillion
is what economists call the gross domestic product.
In simple words, gross domestic product is the total market value of all final
goods and services produced annually within a countrys borders.
Methods to Calculate GDP

There are three approaches to compute GDP the expenditure approach, the
income approach and the value-added approach. We shall now describe each of this
approach in terms of simple economy.
Consider an example in a simple economy in which one good is produced and

sold. Rohan find a seed and plants it. Sometime later an orange tree appears. Rohan
pays Suraj $5 in wages to pick and box the oranges. Next, Rohan sells oranges to
Abhishek for $8. Abhishek turns the oranges into juice and sells orange juice to Sonali
for $10. Sonali drinks the juice. What is the GDP of simple economy? Is it $5, $13,
$10, $18 or some other amount? Economics for
Managers : 225
Measuring National Income Expenditure approach
and Concepts
To calculate GDP using expenditure approach, we add the amount of money spent
by buyers on final goods and services.
NOTES
The words final goods and services are important in calculating GDP because
not all the goods are final goods. Some are intermediate goods. In example above,
oranges are intermediate goods. An intermediate good is an input in the production of
a final good (orange juice). Thus, GDP in this tiny economy is $10.
If we count expenditures on both final and intermediate goods, we would be

double counting. Double counting refers to counting a good more than once when
computing GDP. In this case, if we count both Sonalis purchase of the orange juice
($10) and Abhisheks purchase of the oranges ($8), we count the purchase of oranges
twice once when oranges are purchased by Abhishek and once when the oranges are
in the orange juice.
To avoid double counting of intermediate products, value added at each stage of

production is calculated.
Income approach
To simplify and understand at this stage we state that; in our simple economy,
income consists of wages and profits. To calculate GDP using income approach, we
find the sum of all the wages and profits.
First, Suraj earns wages for $5. Second, Rohans profit is $3 (as the wages paid
by Rohan are $5 i.e. cost and receives $8 when he sells them to Abhishek. Cost subtracted
from revenue leaves Rohan with a profit of $3. Third, Abhisheks profit is $2; as his
cost is $8 and he sells juice to Sonali for $10 therefore with Abhishek is $2.
In simple economy, sum of Surajs wages, Rohans profit and Abhisheks profit is
($5 + $3 +$2 =$10) $10. So, GDP is equal to $10.
Value Added approach

As mentioned in above in the expenditure approach, to avoid double counting we
subtract the intermediate goods that are used up in making the final goods. We take
care to include only final goods in GDP.
In this small economy, orange juice is sold, or has a market value of $10. How
much of the $10 market value is attribute to Abhishek? In other words, how much of
the $10 market value is value added by Abhishek? It is $2. Value added is the dollar
value contributed to a final good at each stage of production. It is the difference between
the dollar value of the output the producer sells and the dollar value of intermediate
goods the producer buys.
To calculate GDP using value added approach, calculate the sum of the values
Economics for added at all the stages of production. Rohan buys no intermediate goods but he sells
Managers : 226
oranges to Abhishek for $8. Value added at this stage is thus $8. Abhishek purchases Measuring National Income
and Concepts
oranges and turns into juice to sell it for $10 to Sonali. Value added at this stage is $2.
The sum of the value added at all (two) stages is therefore equal to $10.
This section involved an example of simple economy which consist one person NOTES
producing orange, one person producing juice and one person buying juice. Obviously,
Indian economy is much more complex. Following section helps us to understand the
measurement of GDP through these three approaches in a real world economy.
Expenditure approach to calculate GDP for a real world economy
Economists often divide economy in four sectors: (1) household sector, (2) business
sector (3) government sector and (4) foreign sector. Different goods and services are
bought in these sectors by different economic actors; in other words they spend. The
expenditure of the sectors is called respectively (1) consumption (2) gross private
domestic investment (3) government consumption expenditures/gross investment/
government purchases; and (4) net exports.
Consumption (C) includes (i) spending on durable goods, (ii) spending on non-
durable goods and (iii) spending on services.
Investment (I) is the sum of (i) the purchases of newly produced capital goods (ii)
changes in business inventories, sometimes referred as inventory investment and (iii)
purchases of new residing housing. The sum of purchases of newly produced capital
goods and the purchases of new residential housing is often referred as fixed investment.
In other words,
Investment = Fixed investment + Inventory investment.
Government purchases (G) includes central, state and local governments purchase
of goods and services and gross investment in highways, bridges and so on.
Net exports (NX) People, firms and governments in India sometimes purchase
foreign produced goods. These purchases are referred as imports (IM). Foreign residents,
firms and governments sometimes purchase U.S. A. produced goods. These purchases
are referred as exports (EX). Net exports are calculated by subtracting imports from
exports. NX= EX-IM.
To calculate GDP by expenditure approach, we can sum all the purchases made
by the four sectors of the economy.
GDP = C + I + G + (EX-IM)
Income approach to calculate GDP for a real world economy

Every dollar of goods produced is equal to a dollar of income, therefore, the
amount of GDP arrived would be same for the value of economys goods and services
on the income side that we reach on the product side. We need to be careful about what
is to be included under the heading of income. There need to be some adjustments Economics for
Managers : 227
Measuring National Income made for doing so.
and Concepts
To be specific, only those particular income flows that originate with production
of goods and services in the current year are included while estimating income. E.g.
NOTES cars produced in the previous financial year. We must exclude from the income anything
for which neither a good nor a service is supplied in exchange (and for which there is
no corresponding production). An example is income received by people from
government as transfer payments (social security benefits, unemployment allowance
etc.). Keeping these specifications in mind, the income approach to calculate GDP
with income approach needs to add certain things and subtract certain things to national
income.
Income earned from rest of the world, income earned by the

rest of the world
Now, we examine two steps involved in computing GDP using the income
approach. We shall begin with calculating national income first. Second, we shall adjust
national income for certain things which would lead us to GDP.
Calculating national income

National income is the sum of five components (i) compensation of employees
(ii) proprietors income (iii) corporate profits (iv) rental income of persons, and (v) net
interest.
Compensation of employees
It consists of wages and salaries paid to employees plus employers contribution
to social security and employee benefit plans plus the monetary value of fringe benefits,
tips and paid vacations. Compensation of employees is the largest component of national
income
Proprietors income
It includes all forms of income earned by self-employed individuals and the owners
of unincorporated business, including unincorporated farmers. Included in farm is an
estimate of the value of the food grown and consumed on farms.
Corporate profits
It includes all the income earned by stockholders of corporation. Some of the
profits are paid to stockholders in the form of dividends; some are kept within firm to
finance investments (undistributed profits or retained earnings) and some are used to
pay corporate profits taxes.
Rental income (of persons)

Rental income is income received by individuals for the use of their non-monetary
assets. It also includes returns to individuals who hold copyrights and patents. Finally,
Economics for
it includes an imputed value to owner occupied houses.
Managers : 228
Net interest Measuring National Income
and Concepts
It is the interest rate income received by Indian households and government
subtracted the interest they paid out
NOTES
Hence, we calculate national income by summing up these variables
National income = Compensation of employees + Proprietors income + Corporate

profit + Rental incomes + Net interest
From national income to GDP: Making some adjustments

After calculating national income to compute GDP, it requires to add certain things
to national income and subtract certain things from national income.
Income earned from rest of the world, income earned by rest of the world
When we calculate national income, we include the income earned by Indian

citizens who work and live in other countries, but we do not include the income earned
by foreigner living in India.
Indirect business taxes

The main items that comprise indirect business taxes are excise taxes, sales taxes,
and property taxes. These taxes are not part of national income because they are not
considered a payment to any resource (land, labour and so on). These taxes are included
in purchases of goods and services (you pay a sales tax when you buy most goods) so
are included when the expenditure approach is used to calculate GDP.
Capital consumption allowance

Some capital goods are used up in the production processes through natural wear
and tear, obsolescence or accidental destruction (break down machinery). The cost to
replace these capital goods is called capital consumption allowance or depreciation.
This is included to national income because we want a measure of all the income
earned in the economy.
Statistical discrepancy in GDP and national income are computed using different
sets of data. Hence, statistical discrepancies or pure computational errors often occur
and must be accounted for in the national income accounts.
GDP = National income Income earned from the rest of the world + Income
earned by the rest of the world + Indirect business taxes + Capital consumption
allowance+ Statistical discrepancy.
Income earned by the rest of the world is the income of non-Indian citizen earned
by producing and selling goods in India.
Economics for
Managers : 229
Measuring National Income
and Concepts 18.3 Method to calculate GDP in India
It is often asked that which method is most appropriate to estimate national income
NOTES
in India. Though national income can be calculated by any of the three methods
mentioned above provides with identical results yet it does not mean that any single
method can be used for estimating it. Ideally, national income should be measured by
three different measures as they provide different perspectives of the economy and can
also therefore check the accuracy of other methods. The choice of particular method
depends upon many factors such as purpose, nature of economic activities, and
occupational distribution of population, economic and social structure and most
important is availability of data.
Check Your Progress Production (value added) method is most suitable for estimating income of primary
1. What do you sector (agriculture, mining, forestry, fishery etc) where cost of inputs can be easily
understand by GDP? determined. On the other hand, income method is more suitable in measuring
What are different contribution of manufacturing sector. Expenditure method is relatively suitable for
methods of calculating estimating income in construction activity but it is rarely used since reliable data relating
GDP? to expenditure method is relatively difficult to find. Henceforth, an amalgam or mixture
2. What do you of production, income and expenditure methods is made use for estimating national
understand by double income in India. Two main reasons for using different methods are (i) lack of data and
counting? How can the (ii) unreliability of data. To conclude, we can say that, production method is to
problem of double appropriate to study productivity of the system, income method to study equitableness
counting be avoided and expenditure method to study economic welfare and economic growth.
while calculating
national income? 18.4 Other national income accounting measures
Besides GDP, there are other national income accounting measures. They are
Gross national product (GNP), net domestic product (NDP), personal income, disposable
income and real GDP.
Gross National Product (GNP)

GNP is an economic measure much like GDP. Gross national product (GNP) is
the total market value of all final goods and services produced annually by citizens of
a country. GDP measures the production of goods and services in the physical area of
the country, no matter by whom the goods and services are produced. GNP measures
the production of goods and services by the citizen of a country, no matter where in the
world they reside.
GNP = GDP + Net income from abroad

For e.g. If a Japanese citizen lives in India and produces cars, the total market
Economics for value of these cars is counted in GDP because the Japanese citizen produced cars in
Managers : 230 India. But the value of cars will not be counted in GNP because Japanese person is not
an Indian citizen. On the other hand, if Indian citizen produces cars in Ethiopia, the Measuring National Income
and Concepts
total market value of these cars is not counted in GDP because the cars are not produced
in India. However, the value of the cars would be counted in GNP because the cars
were produced by an Indian citizen. NOTES
In short, for GDP, geography matters, not citizenship. For GNP, citizenship matters
not geography. There are some exchanges that are not included in GDP. The exchanges
that are omitted from GDP are indicated below:
(i) Certain nonmarket goods and services: If family hires a driver through the
classified section of the newspaper to drive a car, the service is counted in
GDP. If family member perform the same tasks, however their services are
not counted in GDP. Some nonmarket good are included in GDP, for e.g. the
market value of food produced on a farm and consumed by the farm family
is estimated, and this imputed value is part of GDP.
(ii) The underground activities (both legal and illegal) consist of unreported
exchanges that take place outside the normal recorded market channels. Such
activities involve illegal goods (e.g. cocaine), legal goods (gold) and tax
evasion. As there are no written records of such transactions these are not
included in GDP. Similarly, if both the parties do not wish to record the
transaction (avoid taxation) and deal in cash, here also exchange is not
recorded, thus omitted from GDP.
(iii) Sales of used goods (for e.g. car) is not included in the GDP as it was entered
in the year when it was originally produced
(iv) Financial transactions like trading of stocks and bonds is not counted in
GDP because it does not represent production of new assets but simply the
trading of existing assets (the exchange of stocks and bonds for money)
(v) Government transfer payments are not included in GDP because there is no
return in terms of goods and services for such payments.
(vi) Leisure is a good but is not included in GDP as it is difficult to quantify.
Per capita GDP : If we divide a countrys GDP by the population of the country,
we get per capita GDP. For e.g. If a countrys GDP is $2,000 billion and its population
is 100 million, GDP per capita is $20,000.
Net Domestic Product (NDP)

Some of the fixed investment is used to replace the worn out or obsolete capital
goods. It is not used for the production of new goods. Gross domestic investment contains
within capital allowance. To calculate NDP we subtract capital consumption allowance
from GDP
NDP = GDP Capital consumption allowance (depreciation)

Economics for
Managers : 231
Measuring National Income Personal income
and Concepts
Personal income is the amount of income that individuals actually receive. We
subtract major earned-but-not-received items as undistributed corporate profits, social
NOTES insurance taxes, and corporate profits taxes and add transfer payments in national income.
Personal income = National income Undistributed corporate profits Social

insurance taxes Corporate taxes + Transfer payments
Disposable income
It is equal to personal income minus personal taxes.
Disposable income = Personal income Personal taxes
It is also known as spendable income, take-home pay or after-tax income.
Real GDP
The value of the entire output produced annually within country borders, adjusted
for price changes.
In 2009, Indias GDP was $1.36 trillion. In 2011, two years later, GDP was $1.84
trillion. Though we know GDP was higher than 2009, do you know the reason why
GDP was higher in 2011 than in 2009?
To understand this, lets look at GDP in a one-good economy. Suppose 10 units of

this good are produced and each unit is sold for $10, so GDP of economy is $100.
GDP = $10 $10 = $100
Now suppose GDP rises from $100 to $250. What caused it to rise? It could be
because of price increased from $10 to $25. i.e. GDP = $25 10 units = $250
Or
It could be because quantity of output produced increased from $10 units to $25
GDP = $10 25 units = $250
Or
It could be because price increased to $12.50 and quantity increased to 20 units.
GDP = $12.50 20 units = $250
To gauge the health of the economy, economists want to know the reason for an
increase in GDP. If GDP increased simply because price increased, then the economy
is not growing. For an economy to grow, more output must be produced. It is because
an increase in GDP can be due in part to simply an increase in price, a more meaningful
measure is real GDP is GDP adjusted for price changes.
In real world there are more goods than one and more prices than one. Therefore,
Economics for real GDP is calculated:
Managers : 232
Real GDP = (Base year prices Current year quantities) i.e. Measuring National Income
and Concepts
Real GDP is the summation of all current year quantities times their base year
prices.
NOTES
Economists analyse two major macroeconomic topics with the help of real GDP.
(1) Economic Growth: If real GDP in one year is higher than real GDP in the previous
year, economic growth has occurred. The growth rate is equal to positive percentage
in Real GDP. The growth rate is calculated by following formula:
(2) Business Cycles: If real GDP is rising or falling in otherwise the economy is
said to be incurring a business cycle. There are five phases (italicised below) of
business cycle:
(i) At peak of the business cycle, real GDP is temporary high
(ii) During contraction, real GDP is declining
(iii) Low point in real GDP, just before it is going to turn up is called trough.
(iv) During recovery period, real GDP is rising. It begins at the trough and ends
at the peak
(v) The expansion refers to increases in real GDP beyond recovery.
National income at Factor cost

Gross domestic product is calculated at market prices which diverge from the
true cost of production, based on payments to factors of production, due to the presence
of indirect taxes and subsidies. We assume that, the factor cost of one unit of output
(including profit) is Rs. 100. If tax levied is Rs. 10 per unit, on the commodity service,
the tax- inclusive market price will be Rs. 110. If instead of a tax, there was a subsidy
of Rs. 10 per unit, the producer could sell at Rs. 90 and still incur no loss. Thus,
indirect taxes push market price above cost of production and subsidies do the opposite.
In order to calculate the value of aggregate output at factor cost (actual payments to
factors for their productive service which is true measure of their contribution to
national income), indirect taxes are deducted and subsidies are added.
National income at Factor cost = GDP (Indirect taxes Subsidies)
18.5 Statement of National product and Related

Aggregates of India
After discussing various methods to calculate national income and important

macroeconomic variables we conclude by introducing a statement showing Indias
national product and related aggregates for the year 2010-11. Economics for
Managers : 233
Measuring National Income Statement of National product and related aggregates of India (for 2010-11 at
and Concepts
current prices)
S.No Items (Rs. In crores)

NOTES
1 Net national product at factor cost (National income) 63,25,038
2 Add: indirect taxes 8,03,711
3 Less: Subsides 2,86,975
4 Net national product at market prices 68,41,774
5 Less: net factor income earned from abroad (-)78,900
6 Net domestic product at market prices (by subtracting 69,20,674
indirect taxes)
7 Net domestic product at factor cost 64,03,938
8 Less: income from entrepreneurship and property 1,94,620
accruing to govt. administrative departments
9 Less: savings of non-departmental enterprises 1,14,624
10 Income from domestic product accruing to private sector 60,94,694
11 Add: net factor income from abroad (-)78,900
12 Add: national debt interest 3,34,359
13 Add: current transfer from govt. administrative depts. 2,33,763
14 Add: other current transfers from rest of the world (net) 2,42,000
15 Private Income 68,25,916
16 Less: saving of private corporate sector net of retained 3,24,789
earnings of foreign companies
17 Less: corporate tax 2,95,909
18 Personal income 62,05,218
19 Less: direct tax paid by households and miscellaneous 2,55,774
20 Personal disposable income 59,49,444
21 NNP at market prices (item no. 4) 68,41,774
22 Add: other current transfers from rest of the world (net) 2,42,000
23 Net national disposable income 70,83,774
Source: NAS, 2012

Economics for
Managers : 234
In the last section of this chapter we shall briefly highlight the changes taking Measuring National Income
and Concepts
place in growth rate of GDP since 1950-51 till preset times and the target growth rate in
the subsequent plans of government with a mention of structural change in GDP of
India. NOTES
18.6 GDP growth in India
Figure 18.1 below shows how GDP growth rate has behaved in India since 1950-
51. It has fluctuated significantly from year to year. Despite these short-term fluctuations,
certain long term growth trends are noticeable. We can observe the rise and fall of GDP
with the help of rise and fall in the curve. The RBI data has been used to calculate
growth rate of GDP (dividing GDP of the present year with GDP of previous year to
reach the growth rate during the respective year). We observe in the diagram the highs
and lows of the GDP during different time periods in the economy. During the initial
planning years it is observed that, performance of economy was little slow (while
planning strategy), gradually it started growing. The GDP growth during 1951-75 was
about 3.6 per cent followed by 5 per cent during next one and a half decade i.e. 1975-
90. This transition was all the more remarkable in context of the growth slowdown in
practically all the developed (non-oil producing) and developing countries during the
1970s and 1980s due to skyrocketing petroleum prices.
Figure 18.1 - Growth rate of GDP since 1950/51-2010/11
The fact that Indian economy could sustain an average growth of more than 5 per
cent even though the share of petroleum in the import bill went up by nearly six times,
might be viewed as a sign of strengthening of the countrys economic fundamentals
during this period.
With introduction of reforms i.e. beginning of liberalization era in July 1991

(when growth rate of GDP fell down to 1.30 per cent) to overcome the crisis in the
economy, average GDP growth rate rose to 6.1 per cent during 1992-97. In the following Economics for
years there was gradual increase in the GDP that was due to introduction of reforms in Managers : 235
Measuring National Income Indian economy since July 1991 until there was a slump that began in 1997 (for next
and Concepts
few years GDP was low as compared to previous years) and continued almost till 2001.
It was due to some market shocks and devaluations of many Asian competing countries
NOTES in Asia in late 90s and further enhanced by IT bust in 2000 and global recession in
2001. Economy once again picked up in 2002-03 as a result of several reforms and
innovations taking place in manufacturing sector (largely in pharmaceuticals, automobile
sector and telecom); when India became R&D hub and productivity increased. Therefore
during, 2002-2007, industrial growth picked up and GDP growth crossed 8 per cent as
shown in the figure above. This continued till late 2008 when due to slowdown in
global economy GDP growth once again falling down in the world and many Asian
countries including India. Government has been taking certain measures recently
(opening up of various sectors for foreigners, increasing FDI share in retail and
strengthening of financial sector reforms and regulatory bodies) to recover GDP growth.
In coming five year plan; plan wise target for GDP has been increased as shown in the
table 18.1 below.
Table 18.1: Plan wise target and actual growth rate of GDP (in per cent)
Check Your Progress
3. What do you Plan I II III IV V VI VII VIII IX X XI XII
understand by GNP?
Target 2.1 4/5 5.6 5.7 4.4 5.2 5.0 5.6 7.0 8.1 8.3 8.0
Explain the difference
between GDP and Actual 3.6 4.0 2.4 3.3 5.0 5.4 6.0 6.5 5.3 7.7 7.9 -
GNP?
Structural change in GDP growth
4. The government
As a result of these fluctuations and differential rates of growth in GDP, structural
purchases component
changes have take place in Indias GDP over a period of time. In 1950-51, agriculture,
of GDP does not
industry and service sectors accounted for 55 per cent, fifteen percent and 30 per cent
include spending on
respectively. During recent times, there has been structural change and more of GDP is
transfer payments such
now being contributed by service sector. As per 2011 estimates agriculture fell drastically
as social security.
to 17.2 per cent, manufacturing rose to 26.4 per cent and that of services increased
Thinking about the
sharply to 56.4 per cent. In fact industrys share has stagnated over last few decades. As
definition of GDP
far as structure is concerned, it is similar to developed countries such as US with service
explain why transfer
sectors share being the highest but there lies an important difference i.e. transformation
payments are
in production has been associated with similar structural change in labour employed
excluded?
whereas in India; despite of sharp fall in agricultures output share, still approximately
50 per cent people continue to depend on agriculture sector.
18.7 Summary
The major task of macroeconomics is the explanation of what determines the

economys aggregate output of good and services. In this chapter, we covered the
Economics for essentials required for measuring national output. Three different approaches to calculate
Managers : 236
national income (GDP) have been explained viz a viz their limitations. Few related Measuring National Income
and Concepts
measures have also been explaned which are improtant to characterize economy.
18.8 Key Terms NOTES
Gross domestic product is the total market value of all final goods and services produced
annually within a countrys borders. It is the single most important indicator
in macroeconomics and yardstick of an economic performance. Certain
exchanges like non market goods, underground activities, used goods,
financial transactions like trading of stocks and bonds and transfer payments
are not included while calculating GDP.
Expenditure approach, Income approach and Value added approach are three methods
to calculate GDP of the country. All the three methods provide identical
results.
Gross national product is the total market value of all final goods and services produced
annually by citizens of a country (no matter where in the world they reside).
Net domestic product is calculated by subtracting depreciation from GDP.
Personal income is the amount of income that individual receives.
Disposable income is what people have actually left with after all tax payments,
corporate saving of undistributed profits, and transfer adjustments have been
made to spend on consumption or to save.
Real GDP is value of all the goods and services produced in the country, adjusted for
price changes. By using a price index, we can deflate nominal GDP to
arrive at a more accurate measure of real GDP
Net income at factor cost is obtained by deducting indirect taxes (and adding subsidies)
from gross domestic product.

1. If you hear on the news that GDP is higher this year than it was during previous
year. Does this mean that we are better off this year? Comment.
2. What is the difference between GDP and GNP?
3. Why does GDP omit sales of used goods of financial transactions?
4. Explain the various methods to measure GDP? Which method is more suitable to
measure GDP in Indian conditions?
5. Economists prefer to compare Real GDP figures for different years instead of
comparing GDP figures. Why?
Economics for
6. Using the following data, calculate: (a) gross domestic product (GDP); (b) net
Managers : 237
Measuring National Income domestic product (NDP); (c) National income (NI); (d) Personal income (PI). All
and Concepts
the numbers are in billions of dollars
Particular Amount (in $) Particular Amount (in $)

NOTES Consumption 1149 Corporate profit taxes 70
Investment 400 Personal taxes 340
Government purchases 425 Dividends 10
Net exports 89 Compensation of employees 800
Capital consumption allowance 300 Income earned from rest of the world 60
Indirect business taxes 215 Income earned by rest of the world 55
Statistical discrepancy 5 Proprietors income 400
Social security insurance taxes 220 Rental income 150
Transfer payments 400 Net interest 25
Undistributed profits 100
7. Write a note on changing trends of GDP in India since independence. Has there
been some change in terms of structure of GDP?
8. State the relevance of calculating national income. What influence does national
income has on business decisions and policymakers?

1. Macroeconomics : Rudiger Dornbusch, Stanley Fischer Richard Startz; Tatr
Mc Graw Hill (9th Edition) 2004.
2. Macroeconomic Analysis : Edward Shapiro, Galgotia Publications (P) Ltd.,
(5th Editon), 2005.
3. Macroeconomic : Theory and Policy, D. N. Dwivedi (8th Reprint), 2013.
Economics for
Managers : 238
Consumption, Investment and
UNIT 19 CONSUMPTION, INVESTMENT Savings
AND SAVINGS
NOTES
Structure
19.0 Introduction
19.2 Consumption and Saving:
19.3 Determinants of Consumption:
19.4 Investment:
19.5 Shifts in the Investment Demand Curve
19.6 Saving and Investment pattern in India:
19.7 Summary
19.8 Key Terms
19.0 Introduction
Consumption and investment are the major components of national output. All
the nations thrive for higher levels of consumption items such as housing, food,
education and recreation. At the same time, saving and investment that part of output
which is not consumed also plays a critical role in nations economic performance.
Economies that save and invest large part of the income tend to have rapid growth of
output, income and wages; this pattern characterized the United States in nineteenth
century, Japan in twentieth century, and miracle economies of East Asia, in recent
times. (In contrast, nations that consume large part of their incomes, like poor countries
in Africa and some of Latin American countries.) They have low educational standards,
relatively backward techniques, low level of investment and slow growth.
In section 19.2 of this unit we define consumption and saving functions; followed
by deriving relationship between them. After explaining both concepts in detail we
move to next section 19.3 we discuss the determinants of consumption and share a
table depicting consumption pattern in India. In the following section 19.4 on investment,
we try to understand determinants of investment in section and derive investment demand
curve with the help of a table depicting relationship between interest rate and the
investment level expected at the given level in the economy. Shift along the investment
demand curve is explained in section 19.5. We conclude the chapter after discussing
saving and investment patterns in India since beginning of 1950s in section 19.6. Economics for
Managers : 239
Savings 19.1 Unit Objectives

NOTES
* To understand what drives consumption and the dynamics of link between
consumption, income, saving and investment functions.
* To learn about the determinants of consumption, investment and changes
happening in investment demand curve due to change in rate of interest.
19.2 Consumption and Saving:
In this section we shall explain consumption and saving behaviour; beginning

with individual spending patterns and then looking at aggregate consumption behaviour.
Consumption is expenditure of households on final goods and services and Savings

is that part of disposable income that is not consumed. Consumption is largest single
component of GDP, constituting two third of total spending over last decade. The basic
needs including housing, food, clothing, transportation, consumer durables and various
goods and services constitute major components of consumption. They can be
categorized into three main parts i.e. durable goods, non-durable goods and services.
All the individuals/families consume large part of income and spending pattern differs
across different households. Yet, overall statistics show that there is a predictable
regularity in the ways people allocate their expenditures among food, clothing and
other major items. Poor families spend their incomes largely on the necessities of life;
food and shelter. As the income increases, expenditure on many food items goes up.
People eat more and better and consequently spending on food items decreases relatively
as income rises. Similar pattern is followed in other needs and goods and services
consumed by an individual.
Relationship between consumption, income and saving

Income, consumption and saving are closely related. Money left with an individual
after deducting income tax from the income is referred as personal disposable income.
Part of this income is consumed for various needs and services. Personal saving is that
part of income which is not consumed. Savings are useful during unforeseen
contingencies to an individual and also used as investment. An individual does spend
on basic needs even when there is no income.
Y = C + S
As the income increases, smaller proportion of the income will be consumed and
more amount of increase shall be saved. This is so because, once the minimum conditions
for living or basic needs of the consumer are satisfied, he shall spend less and save
Economics for more after that. The ration of saving to income shall be greater with the increases in the
Managers : 240 income.
Consumption function Consumption, Investment and
Savings
As per the psychological law of consumption, absolute level of consumption varies
directly with increase in the level of income and the fraction of income consumed
varies inversely with the level of income. The relationship between consumption and NOTES
income that emerges from these particular assumptions is referred to as consumption
function.
It will vary in a specific manner. Keynes stated this in his fundamental

psychological law of consumption The law states that; men are disposed, as a rule
and on the average, to increase their consumption as their income increases, but not as
much by as the increase in the income . Keynes made three basic points about
consumption and disposable income: (1) Consumption depends on disposable income
(2) Consumption and disposable income move in the same direction (3) when disposable
income changes, consumption changes but less than the change in income. These three
points make a specific statement about the relationship between consumption and
disposable income. The statement specifying this relationship is called consumption
function. It can be written as:
C = C0 + (MPC) (Yd)
Where we know that C is consumption, Yd is disposable income and we shall

look at MPC and C0.
MPC stands for marginal propensity to consume, which is the ratio of change in
consumption to the change in disposable income.
Marginal propensity to consume = Change in consumption/Change in disposable

income
C
MPC = -----------
Yd,
Here, stands for change in. Thus, MPC is equal to the change in consumption
divided by the change in disposable income. We shall illustrate this by assuming that
consumption rises from $800 to $900 as disposable income rises from $1,000 to $1,200.
If we divide the change in consumption, which is $100, by change in disposable income,
which is $200, we see that the MPC = 0.50
C0 is autonomous consumption. Autonomous consumption does not change as

disposable income changes; it changes due to factors other than disposable income.
Consumption is being made up of two parts. One, which is independent of disposable
income and second which depends on disposable income, is called induced consumption
i.e.
Consumption =
Autonomous consumption + (Marginal propensity to consume) (Disposable

income) Economics for
Managers : 241
Consumption, Investment and C = C0 + (MPC) (Yd)
Savings
Suppose, C0 = $800, MPC =0 .80 and Yd = $1,500. In this case, values can be
substituted in the equation above i.e. C = 800 + (0.80) ($1,500) Thus C = $800 +
NOTES $1,200 = $2,000. Therefore, Consumption C will increase when there is increase in
autonomous consumption, MPC or disposable income.
In the table 19.1 below, we set C0 equal to $200 and MPC = 0.80, thus C = $200
+ (0.80) (Yd).. In column 3, consumption is calculated at different levels for different
levels of disposable income in column 1.
Saving and Consumption

In table below, we have also calculated the saving levels (column 5) at the different
disposable income levels. This is calculated by deducting consumption from disposable
income.
Saving = Disposable income consumption
S= Yd- (C0+ (MPC) (Yd))
Table 19.1: Relationship between consumption, income and saving
1 2 3 4 5 6
Disposable Change in Consumption Change in SavingS= Change in
income Yd disposable C=C0+(MPC) consumption Yd-(C0+(MPC) saving
income Yd (Yd) C (Yd) S=Yd- C
$800 $ - $840 $ - -$40 $-
1,000 200 1,000 160 0 40
1,200 200 1,160 160 40 40
1,400 200 1,320 160 80 40
1,600 200 1,480 160 120 40
1,800 200 1,640 160 160 40
The MPC and MPS
In the table above, we have set MPC = 0.80. This means that for every $ change
in disposable income, there is a $0.80 change in consumption. For e.g. at disposable
income of $1,200 billion, consumption is $1,160 billion; but at disposable income of
$1,400 billion, consumption is $1,320. This is a difference of $160 billion or $0.80
additional consumption for every $1 of extra disposable income.
The marginal propensity to save is the ration of the change in saving to the change
Economics for in disposable income.
Managers : 242
Marginal propensity to save + Change in saving/Change in disposable income Consumption, Investment and
Savings
MPS = S/Yd
We know that disposable income can be used only for consumption or saving i.e.
NOTES
Yd = C + S. Therefore, any change to disposable income can only change consumption
or saving. Thus Yd = C + S. It follows that
MPC + MPS = C/Yd + S/Yd = C + S/Yd = C + S/C +S = 1
Thus, marginal propensity to consume plus marginal propensity to save must be

equal to 1
In the table above, we set marginal propensity to consume at 0.80, so it follows

that marginal propensity to save is 0.20; or for every $1 change in disposable income,
saving changes by 0.20; or for every $200 change in disposable income in column 2,
there is a $40 change in saving in column 6.
The APC and APS
Another measure relating consumption and disposable income is the average

propensity to consume (APC). It is defined as proportions of disposable income spend
on consumption.
Average propensity to consume = Consumption/Disposable income i.e. APC = C/Yd
In the table above, at an income level of $1,400, APC = $1,320/$1,400 = 0.94. At

an income level of $1,800, APC = $1,640/$1,800 = 0.91
A similar concept, the average propensity to save (APS), is the proportion of

disposable income saved.
Average propensity to save + Saving/Disposable income i.e. APS = S/Yd
Once again, because saving and consumption are only ways of households can
dispose income, it follows that
Average propensity to consume + Average propensity to save = 1
i.e. APC + APS + 1
It is important to differentiate between marginal and average magnitudes.

Although they may sound alike, the MPC and the APC, and MPS and APS are not the
same. The average magnitudes i.e. APC and APS refer to the fractions of disposable
income that are consumed and saved, respectively. On the individual basis, if a person
has disposable income of $1,000 and her consumption is $6,000 and her saving is
$400, then her APC = 0.60 and her APS = 0.40. The marginal magnitudes, MPC and
MPS, refer to the fractions of any change in disposable income that are consumed and
saved, respectively. For an individual basis, suppose when persons disposable rises by
$100, her consumption rises by $70 and her saving rises by $30. Then her MPC = 0.70
and her MPS = 0.30. Economics for
Managers : 243
Consumption, Investment and National consumer behaviour
Savings
In this section, we shall consider consumption for entire nation instead of individual
consumption. This transition exemplifies the methodology of macroeconomics:
NOTES economic activity individual level is examined and then adds up or aggregates the
totality of individual studies to understand the way overall economy operates.
Check Your Progress
It is important to estimate national consumption trends as it helps us to understand
1. What do you
both short-term and long-term business cycles and long-term economic growth. In
understand by
short-run, consumption is major component of aggregate spending. With sharp change
Consumption? What is
in consumption, there is likely affect to output and employment through its impact on
the relationship
aggregate demand. Additionally, consumption behaviour is crucial because savings
between consumption,
are available for investments in capital goods and capital serves as a driving force
income and saving?
behind long term economic growth. Consumption and saving behaviour are important
2. Along the
to understanding economic growth and business cycle. Before moving to consumption
consumption function,
pattern of India we shall briefly discuss determinants of consumption below:
income changes more
than consumption.
What does it imply for 19.3 Determinants of Consumption
MPC and MPS?
The major factors that affect the consumption at national level are following:
Disposable income: The consumption levels are higher when economic growth
takes place and also when income is not taxed heavily resulting in higher disposable
income available with people. When disposable income declines in recession,
consumption usually follows decline.
Permanent income and the life cycle model of consumption: In simple model of
theory of consumption, we take into account only current years income. Some other
factors are also important:
In practical world, it is often seen that consumers generally choose their

consumption levels considering both current as well as long-run income prospects.
With an objective to understand how consumption depends on long-term income trends,
economists have developed the permanent-income theory and the life-cycle hypothesis:
Permanent-income is the trend level of income i.e. income after removing

temporary or transit influences due to windfall gains or losses. According to the
permanent-income hypothesis theory, consumption primarily depends on permanent
income. It implies that consumer do not respond equally to all income shocks. If a
change in income appears permanent, people are likely to consume a large fraction of
increase in income. At the same time, if income change is transitory, a significant part
of additional income will be saved.
Life cycle hypothesis People save as they wish to smooth their consumption over
Economics for their lifetime and have an objective to have an adequate retirement income. Therefore,
Managers : 244 people tend to work hard during young years of their career and save more for later part
of the life. Countries where programs like social security systems are in place, and are Consumption, Investment and
Savings
providing income for retirement; consumers have incentive to spend more during their
middle ages as they do not have to worry about savings for retirement.
Wealth and Other influences: Another important determinant of consumption is NOTES

wealth. The money available with the consumer in bank as deposits/savings does have
an effect on the consumption pattern. It usually changes gradually over a period of
time. When there is increase or decrease in the wealth, this leads to changes in
consumption spending. Over last decade in US, the rise and decline in the housing
prices have had affect on consumption. Initially, during 2000-2006, total value of
household real estate was rising, so consumption levels were rising. By early 2009,
average price of residential houses had declined by 30 per cent from peak in 2006. The
wealth effect from declining housing values was a drag on consumer spending during
this period. Similar changes were observed in India too during this period.
Consumption pattern in India

Consumption and saving behaviour have changed remarkably in India since 1950s.
Aggregate private final consumption share in aggregate GDP has declined significantly.
Still, household consumption constiutes the single largest component of GDP (55 per
cent in 2008). Table 19.2 shows the major elements of consumption expenditure in
India in 2008-09. the important components of expenditure are food, tobacco, beverage,
transport and communication and rent, fuel and power.
Table 19.2 - Major components of consumption in India, 2008-09
Classified by obect Rs. crores Percent of total
Food, tobacco, beverages 1182211 36.64
Clothing and footwear 213344 6.61
Gross rent, fuel, power 415436 12.87
Furniture, furnishing, appliance, and services 121984 3.78
Medical care and health services 140584 4.35
Transport and communication 608048 18.84
Recreation, education, and cultural services 110954 3.43
Miscellaneous 434265 13.46
3226826 100
Source: Indian Statistics, available at http://mospi.nic.in
The table above provides aggregate picture. Due to high income inequality and
Economics for
absolute poverty, the pattern of consumption expenditure varies a lot between different
Managers : 245
Consumption, Investment and classes of people in India. Still, there is large population of India that is not able to
Savings
afford bare necessities of life.
NOTES 19.4 Investment
After consumption, investment is second most important component of private

spending. Investment plays two critical roles in macroeconomics: (i) in short run
investment leads to change in aggregate demand and affects the business cycle (ii) in
long run it leads to capital accumulation. With addition to the stock of buildings and
equipment increases the nations potential output and promotes economic growth in
the long run.
Determinants of Investment
Investment is one component of total investment, which also includes foreign
investment, government investment, and intangible investment in human capital and
improved knowledge. In this section, we shall focus only upon private domestic
investment or ( I) but the principles apply to other sectors as well. The major types of
gross private investment are building of residential structures; investment in business
fixed equipment, software and structures; and additions to inventory.
Investment (to buy capital goods or investment into machinery for manufacturing
purposes) is done with an expectation to earn revenues on the cost incurred. Three
elements mentioned in this statement are essential to understand investment; revenues,
costs and expectations.
Revenues: Investment in plant and machinery helps the firm to bring in additional
revenue when the output produced is sold in the market. It suggests that overall output
(GDP) is an important determinant of investment. If new factories are not being set up
or the present ones are lying idle it conveys that investment is low. Investments therefore,
in general will depend upon the revenues that will be generated by state of overall
economic activity. It is very sensitive to business cycle.
Costs: Cost incurred in purchasing of capital goods is another important

determinant of investment. Investment done in goods last for many years, therefore
calculating the cost of investment is little complex than doing so for other commodities
that we buy for our daily use. For durable or capital goods, the cost of capital not only
the prices of the good but also the interest rate that borrowers pay to finance the capital
as well as the taxes that firm pays on their income. In case of a family buying a house,
the interest rate is the mortgage interest rate. In case of firms, government levies
corporate income tax. Sometimes government does give tax breaks to particular sectors
or may deduct mortgage interest from their taxable income. For e.g. some tax benefits
are given to the families that have invested in purchasing house and taken home loans
from the bank
Economics for
Managers : 246 Expectations: Investment requires to weight present costs with unseen future profits
by businessperson. Thus, expectations from the economy and business confidence Consumption, Investment and
Savings
through forecasts in the market are important to take investment decision. Recently, in
India it has been often heard that due to policy paralysis not many investments are
taking place in infrastructure. As the period of returns on investments in this sector is NOTES
long and there are uncertainties in the market, people are little reluctant to invest in the
sector. People do not expect gains in near future so that are cautious to invest in this
sector. Similarly, if expectations are higher in certain sector, huge investments are done
in that sector.
Investment Demand Curve: It shows the relationship between interest rate and
investment level i.e. at the given level of interest rate prevailing in the economy, certain
level of investment will be expected in general. If rate of interest is high, level of
investment shall be low as expected revenue over the costs incurred would be low in
this case. Similarly, if rate of interest is lower, cost of borrowing would be economical,
businessman would be keen to invest more as revenues earned would be more than the
cost of borrowing money; thus resulting into profits. We consider an example of a
simple economy where firms are investing in different projects shown in the table 19.3
below:
Table 19.3: Different projects in which firms are investing
1 2 3 4 5 6 = 3- 4 7= 3- 5
Project Total I in Annual revenues Cost per $1,000 Annual profit per
project per $1,000 borrowed at annual $1,000 borrowed at
(in million invested interest rate annual interest rate
$) ($) ($) ($)
10% 5% 10% 5%
A 1 1,500 100 50 1,400 1,450
B 4 220 100 50 120 170
C 10 160 100 50 60 110
D 10 130 100 50 30 80
E 5 110 100 50 10 60
F 15 90 100 50 -10 40
G 10 60 100 50 -40 10
H 20 40 100 50 -60 -10
In the table above, consider project A. This project cost $ 1 million. It has very
high return - $1500 per year of revenues per $1000 invested (this is a rate of return of Economics for
150 per cent per year). Column (4) and (5) show cost of investment. We assume that, Managers : 247
Consumption, Investment and investment is financed purely by borrowing at the market interest rate, here taken
Savings
alternately as 10 per cent per year in column (4) and 5 per cent in column (5). Thus at
10 per cent annual interest rate, the cost of borrowing $1000 is $100 a year. As shown
NOTES in all entries in column (4); at a 5 per cent interest rate, the borrowing cost is $50 per
$1000 borrow per year.
Finally, last two columns show the annual net profit from each investment. For
lucrative project A, the net annual profit is $1400 a year per $1000 invested at a 10
percent interest rate. Project H loses money.
Therefore, in choosing amongst investment projects, firms compare the annual

revenues form an investment with the annual cost of capital, which depends upon the
interest rate. The difference between annual revenue and annual cost is the annual net
profit. When annual net profit is positive, the investment makes money, while a negative
net profit denotes that the investment loses money. While examining last column, annual
net profit at 5 per cent interest rate we find that it is at this interest rate, investment
projects A through G would be profitable. We would therefore, expect profit maximizing
firms to invest in all seven projects, which (from column 2) total up to $55 million in
investment. Thus at 5 per cent interest rate, investment demand would be $ 55 million.
However, suppose interest rate rises to 10 per cent. Then the cost of financing
these investments would double. We therefore, see from column (6) that investment
projects F and G and it become unprofitable at an interest rate of 10 percent; investment
demand would fall to $30 million. These results are shown in the figure 19.1 below.
/ )LJ
'
Check Your Progress 5HWXUQRQ

% 'HPDQGIRU,QYHVWPHQW6FKHGXOH
3. What are different ,QYHVWPHQW
factors that affect
consumption at ,QWHUHVW5DWH
national level? Explain
in Detail.
4. What is investment?
0
What are different
determinants of 0
investment? Explain in 2
detail.
,
,QYHVWPHQW6SHQGLQJ
Economics for These figures show demand-for-investment schedule, which is here a downward
Managers : 248 sloping step function of the interest rate. This schedule shows the investments that
would be profitable at each level of the interest rate. In case, market rate of interest is 5 Consumption, Investment and
Savings
per cent, the desired level of investment will occur at a point M, which shows investment
of $55 million. AT this interest rate, projects A through G are undertaken.
If interest rates were to rise at 10 per cent, projects F and G would be squeezed out; in NOTES
this situation, investment demand would lie at point M with total investment of $30
million.
19.5 Shifts in the Investment Demand Curve
It has been shown on the previous page that interest rate affects the level of
investment. Investment is affected by other forces as well. For e.g. an increase in the
GDP will shift the investment demand curve out, as shown in the figure below.
An increase in business taxation would depress investment. Suppose, government

introduces taxes and half of the net yield (column 3 of the table on previous page) is
taken away; with interest costs in column (4) and (5) not being deductible. The net
profits in column (6) and (7) would therefore decline. Higher taxes on capital income
would result in left shift for investment demand curve. In case of business expectations
being positive, investment demand curve will shift to right or outwards as shown in the
figure 19.2 a and 19.2 b.
)LJ
$ %
< <
5HWXUQRQ 5HWXUQRQ
5HWXUQRQ
,QYHVWPHQW ,QYHVWPHQW
,QYHVWPHQW
,QWHUHVW ,QWHUHVW
,QWHUHVW
5DWH 5DWH
5DWH
2 , 2 ,
,QYHVWPHQW6SHQGLQJ ,QYHVWPHQW6SHQGLQJ
,QYHVWPHQW6SHQGLQJ
Investment component is the most volatile component of spending. Many a times

it behaves unpredictably because it depends on uncertain factors such as the success or
failure of new and untried products, changes in tax rates, interest rates, political situation
and state of economy.
Economics for
Managers : 249
Savings 19.6 Saving and Investment pattern in India
In the early 1950s, both the gross savings and gross fixed investment (termed as
NOTES
gross fixed capital information (GFCF) in Indias National Account Statistics) rates
were less than 10 per cent of GDP. By 2007-08, the former had exceeded 35 per cent
and the latter had reached a level of about 35 per cent. This has been one of the most
dramatic changes in the contemporary India. India now has one of the highest saving
and investment rates in the world. In the past few years (since 2008-09), due to slowdown
in the economy and high inflation savings have been decreasing and so has been the
case with investment also. The fall is clearly visible in the figure 19.3 below.
Figure 19.3: Growth rate of Savings and Investment in India since 1950-51
Check Your Progress

3. What are different
factors that cause shift
in the investment
demand curve? Explain So far the savings are concerned; the main source has been household sector.
through diagram. Despite this drop in recent years, it still contributes to about two-thirds of aggregate
4. Write a short note on savings. In the former years, the share of public sector and the private sector was fairly
Indias saving and stable but since 1980s, public sector share has declined sharply and share of private
investment pattern over corporate sector has increased.
the last decade.

19.7 Summary
In this chapter we developed an understanding of the relationship between the

basic concepts of consumption, saving investment and how do they work through the
mechanics of the average and marginal propensities to consume and save. chapter is
conclude with explanation of what determines the total consumption, savings and
investment and depicts the relationship between rate of interest and investment through
investment demand curve.
19.8 Key Terms

Economics for
Managers : 250 Consumption (or saving) function relates the level of consumption (or saving) to the
level of disposable income. Consumption, Investment and
Savings
Marginal propensity to consume (MPC) is the amount of extra consumption generated
by an extra dollar of disposable income.
NOTES
Marginal propensity to save (MPS) is the extra saving generated by an extra
consumption generated by an extra dollar of income.
MPC + MPS = 1
Average propensity to consume (APC) is defined as proportion of disposable income

spent on consumption.
Average propensity to save (APC) is defined as proportion of disposable income

saved.
APC + APS =1
National consumption function is the sum together of individual consumption

functions. In simplest form, it shows total consumption expenditures as a
function of disposable income. Other variables, such as permanent income
or long term income trends as well as wealth, also have a significant effect
on consumption patterns. Household consumption is the largest component
of GDP (55 60 per cent).
Personal saving rate has declined in last few years in India (2008-09). Economic
slowdown across the world coupled with inflation in India is major cause
of this decline. Declining saving does hurt the economy because personal
savings is a major component of national saving and investment.
Investment is second most important component of private spending. In short-run it

leads to change in aggregate demand and affects business cycle and in
long-run it leads to capital accumulation.
Investment demand curve shows the relationship between rate of interest and
investment level i.e. at the given level of interest rate prevailing in the
economy, certain level of investment is expected. Higher business taxes
would result in leftward shift for investment demand curve and positive
business expectations would shift the curve upwards right.
Gross fixed investment in India had reached little more than 35 per cent in India from
10 per cent in 1950s before declining a little since 2008-09 since the global
slowdown.

1. State a consumption function. Derive the relationship between MPC and MPS.
2. How is autonomous investment different from consumption? Explain determinants Economics for
Managers : 251
Consumption, Investment and of consumption.
Savings
3. Given Keynesian consumption function, how would a cut in income tax rates
affect consumption? Explain.
NOTES 4. State a saving function. What has been the saving pattern followed by household
sector in India since independence (Hint: visit http://www.rbi.org.in for the table
on saving and investment (i.e. gross domestic capital formation)
5. In a simple Keynesian model, suppose the MPC = 0.75 and the APC = 0.90. If real
national income is $ 4,000 billion, what does consumption equal to?
6. Suppose the MPC = 0.80 and that is the same at all real GDP levels. Suppose,
autonomous consumption decreases by $500. How much does real GDP change?
7. What are the determinants of Investment? Derive investment demand schedule
and show it diagrammatically.
8. Along the consumption function, income changes more than consumption. What
does this imply for the MPC and MPS?
9. What would be the effects of the following on the investment demand function
illustrated in table 19.3 in this unit?
a. A doubling of the annual revenues per $1000 invested shown in column
(3)
b. A rise in interest rate to 15 per cent per year
c. A 20 per cent tax on net profits shown in column (6) and (7)

(5th Editon), 2005.
Economics for
Managers : 252
Monetary Policy
UNIT 20 MONETARY POLICY
Structure NOTES
20.0 Introduction
20.2 Monetary Policy
20.3 Instruments/Tools of Monetary Policy
20.4 Defining IS and LM curves
20.5 Explaining Monetary policy with IS and LM curves
20.6 Limitation of IS-LM model
20.7 Monetarist school of thought
20.8 Keynesian v/s Monetarism (New classical economists)
20.9 Changing Paradigm of Monetary policy
20.10 Summary
20.11 Key Terms
20.0 Introduction
Economists have different theories about how an economy works. Economists do

agree that the goals of monetary policy are to stabilize the price level, achieve low
unemployment, and promote economic growth, among other things. Monetary policy
does help to eliminate both inflationary and recessionary gaps. Generally, they agree
that monetary policy affects to stabilize economy, however they disagree to which
extent and under which conditions it does so. To a large extent, is management of
expectations; it rests on the relationship between rates of interest in the economy i.e.
the price at which money can be borrowed and its money supply.
In section 20.2 we begin with defining monetary policy and stating goals of the
policy. In the following section 20.3 we move to explain these tools (instruments) after
stating the goals (ultimate and intermediate) of monetary policy. We then define IS and
LM curves in section 20.4. In next section 20.5, we make use of IS-LM framework to
explain the working of monetary policy. With the help of IS-LM framework transmission
mechanism in Keynesian perspective explain the limitations of this framework in section
20.6. This is followed by understanding the monetarism school of thought provided by
new classical economists in section 20.7 as they see a close and stable linkage between
money supply and change in money income level. Keynesian and Monetarist approaches Economics for
are compared in section 20.8. In concluding section 20.9 of this unit, we mention the Managers : 253
Monetary Policy changing perspective of monetary policy in recent times with an example of Taylors
rule being generally referred by central banks.
NOTES 20.1 Unit Objectives

* To introduce the goals of monetary policy and instruments utilized by
government to realize these goals.
* To understand how does monetary policy work? Specifically, what is the
transmission process by which a change in money supply causes change in
the level of money income?
* To understand the transmission process with the help of keynesian and
Monetarist school of thought (IS and LM curves).
20.2 Monetary Policy
In simple words, monetary policy is the process by which monetary authority

(RBI in case of India), generally central bank controls the money supply in the economy
by exercising its control over interest rates in order to maintain price stability and
achieve high economic growth.
Goals of Monetary Policy

Apart from general maintaining right price level, main targets of monetary policy
to attain following goals, as stated by RBI are:
1. Price stability: Inflation has strong and negative impact on the poor and to
lower middle class people. In particular, poor are hit hard with higher prices
of all the utilities, food and other requirements. Therefore, it is not surprising
that all the central banks adopt price stability as a major goal of economic
policy. Growth in output with price stability is ideal towards which a society
can be steered with the help of efficient economic policy of which monetary
management forms a very important part. Monetary policy thus helps to
maintain low levels of inflation by controlling expansion of credit when
required by increasing the interest rates on borrowings and maintaining higher
credit reserve ration with the banks.
2. High and stable employment: Unemployment means loss of potential output
in the economy and does cause suffering among the youth. It is therefore an
important goal to maintain unemployment at tolerably low levels.
3. Economic growth: Steady rise in the national income over time is very
essential for improving the standard of living of a country. When income
Economics for and output are rising, firms are stimulated to undertake new investments in
Managers : 254 plant, equipment, hiring humans resources and this keep the economy on its
path of growth. Since productive activities cannot be undertaken or sustained Monetary Policy
without availability of adequate financial resources, sound management of
monetary and credit policy is a key for supporting the process of growth in
the economy. NOTES
4. Financial stability: A strong and stable financial system contributes to growth
by smoothly channelling funds from savers to business firms with profitable
investment opportunities. Financial crisis or shocks causes sharp setbacks in
the economic activity and lowers output, thus welfare of the society. Stable
financial system that can avert crisis by absorbing shocks is therefore an
important goal of central bank. Since Indian economy opened up in July
1991, number of financial reforms have taken place in Indian financial sector
that includes banks, insurance, stock exchange and these have been
accompanied by changes required in regulations by SEBI. The financial panic
of 1907 was a prominent factor behind creation of the Federal Reserve System
of the USA.
5. Stability in foreign exchange market: With the opening up of Indian economy,
importance of trade and investment has increased several fold in the national
economies, therefore exchange rate (the value of national currency in terms
of dollars) has become crucial macroeconomic variable. A rise in value of
rupee against dollar or euro (appreciation) makes Indian exports less
competitive abroad whereas decline (depreciation) tends to raise the
inflationary pressures. Fluctuating exchange rate makes planning difficult
for traders. Therefore, in post-reforms period, preventing sharp fluctuations
in the value of rupee so as to maintain orderly conditions in the foreign
exchange market is rightly counted as major goal of RBI.
The goals mentioned above are consistent with each other growth and higher
employment, low inflation and financial stability this need not always be the case.
Control of inflation for example, may call for restrictions on aggregate demand and
this may cause unemployment to rise. Conflicting goals confront monetary authorities
with difficult choices which have to be handled carefully with proper balancing of
trade-offs involved. This is what makes central banks role critical in maintaining a well
balanced economy.
Ultimate versus Intermediate Targets

The ultimate target of monetary authority is to control the major macro variable
such as unemployment, inflation and growth or real GDP. However, due to imperfect
monitoring under imperfect information and about the operation of the economy, it is
not possible for RBI to act on the ultimate goals directly. Therefore, it chooses to
control intermediate targets which are not important in their own right, but are helpful
in influencing the ultimate goals in a predictable manner. Important intermediate targets
Economics for
are the monetary aggregates (M1, M2 & M3) or the interest rate. By regulating money
Managers : 255
Monetary Policy supply in an effective manner, the rate of inflation and changes in the structure of
interest rate affects growth by altering the incentives for investment in physical capital
and other financial assets (liquidity preference).
NOTES Intermediate targeting on a monetary aggregate by the RBI typically proceeds as
follows. In the beginning of each quarter, the Bank determines the money growth rate
that it deems consistent with ultimate goals of price stability and growth. The decision
Check Your Progress made in light of the data on past performance and forecasts about the next quarter or
1. What do you understand year made by its team of analysts. Policy actions during the quarter are chosen to hit
by monetary policy? this chosen target. At the beginning of next quarter, the money supply is reviewed and
Explain its importance adjusted on the basis of the experience within the quarter. In 1998, RBI formally
in the economy. switched from exclusive money supply targeting to a broad-based list of policy
2. How does the reserve indicators. Nevertheless, monetary aggregates such as M3 continue to be an important
bank of any country indicator of its policy stance. This is chiefly because M3 remains a reasonably accurate
maintain stability of the predictor of headline inflation (measured by WPI).
financial system?
20.3 Instruments/Tools of Monetary Policy
RBI takes into account various market operations (tools of monetary policy) which
include cash reserve ratio (CRR), open market operations (OMO), statutory liquidity
ratio (SLR), bank rate, repo rate and reverse repo rate and moral suasion to realize the
objectives of monetary policy mentioned above. The working of these important
instruments is mentioned in following points:
Variation in CRR: As RBI raises CRR, the funds available with the commercial
banks for loan purpose get reduced at one stroke and total money supply available in
the economy contracts. To meet higher reserve ratios, banks have to recall loans. On
the other hand, if CRR is reduced, banks can loan higher amount of money is available
for loans and more investments take place in the economy which result in increased
output and multiplier effect on the growth of economy. This enhances the ability of
banks to create deposit money. This is often referred as drastic measure of changing
multiplier, therefore is not used frequently; because this would destabilize economy.
In last decade and a half, central banks all over the world (Switzerland, New
Zealand, Australia have eliminated it completely) have been reducing the reserve ratio
requirements of their commercial banks. In India, CRR has been gradually reduced
from 15 per cent in 1992 to around 5 per cent in the recent years. In second quarter of
2012, RBI (central bank of India) had enormous pressure from industry and finance
ministry to bring down cash reserve ratio (CRR). In line with market expectations,
bank did not do so; because inflation was high and more money supply may have
adverse affect on price level. The rates were cut a little in third quarter as government
Economics for had introduced some reforms and RBI acknowledged the fact that demand side activity
Managers : 256 has been low so reforms should be complemented by rate cuts in the policy
Variation in Bank rate: Commercial banks can approach RBI for loans to add Monetary Policy
their reserves. The bank rate is the interest charged by the bank for such loans. If bank
rate is low, the banks are encouraged to borrow reserves against which they can advance
loans. This facilitates credit creation. An upward revision in the rate discourages NOTES
borrowing and exerts a contractionary effect on money stock. A rise in bank rate is
usually followed by a rise in the rates the banks charge on their loans. This diminishes
the demand for credit by firms and households.
Open Market Operations: RBIs open market operations consists of purchase and
sale of bonds (mostly government bonds) in the open market. An open market sale
contracts money supply and purchase enhances it. OMOs are usually classified into
two broad categories;
(i) dynamic: deliberately planned to change the level of bank reserves and the
monetary base and
(ii) defensive: intended to offset undesirable changes in reserves brought about
by exogenous factors
If RBI buys bonds worth Rs. 10,000 from Mr A by writing a cheque on itself, the
banks reserves go up when A deposits this in the bank account. This will lead to rise in Check Your Progress
the aggregate money stock through the multiplier process outlined above. Similarly, 3. What is CRR? How is
sales of the bond will have opposite effect. Instead of governments bonds and securities, it helpful in controlling
OMO may involve buying and selling of foreign exchange. Therefore, the ability of money supply in the
economy?
RBI to reduce money reserves by selling bonds or foreign exchange is limited by its
stock of such assets. The main advantage of OMO over other instruments is of control
between Repo Rate and
available to central bank is that they are flexible, precise and can be implemented
reverse Repo rate.
quickly. They are easily reversed. If a mistake is made and detected, correction policy
Explain with the help
can be made immediately without administrative cost or delay. However, OMOs requires
of an example.
the existence of a well-developed market for government bonds. It developed more in
5. What is IS-LM model?
the post liberalization era when reforms in financial sector took place in India. In pre-
Explain in detail, with
liberalization era, OMOs were insignificant as government debt could not be traded at
example.
market determined rates. In recent years, net sales of GOI securities and treasury bills 6. Explain in detail the
have climbed up to attain average annual value of approximately 6 per cent of reserve difference between
money. A major disadvantage of OMO is that sale of government bond imposes a cost monetarism and
on the government as interest will have to be paid to the purchaser of the bonds. Since Keynesian model of
changing the CRR has no such cost, it used to be the favoured method of India. money supply. In what
Repurchased Agreements: Under repurchased agreements (repo rate), RBI buys situations Keynesian
transmission
securities from banks under a contract that specifies a date and price for their resale to
mechanism fails?
banks. Under reverse repo the bank sells financial instruments to banks under a contract
that specifies a date and price for buying them back. Usually, contract period is short
Economics for
ranging from 1 to 30 days. The buying and selling prices determine the banks short
Managers : 257
Monetary Policy term lending rate (repo rate) or borrowing rate (reverse repo rate). Securities are
transferred only temporarily and there is no link between the maturity period of these
securities and that of the transactions.
NOTES The main advantage of repurchase agreements is that these are very flexible
instruments of short term reserve management (injection of liquidity by repo and
absorption of excess liquidity by reverse repo). They do not require developed markets
for securities. Under the processes of financial liberalization, they are now widely used
by all countries, developed or less developed, to engineer temporary changes in the
liquidity positions of banks. Some economists mention that repo rate is a useful tool
when there is surplus liquidity in the system.
In the following section, we shall explain the working of monetary policy. To

understand the working of policy we begin with defining of IS and LM curves (in
brief) which would be used later to explain the changes taking place in the economy.
20.4 Defining IS and LM curves
IS curve: It shows the combinations of r (rate of interest) and Y (income level) at

which equilibrium prevails in the market for commodities. IS curve is negatively sloped
(figure 20.1 below). Larger the interest elasticity of investment or small the marginal
propensity to save, flatter will be the IS curve. This is so because, the rise in I and hence
upward shift of AD following a decline in r will be larger if interest elasticity of
investment is higher. The upward shift will bring about a larger rise in income (Y) if
the multiplier is higher (smaller marginal propensity to save).
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Economics for
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LM curve: The supply of money (M) fixed by the monetary authorities, is given Monetary Policy
from outside. Dividing money supply by price level, we get money supply in real
terms or the supply of real balances. Equilibrium of the money market needs
M/P = kY hr. NOTES
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Here, M is fixed supply of money in nominal terms. The equation of the LM

curve (L stands for liquidity) which shows the combination of r and y that ensure
equilibrium in the money market for given values of M and P. It represents a straight
line with slope (k/h). The LM slope is positively sloped (figure 20.2). It will be relatively
flat if the income elasticity of money demand (k) is low and/or the interest elasticity of
money demand (h) is high. The position of LM curve depends upon the money in the
system. A rise in M (with P remaining unchanged) causes increase in Y to rise for any
given value of r. The curve shifts to the right. Fall in M causes a leftward shift. There
are only two forms in which wealth can be held either money or bonds. So if money
market is in equilibrium, bonds market will also be in equilibrium
20.5 Explaining Monetary policy with IS and LM curves
Other factors remaining same, we suppose that there is a change in money supply,
M. This will shift LM1 to LM2 as shown in the figure. At the new equilibrium point
E2 income would is higher and r2 is lower than r1. The higher the g (interest elasticity of
investment), the larger will the boost in the I, with the fall in r. Thus, the effectiveness
of expansionary monetary policy shall vary positively with g. In figure 20.3 a, the IS
curve is steeper than in figure 20.3 b, therefore rightward shift in LM is more in figure
20.3 b and raises more Y in the latter case Economics for
Managers : 259
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The effect of decrease in money supply contractionary or tighter monetary policy

is to raise the r and will therefore reduce Y. If the objective of monetary policy is to
raise the level of investment in the economy, expansionary policy shall be followed as
shown above in the figure 20.3 a & b whereas if objective is to control inflation and
money supply, a tighter monetary policy measures shall be undertaken where income
will decrease and rate of interest shall become higher.
In the IS-LM model it is easy to verify that fiscal policy (shall discuss in next
unit) cannot affect output if LM curve is vertical and monetary policy cannot be affect
output if IS curve is vertical. LM will be vertical if money demand does not depend on
r. IS will be vertical if investment does not depend on r.
20.6 Limitation of IS-LM model
IS-LM model considers that money affects economy indirectly through rate of
interest r i.e. transmission mechanism. A rise in M lowers r, this raise Y by boosting I.
The positive impact on Y may be small if (a) r does not fall significantly after the rise
in M (high interest elasticity of money demand) or (b) I does not respond much to the
fall in r (lower interest elasticity of investment). Keynesian generally believed that
both are likely to hold, particularly in a situation of recession, and therefore, are sceptical
about the effectiveness of monetary action in fighting recession. Apart from that;
(1) IS-LM model concentrates only on demand side of economy; i.e. a fall in
money supply pushes up rate of interest (r). The rise in the interest cost of
loans (credit) results in cutback of planned investment (and consumption).
Output Y falls because I and C are components of aggregate demand.
Economics for However, loans are taken by businessperson not only to finance long-term
Managers : 260 investment in plant and machinery but also to purchase intermediate inputs
and maintain inventories for current production (working capital). Rising Monetary Policy
cost or production loans will have direct contractionary impact on Y through
supply-side channel.
(2) This model has no room for expectation factors although such factors heavily NOTES
influence decision making and thereby govern the outcomes of government
policies. If for e.g. monetary authorities expand money supply to reduce the
nominal rate of interest by 2 per cent because it fears a recession is imminent.
This reduction will not translate into decline in the ex ante real interest if
businessperson thinks that recession will produce a drop in the inflation rate
of more than 2 per cent. Investment spending will not be stimulated in this
case. Japan in 1990s went through similar situation and was in a grip of
recession. Easy money policy drove nominal rate of interest close to zero
but failed to boost consumption and investment because of strong deflationary
expectations. In sharp contrast with nominal, real interest remained high.
Hence, future expectations do play an important role in framing policies and
policies expected to prevail in future will be taken into account by forward
looking economic agents in their choice of current action.
Monetarists pointed out that such complex relation and interdependence is entirely
left out of Keynesian analysis which essentially static and allows no fundamental role
for the future in current decision. Monetarist therefore strongly rejected Keynesian
transmission mechanism because in their view, money has direct impact on total spending
of goods and services in the economy.
20.7 Monetarist School of Thought
Transmission mechanism refers to the chain of events through which a policy

change affects the economy. This is very important point of disagreement between
Keynesians and monetarists. Monetarism is counter attack designed to reassert the
importance of money as an instrument of macro policy; in their view money has direct
(and not via interest route alone) impact on total spending on goods and services in an
economy. The major conclusions of monetarist approach are summed up below:
(i) Money supply is dominant influence on nominal GDP (PY)
(ii) In the long run, money supply affects only nominal variables such as the
price level P or nominal wages. Real output, employment and other real
variables are unaffected. They are determined by real forces of demand and
supply
Monetarist invoked the equation to justify (i) i.e. MV + PY, where V is income
velocity of circulation of money (or velocity). It is the number of times per year that
money stock M turns over to finance national income. i.e. if M = 2000 and V = 10 then
Economics for
GNP = Rs.20,000.
Managers : 261
Monetary Policy Monetarists believe that V is a stable constant determined by the degree of financial
development of an economy and the payment habits of its citizens. This equation then
posits proportionally between PY and M. A change in M will cause equal and
NOTES proportionate change in PY.
In the long run, Y attains full employment value Yf, so that, with both V and Y
given, equation yields a proportional relation between M and P. In short run, Y is not
at full employment and change in PY, following change in M, will partly be a change in
P and party a change in Y. Thus fluctuation in money supply will cause short-run
fluctuations in both prices and income.
20.8 Keynesian v/s Monetarism (New classical economists)
The Keynesian theory explains changes in the money supply working their way
through the system in a ways that does not result in a close and stable linkage between
changes in the money supply and change in the money income level. The monetarists
do see a close and stable linkage between money supply and change in the money
income level.
As per Keynesian model, increase in the money supply causes decline in the rate
of interest; and given MEC schedule, a lower rate of interest will lead to a rise in
investment spending which results in rise of income level. This is true but it does not
explain the actual transmission process. Monetarists in 1960s went a step ahead by
recognizing the complex sequence of substitution among the financial and real assets
that makes up wealth-holders portfolios, which arises with increase in money supply
and subsequent raise in income level. It is referred as Portfolio adjustment process.
Monetarist (Friedman and other economists) did explain the effect of changes in
money supply through a portfolio adjustment process as mentioned above, but they did
not consider interest rate as prerequisite to the changes in demand of goods and services.
According to them, the end result need not be a change in interest rates at all; but it may
change general price level and output. In this case, increasing or decreasing money
supply may not necessarily mean adding or subtracting from the publics wealth or
income. In some case it happens, and in some it may not.
Thus, Keynes basic assumption that prices and wages will be inflexible, in situation
of depression, is rejected on the ground that prices are never rigid and falling wages
and prices can always be relied on to lead the system out of depression. Also, it
maintained that Keynes policy is seriously flawed because it does not take into account
the publics possible response to policy in the account. In particular it ignores the role
played by peoples expectation about economic variables and government policy.
Intelligent and well informed (rational agents), according to the new classical, have
rational expectations in the sense that they can anticipate the type of policy the
Economics for
Managers : 262
government will initiate in any particular phase of a business cycle. They will internalize Monetary Policy
the knowledge into their decision making, change their behaviour accordingly, and this
reaction of rational agents will nullify the attempt by the government to alter the course
of the economy. NOTES
20.9 Changing Paradigm of Monetary policy

The major policy conclusion of monetarism is that stability in money supply is
crucial for stability in the economic system. Stability can be ensured by adopting a
rule for the growth of M. The best possible thing that monetary authorities can do is to
announce a fixed rate of growth of the money stock and stick to that irrespective short-
run fluctuation in prices or output. Discretionary action (raising M to fight a recession
or lowering it to combat inflation) will actually be a destabilizing force.
The current consensus on monetary policy seems to be that central banks should
use some simple and transparent set of rules as guidelines when choosing policy
instruments. Discretion is retained in the sense that the rule should allow feedback
from the actual state of the economy. An important example of such a rule is the so-
called Taylor Rule, which may be stated as
where Y* is the full employment or capacity output, r* is the estimate of the

equilibrium real rate of interest (given by the IS - Y = Y*), is the target rate of inflation
and and are positive fractions.
As per this rule, nominal rate set by the central bank should equal (r* + ) when
inflation is at the target level and the output gap (Y - Y*) is zero so that the real rate
equals r*. For each percentage point by which inflation rises above its target value, the
nominal rate should be raised by (1 + ) percentage point. The change in the nominal
is higher than the change in inflation to bring about a higher real rate. For each percentage
point by which GDP falls below its full employment level, the nominal rate falls by
per cent.
In its short term monetary policy (liquidity) RBI in India roughly follows this
type of rule in the sense that the key rates set by it are adjusted in response to perceived
changes in inflation and the output gap. But control of inflation is considered more
important than minimization of the output gap. Increase in CRR is resorted to (in
combination with interest rate policy) only when the magnitude of required monetary
contraction is deemed to be large.
The consensus seem to be that governments stabilization policy is effective for

all practical purposes in the short run, as continuous and complete market clearing
through flexible wages and prices does not happen, rational expectation hypothesis does
not hold, and the authorities have information superior to that possessed by general public.
Economics for
Managers : 263
Monetary Policy
20.10 Summary
Monetary policy affects the economy, first by affecting interest rate and then by
NOTES
affecting aggregate demand. An increase in the money supply reduces interest rate,
increases investment spending and aggregate demand and thus increases equilibrium
output. This phenomenon has been explained in this chapter (previous sections) with
the help of two different schools of thought i. e. Monetarism and Keynesian transmission
mechanism (IS & LM curves). Key terms in the following section will help the reader
to have a synoptic view of the chapter.
20.11 Key Terms
Monetary policy is the process by which monetary authority (central bank) controls
the money supply in the economy by exercising its control over interest
rates in order to maintain price stability and achieve high economic growth.
Tools of Monetary policy : Cash reserve ratio (CRR), bank rate, open market operations
(OMO) and Repurchased agreements are major tools (instruments) of the
monetary policy.
Keynesian Transmission mechanism considers that money affects economy indirectly
through rate of interest r. Assuming that no liquidity trap and investment is
not interest insensitive; an increase in money supply lowers rate of interest
and increases investment and a decrease in money supply increases rate of
interest and decreases investment.
Keynesian Transmission mechanism fails to address the two possibilities i.e. liquidity
trap and interest insensitive investment. If either is present monetary policy
will be unable to change real GDP and unemployment.
Monetarist transmission mechanism links money market and goods and services
market directly. Changes in money supply increases aggregate demand.
An increase in the money supply causes individuals to increase their
spending on variety of goods.
Taylors rule is stated as:
It states that for each percentage point by which inflation rises above its target value,
the nominal rate should be raised by (1 + ) percentage point. The change
in the nominal is higher than the change in inflation to bring about a higher
real rate. For each percentage point by which GDP falls below its full
employment level, the nominal rate falls by per cent.
Economics for
Managers : 264
Monetary Policy
1. What are the goals of monetary policy?
NOTES
2. Central bank uses different tools of monetary policy to bring stability in the
economy during high inflation and recession. How do these tools work to keep
economy stable?
3. Use IS-LM analysis to trace the impact of an autonomous export boom on the
economy. (Hint: IS-LM graph to explain)
4. a. Differentiate between ultimate and intermediate targets of monetary policy
b. State Taylor rule. Why do central banks prefer to use this tool?
5. How were major conclusions of Monetarist different from Keynesian model?
Explain.
6. How might monetary policy destabilize economy?
7. If an economy is stuck in a recessionary gap, does this make the case for
expansionary monetary policy stronger or weaker? Explain your answer.
8. What is an advantage of open market operations over other instruments of monetary
policy? Was OMO significant as an instrument in pre liberalization era or not?
Why?

(5th Editon), 2005.
Economics for
Managers : 265
Fiscal Policy
UNIT 21 FISCAL POLICY
NOTES Structure
21.0 Introduction
21.2 Fiscal Policy
21.3 Demand-side fiscal policy
21.4 Fiscal policy and IS-LM Model
21.5 Crowding out effect:
21.6 New Classical View of Fiscal Policy
21.7 Supply side Fiscal Policy
21.8 Combined effect of Monetary and Fiscal Policy
21.9 Summary
21.10 Key Terms
21.0 Introduction
As mentioned in the previous unit of monetary policy, we often hear economists

ask themselves whether the budget program has been stimulative (expansionary) or
restrictive (contractionary). Partial answer is provided to this issue is by how certain
economic variables (aggregate demand, aggregate supply, real GDP, unemployment
etc) behave during one quarter to next quarter and from comparing them to same quarter
in the previous year. Complete answer is provided by exploring the affect of measure
undertaken in the budget w.r.t. fiscal policy.
The deliberative use of government spending and taxing as possible means of

attaining full employment, a stable price level and satisfactory growth rate became
prominent with introduction of Keynesian economics. It was largely result of three
developments in 1930s;
(i) ineffectiveness of monetary policy as a means of overcoming severe
unemployment of the great depression,
(ii) new economics advanced by Keynes with emphasis on aggregate demand
and
(iii) Growing importance of government spending and taxation in relation to the
economys total income and output.
Economics for
Managers : 266 After relatively modest beginning, fiscal policy did become a major means by
which government in different countries attempts to stabilize economic conditions while Fiscal Policy
complementing monetary policy. Economists (such as Keynesian and New Keynesians)
believed that economy is inherently unstable and argue that the government should
play a role in making it stable. One of an important ways government can influence the NOTES
economy is through its fiscal policy.
In section 21.2 we define and mention the objectives of fiscal policy. Section
21.3 provides Keynesian demand side perspective on fiscal policy followed by
explaining the working of policy with IS-LM model in section 21.4. An important
concept of crowding out effect under this model is explained in section 21.5. This is
complemented by new classical in section 21.6 and supply side view on fiscal policy in
next section 21.7. Unit concludes on the note that it is combination of monetary and
fiscal policy that government adopts to achieve the stability in the economy. This is
explained with the help of figures and use of IS-LM model in section 21.8.

* To introduce the objectives of fiscal policy.
* To understand the working (demand and supply side) of fiscal policy with
the help of (IS & LM curves) Keynesian and Classical perspective.
* To understand that in real world it is the combined effort of monetary and
fiscal policy which helps government to stabilize economy and achieve
economic growth.
21.2 Fiscal Policy
Fiscal policy refers to changes in government expenditure and/or taxes to achieve

particular economic goals such low unemployment, price stability, and economic growth.
In simple words, government raises revenues through taxes and these revenues
are then spent (government expenditure). To generate revenues and incur expenditure,
government frames a budgetary policy or fiscal policy. Therefore policy is concerned
with government expenditure and government revenue and their role in stabilizing
macroeconomic variables that in turn result in economic growth.
If there is an increase in the government expenditures and/or decrease in taxes to

achieve macroeconomic goals, the policy is referred as expansionary fiscal policy. On
the other hand if there is decrease in government expenditure and/or increases in taxes
to achieve these goals, then policy is referred as contractionary fiscal policy. If changes
in government expenditure and taxes are introduced deliberately by government actions,
fiscal policy is said to be discretionary fiscal policy. In contrast, change in either Economics for
government expenditure or a tax that occurs automatically in response to economic Managers : 267
Fiscal Policy events is referred to as automatic fiscal policy.
In this section, of fiscal policy, we deal only with discretionary fiscal policy i.e.
we will consider deliberate actions of policy makers, to affect the economy through
NOTES changes in government spending/taxes.
Objectives of Fiscal Policy

Fiscal policy is designed to attain following objectives:
1. Mobilisation of development resources through taxation, public and private
savings
2. Efficient allocation of financial resources
3. Price stability and control of inflation
4. Employment generation
5. Balance regional development
6. Reducing deficit of balance of payments
7. Increasing national income and capital formation
8. Development of infrastructure
9. Foreign exchange earnings
21.3 Demand-side fiscal policy
Fiscal policy, through government spending and taxes can affect aggregate demand
(AD). As we mentioned in the previous section that change in consumption, investment,
government spending, or net exports can change aggregate demand and therefore shift
AD curve. For example, an increase in government purchases increase aggregate demand
and shifts the AD curve to its right and decrease in aggregate demand shifts the AD
curve to its left. A change in taxes can affect consumption and investment or both and
therefore can affect the aggregate demand. A decrease in income taxes increases
disposable income (after tax) of the consumer and increases the level of consumption
that shifts the AD curve to the right. An increase in taxes decreases disposable income,
lowers consumption, and shifts the AD curve to the left.
Fiscal policy: A Keynesian Perspective

Suppose, the economy is initially in a recessionary gap at point E in figure 21.1 a
below; Aggregate demand is too low to move the economy towards equilibrium at the
natural real GDP level. As per Keynesian point of view, government must frame
expansionary fiscal policy (an increase in government expenditure or a decrease in
taxes), to shift the aggregate demand curve rightward from AD1 to AD2 and and move
the economy to the natural real GDP level E*. A question might be raised that; why not
Economics for simply wait for the short-run aggregate supply curve to shift rightward E1? Keynes
Managers : 268 explained this phenomenon (i) the economy is stuck at point E and will not move
naturally to point E1 because wage rate will not fall; or (ii) the short run supply curve Fiscal Policy
takes too long to shift rightward and in the interim, we must deal with the high cost of
unemployment and lower level of real GDP
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interim wage rates do not fall. We must deal with the high cost of unemployment and
lower level of real GDP. Therefore, it is not possible that supply curve shifts rightward Check Your Progress
and intersect aggregate demand curve at new point of equilibrium. 1. What do you
understand by fiscal
Similarly, if the economy is initially in inflationary gap at point E in figure 21.1 b
policy? What are its
above; Keynesian economists propose contractionary fiscal policy (a decrease in
different forms?
government expenditure or increase in taxes) to shift the aggregate demand curve
explain various
leftwards from AD1 to AD2 move economy at new point of equilibrium E*. In both the
objectives of the
cases above, fiscal policy has worked as intended by eliminating the recessionary gap
formulation of fiscal
in first case and inflationary gap in the second case.
policy.
In case (a) the economy was in recessionary gap and expansionary fiscal policy 2. Explain the Keynesian
eliminated the recessionary gap and in case (b), the economy was in inflationary gap perspective of fiscal
and contractionary fiscal policy eliminated the inflationary gap. policy. How it
eliminate inflationary
21.4 Fiscal policy and IS-LM Model and recessionary gaps?
Fiscal policy involves changes in government expenditure (G) and taxes (T).
Suppose the government increases spending on goods and services, keeping the taxes
unchanged. In figure 21.2, IS1 shifts to IS2, new equilibrium level is attained at E2 with
both Y and r are higher at new equilibrium.
Economics for
Managers : 269
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Expansionary fiscal action stimulates output and employment as in simple

Keynesian model. The rate of interest goes up after the rise in G. This is because as the
income level (Y) goes up, transaction demand for money also rises. With the money
supply unchanged, this rise in demand will cause r to go up i.e. people will have to sell
bonds to get extra money needed to meet higher transaction demand. This causes bond
price to decline, which is the same as a rise in r. At the new equilibrium r must rise
sufficiently to keep money demand unchanged even though income is higher. The rise
in r dampens the impact of fiscal action by reducing private investment. If r had not
risen from the old level r1, income would have expanded all the way up to the point D
on the new IS. But the rise in r to r2 has choked off the part MD. This offsetting (partial)
of expansionary fiscal action through a rise in rate of interest is called crowding out
effect.
21.5 Crowding out effect
There is a difference amongst economists regarding the degree of success of

discretionary measures in fiscal policy. It does not always work as mentioned
theoretically. Some economists refer to crowding effect as the reason for that. Crowding
out effect refers to a decrease in private expenditure that occurs as a consequence of
increased government spending or the financing needs of a budget deficit.
For example, if government spends more on public libraries, and individuals buy
fewer books at bookstores. In simple words, if government spends $20 million more on
public libraries. Suppose, after that consumers keep spending the same amount of money
then there is no crowding out or zero crowding effect. If all the investment done by
government is offset by private spending, then it is called complete crowding out. i.e.
Economics for
private investors stop investing in bookstores. If there is complete crowding out, then
Managers : 270
expansionary fiscal policy will have no effect on real GDP or unemployment rate (i.e. Fiscal Policy
economy).
In real world, there is a possibility of consumer spending little less on buying

books from bookstores as some of them would use library facility now for reading NOTES
books instead of buying. In that case, there is a possibility that some of the private
bookstores may close over a period of time. This will result in partial/incomplete
crowding out as part of government spending is being neutralized by decrease in private
spending. In this case, expansionary fiscal policy will increase real GDP and decrease
the level of unemployment rate but not as much as if there is zero crowding out. In
simple words, after government spends $20 million more on public libraries, consumer
ends up spending $12 million less on books at bookstores. In this case crowding out is
there but not dollar-for-dollar crowding out; it is incomplete crowding out. Figure 21.3
below depicts consequences of complete and incomplete crowding. For comparison,
figure also includes the case of Keynesian theory where there is zero crowding out.
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Figure above shows effects of zero, incomplete and complete crowding out in
AD-AS framework. Starting at point E1 at AD1, expansionary fiscal policy shifts the
aggregate demand curve to AD2 and moves the economy to point E* at QN. The Keynesian
theory that predicts this outcome assumes zero, or no crowding out; an increase in say
government spending does not reduce private expenditures. With incomplete crowding
out, an increase in government spending causes private expenditures to decrease by
less than the increase in government spending. The net result is shift in the aggregate
demand curve to AD21. The economy moves to point E21 and Q21. With complete
crowding out, an increase in government spending is completely offset by a decrease
Economics for
in private expenditures, and the net result is that aggregated demand does not increase
Managers : 271
Fiscal Policy at all. The economy remains at point E and Q1.
In another example, If government spends more on social programs and defence

without increasing taxes, as a result budget deficit increases. Consequently, the
NOTES government will borrow more funds to finance the larger deficit. This increase in
borrowing causes demand for credit, which in turn, cause rise in rate of interest. As a
result private investment will drop.
21.6 New Classical View of Fiscal Policy
New classical school of thought proposes another perspective of what people

may do. Economists believe that people will react to expansionary fiscal policy. A
larger deficit and greater deficit financing with following approach: a larger deficit
implies more debt this year and higher future taxes. They may save more in the present
so that they can pay higher future taxes required to pay interest and to repay principal
on the new debt. So they will consume less and save more. Therefore, current
consumption may fall as a result of expansionary fiscal policy. At the same time, higher
saving may increase the supply of credit in future and offsets the increased demand for
credit resulting in maintaining same level of interest rates instead of increasing.
Fiscal policy and time lag

In real world, the affect of fiscal policy sometimes may not bring in favourable
results due to existence of lags. Once policy makers are aware of downturn in the
economy, they rarely enact counteractive measures immediately. Instead, they usually
adopt a more cautious approach, wait and see attitude. Even if measures are taken it
takes time to actually implement them. If spending is increased it does take a quarter or
two till the effect is visible in the economy depending on the objective. It may take
little more than that. Once implementation begins in case of expansionary fiscal policy,
measure mandating increased spending on public work projects will require construction
companies to submit bids for the work, prepare designs, negotiate contracts, and so on.
21.7 Supply side Fiscal Policy
The effects of fiscal policy can be felt on supply side also as on demand side. For
example, a reduction in tax may change an individuals incentive to work and produce,
thus changing aggregate supply.
The marginal (income) tax rate is equal to the change in a persons tax payment
dividend by the change in the persons taxable income.
Marginal tax rate = Tax payment/ Taxable income
Economics for For example, If Aravs taxable income increases by $1 and his tax payment
Managers : 272 increases by $0.28 per cent, his marginal tax rate is 28 per cent; if his income increases
by $1 and his tax payment increases by $0.36, then his marginal tax increases by 36 per Fiscal Policy
cent. All other things held constant, lower marginal tax rates increase the incentive to
engage in productive work relative to leisure and tax-avoidance activities. As resources
shift from leisure to work, short run aggregate supply will increase and gradually supply NOTES
curve will shift rightward to raise the output level. As shown in the figure 21.4 below,
a cut in marginal tax rates increases the attractiveness of productive activity to leisure
and tax avoidance activities shifts resources from latter to former; thus shifting rightward
both the short run and the long run aggregate supply curves
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Thus, fiscal policy does play a crucial role in stabilizing economy either through
aggregate demand or aggregate supply side changes taking place accordingly. The
success of fiscal policy depends upon timely measures and their effective administration
during implementation.
21.8 Combined effect of Monetary and Fiscal Policy
In real world, monetary and fiscal policies are used in combination and measures
undertaken do have effect on each other. In figure 21.5, a rise in G shifts IS. By itself
this fiscal action would push r up to r2. Due to crowding out, Y would rise only to Y2. If
the move were accompanied by an increase in the supply of money, LM would shift to
the right. If the new LM passes through E3, output will rise in Y3 without any rise in r.
Here the crowding out effect is neutralized by appropriate monetary action.
Economics for
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Fiscal Policy )LJ
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We consider another policy action. Suppose government raises taxes to reduce

budget deficit but the authorities do not want income to fall. Without any monetary
intervention the tax increase shifts IS down and Y will fall from Y1 to Y2 in figure 21.6.
The downward pressure on Y can be neutralized by increasing the supply of money in
an appropriate manner. The final equilibrium after adjustment in M is at E3, where the
level of output is unchanged at Y1.
An important point here to keep in mind is that fiscal and monetary policy may
interact with each other and the impact of any policy change will depend crucially on
the interdependence.
Although Y can be raised either by fiscal or monetary expansion, the effect on the
consumption of national income is different in two cases. Fiscal expansion reduces I
by raising r, whereas I is stimulated under monetary expansion through the fall in r.
Note that if I is also positively influenced by Y, then, the ultimate impact of fiscal
policy on I will depend on the strength of the income elasticity of I relative to its
elasticity with respect to r. Here, we have not considered possible influence of Y on I.
Since monetary expansion raises Y and reduces r, the impact on I is unambiguously positive.
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In the special case of liquidity trap (LM horizontal at a very low rate of interest) Fiscal Policy
monetary expansion has no effect on the position of LM and fails to have any impact
on output. The reason is that all the extra money put into the system is willingly held at
the prevailing interest rate. Since r does not fall, there is no stimulus to aggregate NOTES
demand. Japan had experienced a trap-like situation with nominal interest rates close
to zero over a considerable period. This is one reason why it was difficult for Japanese
monetary authorities to stimulate the economy.
When LM is horizontal fiscal policy (rightward shift of IS) raises Y to the maximum
possible extent. Since r does not rise, there is no crowding out and we are back to
simple Keynesian system without assets markets. To conclude, the table 21.1 below
states the effect of fiscal and monetary policy.
Table 21.1: Effects of Fiscal and Monetary Policy
Shift in IS Shift in LM Y r
Increase in T Left None Falls Falls
Decrease in T Right None Rises Rises
Increase in G Right None Rises Rises

Check Your Progress
Increase in M None Right Rises Falls 1. What do you
Decrease in M None Left Falls Rises understand by
Crowding Out
New Classical Economics and Economic Policy effect? What is its
In 1970s, new classical economists expressed their strong faith in the equilibrating importance in the study
power of prices and assert that fully flexible prices, including wages, will keep all of fiscal policy?
markets in equilibrium all the time. Keynes basic assumption that prices and wages 2. According to the IS-
will be inflexible, in a situation of depression, is rejected on the ground that prices are LM model, what
never rigid and falling wages and prices can always be relied on to lead the system out happens in the short
of depression. run to the interest rate,
income, consumption,
It also pointed out that, Keynes ignored the role played by peoples expectations
and investment when
about economic variables and government policy. According to the new classical,
government increase
intelligent and informed (rational) agents have rational expectations in the sense that
taxes?
they can anticipate the type of policy the government will initiate in any particular
3. Explain how monetary
phase of a business cycle. They will internalize their knowledge in the decision making,
and fiscal policy work
change their behaviour accordingly, and this reaction of rational agents will initiate in
together o maintain
any particular phase of a business cycle. This very striking result came to be known as
stability in the
the policy ineffectiveness proposition and created quite a stir among macroeconomists
economy?
in the 1970s. Most economists however, found the result unconvincing because of the
stringency and unrealism of the underlying assumptions.
Economics for
Managers : 275
Fiscal Policy
21.9 Summary
Both fical and monetary policy can be used to stabilize the economy. The question
NOTES
of the monetary fiscal policy mix arises because expensionary monetary policy reduces
the interest rate while expansionary fiscal policy increase interest rate. Accordingly,
expansionary fiscal policy increase output while reducing the level of investment;
expansionary monetary policy increase output and level of investment. Government
has to choose the mix in accordance with their objectives for economic growth or
increaseing consumption or from the view point of their beliefs about the desirable size
of the government.
21.10 Key Terms
Fiscal policy refers to changes in government expenditure and/or taxes to achieve

particular economic goals such as low unemployment, price stability and
economic growth.
Crowding out refers to decrease in the private expenditure that occurs as a consequence
of increased government spending or financing needs of the budget.
Expansionary fiscal policy raises both income (Y) and employment in simple
Keynesian model. Monetary and fiscal actions become interlinked through
the government budget constraint.
New classical economists hold that due to rational expectations government policy
(monetary or fiscal) may not bring in favourable results at times to affect
the economic variables due to time lag and peoples expectations.

1. Why is crowding out an important issue in the use of fiscal policy? What could be
the various ways crowding out may occur in the economy?
2. Discuss the policy mix required to reduce the interest rate, keeping output
unchanged with the help of IS-LM framework.
3. Why a need was felt for the introduction of fiscal policy by economists and what
are the major objectives of fiscal policy?
4. How do expansionary and restrictive measures correct the state of the economy?
Explain with the help of diagram.
5. A reduction in tax may change an individuals incentive to work and produce,
thus changing aggregate supply. How will this affect fiscal policy?
Economics for
Managers : 276
6. Are there any effects felt on supply side due to measures undertaken by fiscal Fiscal Policy
policy?
7. Does a combination of tight monetary policy and expansionary fiscal policy leads
to a high rate of interest and uncertain output? Explain. NOTES
8. Suppose that taxes are raised to reduce the budget deficit, but for some reason the
Central bank do not want the interest rate to change. What policy should it adopt?

1. Macroeconomics : Rudiger Dornbusch, Stanley Fischer Richard Startz; Tata
McGraw Hill (9th Edition) 2004.
(5th Editon), 2005.
Economics for
Managers : 277
Business Cycles
UNIT 22 BUSINESS CYCLES
NOTES Structure
22.0 Introduction
22.2 Business Cycles
22.3 Theory of Business Cycle
22.4 Aggregate Demand and Business Cycles:
22.5 Business cycle and Multiplier model
22.6 Effect of Fiscal Policy on Output
22.7 Limitations of Multiplier model
22.8 Real Business Cycles
22.9 Summary
22.10 Key Terms
22.0 Introduction
In unit 18 on Measuring national income and concepts, we had drawn a figure

on the growth rate of GDP in India since 1951. It was briefly mentioned that changes
happening in the economy (booms, shock in stock prices, structural changes, business
environment etc.) result into short term fluctuations. Irrespective of this, GDP growth
does take place in long run. These short turn fluctuations i.e. rise and fall in the growth
rate of GDP in the economy was shown with upward and downward movement of the
curve. These ups and downs in the economy are called Business cycle. In simple
words, if real GDP is on roller coaster rising and falling the economy is said to be
incurring a business cycle.
Either developed or developing economy, none grows in a planned manner; all

are subject to business cycles. We often read in newspapers about them. Since last
quarter of 2008 most of the world economies (US, Europe and many Asian economies)
have suffered due to recession. Similarly, world economy (US, Europe and other Asian
countries) is also going through slowdown and the financial crisis of 2007-09 turned
into waves of contagious pessimism and downturn in the banking and financial sectors
which led to lowering aggregate demand. This did have an impact of manufacturing
sector across the Europe and US. Different measures are being taken to mitigate the
Economics for losses occurred in last few years and bring economies back to normal. These changes
Managers : 278 or fluctuations happening in the economy or main macroeconomic variables due to
market conditions and expectations (internal and external) are referred as business Business Cycles
cycles.
Section 22.2 of this unit begins with explaining different phases of business cycle
followed by theories of business cycle in section 22.3. We try to explain the theories NOTES
with the help of two examples of the housing bubble and the new economy bubble.
After understanding theory of business cycles, we move to factors causing different
phases of business cycles through changes in aggregate demand in section 22.4. In
next section 22.5, we explain the mechanism by which changing in spending gets
translated change in output and employment known as Keynesian multiplier model.
The effect of this working on output is explained in section 22.6. Section 22.87states
the limitations of multiplier model. Concluding section 22.8 of this unit defines the
term used modern economist to called real business cycles.

* To introduce the concept and phases of business cycle with the help of
aggregate demand.
* To understand the business cycle with the help of Keynesian Multiplier model.
22.2 Business Cycles
Indian economy too has been subject to business cycles during pre and post reforms
period. A slowdown in the economy during 90-91 resulted in introduction of reforms
and relatively more liberalized era in July 91. Since opening up of economy after reforms,
recovering started taking place followed by expansion and gradually reaching the peak
in following years until 1997 when recession happened. Following few years were
little difficult before economy once again moved to the path of expansion in 2002;
until global credit crisis hit the economy in late 2008 (longest since mid-eighties lasting
a full 24 months from its peak in 2009 to its through in 2010) which had long lasting
effect. The efforts have been there to recover and bring back Indian economy to
expansion path since last two years through different measures. In simple words,
Business cycles are short-term fluctuations happening in the macroeconomic

variables i.e. total national output, income and employment usually lasting 2-10 years,
marked by widespread of expansion or contraction in most sectors of the economy.
Phases of Business Cycle

Typically, economists identify business cycles into five phases mentioned below:
1. Peak: At the peak of the business cycle, real GDP is at a temporary high and
business environment is irrationally exuberant. Profits are higher and so is Economics for
employment level. Managers : 279
Business Cycles 2. Contraction: This represents a decline in real GDP and optimism flips over
to irrational pessimism. As per standard definition of recession, two
consecutive quarter declines in real GDP constitute recession. A recession is
NOTES a recurring period of decline in total output, income and employment, usually
lasting six to twelve months and market by contractions in many sectors of
the economy. Normally, leading indicators (output, income, employment,
production etc) start moving downwards before an economy on the whole
begins contraction followed by recession.
3. Trough: This is the lowest point of GDP, just before it begins to turn up, is
called the trough of the business cycle.
4. Recovery: The recovery is a period when real GDP starts rising again. It
begins at the trough and ends at the initial peak. In general, economy starts
picking up once again and there is rise in consumption and investment levels
thus affecting aggregate demand.
5. Expansion: The expansion refers to increase in real GDP beyond the recovery.
Recovery phase gradually turns into expansion when there is increase in the
output and business environment is positive. There is increase in the
employment level and new investments are made.
An entire business cycle is measured from peak to peak. Peaks and troughs mark
turning points of the cycle. The typical business cycle is approximately four to five
years, although few have been shorter and some have been longer. Figure 22.1 depicts
the successive phases of business cycle.
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Though we call short-term fluctuations as cycles, the actual pattern is irregular.

No two business cycles are similar and no exact formula can be used to predict the
duration and timing of business cycles. Rather, business cycles more closely resemble
the irregular fluctuations of weather. While individual business cycles are not identical
but they often share similarity in terms of consequent stage being followed. Usually,
Economics for
following characteristics are visible when recession happens:
Managers : 280
i. There is decline in investment. Housing is first to decline either because of Business Cycles
financial crisis or hike in the interest rates by RBI to slow down inflation.
Consumer purchases decline sharply, fall in production level which results
in fall of real GDP. NOTES
ii. Employment usually falls sharply in the early stages of recession Often it is
slow to recover and the situation is referred as jobless recoveries.
iii. When output falls, inflation slows down and demand for crude materials
declines and material prices tumble; wages and prices are unlikely to face
similar decline but they tend to rise less rapidly in economic turn down.
iv. Profits fall rapidly during recessions. Fearing this, common stock prices
usually fall as investors sniff the scent of a business turndown.
Check Your Progress
v. Usually, business conditions deteriorate and employment falls, RBI begins
1. What do you
to lower short-term interest rates to stimulate investment, and other interest
understand by business
rates decline as well. This happens only if inflation is falling down otherwise
cycle? What are its
RBI waits for inflation to come back at normal level before it decreases
different phases?
interest rates.
Explain in detail.
2. What is the lowest
22.3 Theory of Business Cycle point in the business
cycle referred to as?
Economists have engaged in debates about various reasons for business What happens to
fluctuations. A few of them have emphasized that monetary fluctuations are the main saving, income and
cause whereas others have found the cause in productivity shocks, exogenous spending investment in the
or global slowdown as economy are closely related through international trade. Usually, recession phase?
cause of business fluctuations are classified into two categories i.e. Exogenous and
Internal.
The exogenous theory has emphasized that factors outside the economics system
cause fluctuations in business cycle i.e. in oil prices, gold prices/discoveries or other
trading commodities, wars, migration of population, scientific breakthroughs and
technological innovations, weather etc. Eg. Recent slowdown in India during last few
years was often explained with rise in commodity prices like oil, gold etc globally.
In contrast, the internal theory emphasizes that cause in fluctuations of business

cycle lies within the economic system itself. This approach states that every expansion
breeds contraction and recession and every contraction breeds revival and expansion.
In the modern day economy, origin of many business cycles lies in condition of financial
sector. This is the main reason that much attention is devoted to monetary and financial
economics these days.
Speculative booms and busts that took place frequently in nineteenth and twenty
century did produce the upheaval like Great Depression in 1930s that reappeared a few
times in past two decades. A few examples are mentioned below: Economics for
Managers : 281
Business Cycles The new-economy bubble: During 1990s, phenomenal growth and innovation in
new economy sectors like software, internet and newly invented dot.com companies
resulted in a speculative boom of new economy stocks. Companies started selling
NOTES consumer goods online, free birthday cards, many new websites for online shopping.
Many young entrepreneurs left their jobs and became instant millionaires through these
services. Investment in information processing equipment rose by 70 per cent from
1995-2000 in US, representing 1/5th of entire rise in real GDP during this period.
Eventually, investors became sceptical about fundamental value of many of these firms
and losses started piling up. The urge to sell the stocks became higher instead of buying
them as it was in the beginning. Many companies became bankrupt. The fall in
expectations and resulting stock market decline contributed to recession and slow growth
period in US economy in 2002-03. Investment in information processing equipment
also declined.
Recently, once again in last few years India, there has been huge investment in
online shopping websites and lot of venture funding has once again picked up in such
software companies. There is again pick up and expansion in online shopping sector
due to these investments though some people are cautious this time while buying their
stocks due to past experience of US in this sector.
The Housing Bubble: Less than a decade later, another financial crisis erupted in
US that had an effect on global slowdown. In this case, innovation was the process of
financial securitization. This occurs when financial instrument, such as simple home
mortgage, is repackaged and then sold in security markets. While securitization itself
was not a new phenomenon, the scope of packaging and repackaging grew sharply.
Rating agencies failed to provide accurate ratings of the riskiness of these new securities,
and many people bought them thinking they were as good as gold. The worst examples
were subprime mortgages, mortgages provide to people for entire value of a house
on the basis of little or no documentation of their income and job status. By early 2007,
the total value of these securities was over $1 trillion. All went along till house prices
were rising but then in 2006 the housing bubble burst- echoing the end of speculative
dot.com stock market bubble from a decade earlier. Many of the securities lost value
and gradually it resulted in recession. Many large banks faced huge losses (some even
got bust), the began to tighten the credit, reduce loans and cut back sharply on new
mortgages. Risk premiums rose sharply. The economy went into deep depression in
2007.
After understanding the concept and causes of business cycle fluctuations, we

explain aggregate demand theory in detail in the following section:
22.4 Aggregate Demand and Business Cycles:

Economics for
In this section, we shall understand that how do major components of aggregate
Managers : 282
demand (AD) interact with price? How do short-run fluctuations in AD affect GDP? Business Cycles
Aggregate demand is total aggregate of quantity of output willingly bought at

given level of prices, other things remaining constant. AD is desired spending in all
NOTES
product sector consumption, private sector consumption, private domestic consumption,
government purchases of goods and services, and net exports. It has four components
Consumption (C): We mentioned in the previous chapter; consumption is primarily

determined by disposable income, which is personal income less taxes. Other factors,
affecting consumption are long-term trends in income, household wealth, and the
aggregate price level. AD analysis focuses on the determinants of real consumption.
Investment (I): Investment includes purchase of buildings, equipment, software

and accumulation of inventories. Main determinants of investment are the level of
output, cost of capital and expectation about the future.
Government purchases (G): It includes government purchases of goods and

services. Unlike consumption and investment this component of aggregate demand is
determined directly by the governments spending decisions.
Net exports (X): It is calculated by deducting value of imports from value of

exports. Imports are determined by domestic income and output, by the ration of
domestic to foreign prices, and by foreign exchange rates of the dollar. Exports are
mirror image of imports and are determined by foreign incomes and outputs, by relative
prices, and by foreign exchange rates. Net exports are then determined by domestic
and foreign outputs, relative prices and exchange rates.
It was explained in previous chapters, aggregate demand curve is downward

sloping. This means that other things remaining same, real spending declines as price
level in the economy rises. The basic reason of downward slope is that; some elements
of income and wealth that do not rise when the price level rises. For e.g. some items of
personal income might be set in nominal dollar terms some government transfer
payments, the minimum wage, and company pensions are example. When the price
level goes up, real disposable income falls; leading to decline in real consumption
expenditure. Aggregate demand shifts when there are changes in macroeconomic
policies (change in monetary policy) or when exogenous events change spending (change
in commodity prices, business confidence, affecting I).
Factors affecting Aggregate Demand

As mentioned above, aggregate demand curve relates total spending to the price
level but there are other factors also which affect the curve. These include policy variables
(internal) and other exogenous variables. The table 22.1 below lists the factors which
increase aggregate demand and shift AD curve. Economics for
Managers : 283
Business Cycles Table 22.1: Factors affecting AD curve
S.No. Variable Impact on aggregate Demand
NOTES 1 Monetary Monetary expansion may lower interest rates and loosen credit
policy conditions, include higher levels of investment and consumption
of durable goods. In an open economy, monetary policy also
affects the exchange rate and net exports
2 Fiscal policy Increase in government purchases of goods and services directly

increase spending; tax reductions or increase in transfers raise
disposable income and induce higher consumption. Tax
incentives like an investment tax credit can induce higher
spending in a particular sector
3 Foreign Output growth abroad leads to an increase in net exports

output
4 Asset values Rise in stock market increases household wealth and thereby
increases consumption; also, higher stock prices lower the cost
of capital and thereby increase business environment
5 Advances in Technological advances can open up new opportunities for

technology business investment. Important examples have been the
automobile and computers
6 Other Defeat of socialist government stimulates foreign investment;

peace breaks out, with an increase in world oil production, and
lowers oil prices; good monsoon in India leads to lower food
prices
As mentioned above, exogenous variables are the ones that are determined outside
the AS-AD framework. These include foreign economic activity and wars which are
outside the control of policies and have independent movement. For e.g. Sharp increase
in military expenses due to war (e.g. World war II) will increase the cost of ware including
pay for troops, purchase of ammunition and equipment, utilities for soldiers and costs
of transportation. This effect will increase the purchase of government (G); the total
demand curve will shift out and to the right as G increase. Similarly, radical new
innovation that increases profitability of the investment, or increase in consumer wealth
would also lead to increase in aggregate demand and outward shift in AD curve. Figure
22.2 (a) below shows the movement along the AD curve and 22.2 (b) shows shift in
demand curve.
Movement along the AD curve v/s Shift of curve
Economics for The diagram below depicts how the variable mentioned in the table above will
Managers : 284 would affect the AD curve. If
(a) Higher price level with given nominal money incomes lowers real disposable Business Cycles
income; this leads to higher interest rates and declining spending on interest-
sensitive investment and consumption. This explains a movement along the
AD curve from B to C when other things are held constant. NOTES
(b) In case other things dont remain constant; such as money supply, tax policy
or government spending and other variables this would lead to changes in
total spending at a given price level. This would bring a shift in AD curve.
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As mentioned in the previous section, that AD curve shifts right with increase in
aggregated demand variables; AD curve shifts downwards to the left with decline in
aggregate demand. For e.g. in case there is a tax increase (figure 22.3), less disposable
income is left for consumption with people. Say that, the economy begins in short run
equilibrium at point B. Govt levies tax on the income earned that leaves lesser disposable
income available for consumption. This would result in the decrease of aggregate demand
and cure would shift left AD. If there is no change in aggregate supply, the economy
will reach a new equilibrium point C. Note that output declines form Q to Q. In addition,
prices are now lower than they were before equilibrium, and the rate of inflation falls.
The case of economic expansion is just the opposite as shown in previous section.
Economics for
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To conclude, we can say that business fluctuations in output, employment, and

prices are often caused by shifts in aggregate demand. These occur as consumers,
businesses or government change total spending relative to economys productive
capacity. When these shifts in aggregate demand lead to sharp business downturns, the
economy suffers recession or even depression. A sharp turn in economic activity can
lead to inflation.
22.5 Business Cycle and Multiplier Model
To understand the changes in investment due to innovations, fluctuations in

government spending, shocks in financial markets, multiplier model is the simplest
way to understand business cycle. In our initial discussion we had learnt how investment
and consumption spending interact with incomes to determine national output. It was
called the total expenditure approach. In line with the consumption function graph that
we had drawn in the previous section of unit, we shall develop similar figure here to
explain the change in equilibrium level due to any positive or adverse affect on the
expenditure due to fluctuations in the business cycle.
In this section we shall understand that; basic macroeconomic theory of business

cycles holds that shifts in aggregate demand produce the frequent and unpredictable
fluctuations in output, prices, and employment level of business cycles. We try to
understand the mechanism by which changing in spending gets translated change in
output and employment. This approach is known as Keynesian multiplier model.
Multiplier model states that each dollar change in exogenous expenditure (such
as investment) leads to more than a dollar change (or a multiplied change by amount of
x times) in GDP. They key assumption underlying this model is that wages and prices
are fixed and there are unemployed resources in the economy.
In the figure 22.4 drawn below, relationship between total expenditure-output is

Economics for
depicted. This diagram is also referred as Keynesian cross because it shows how
Managers : 286
output equals expenditure when the expenditure curves crosses the 45 degree line. Any Business Cycles
point on the 45 degree line depicts a vertical distance exactly equal to the horizontal
distance. We begin to by drawing consumption function, CC. We then add total
investment to consumption. In real world, investment depends upon interest rates, tax NOTES
policy and business confidence. To simplify things, we assume investment as exogenous
variable, one whose level is determined outside the model. If investment opportunities
are such that investment would be exactly $200 billion per year regardless of the level
of GDP, investment schedule then is stacked on the top of consumption schedule. We
can observe that C+I curve is higher than C curve exactly by the constant amount of I.
This parallel feature indicates that investment in constant. Adding C + I gives total
expenditure (TE) curve of total desired investment plus consumption spending. Along
the 45 degree line, expenditures exactly equals GDP. Equilibrium GDP comes at point
E, which is intersection of the TE line and 45 degree line. This is the only level of GDP
at which the desired spending C + I exactly equals output. At any point on the 45
degree line, total desired expenditure (measured vertically) exactly equals the total
level of output (measured horizontally). We can calculate the equilibrium level of
output in figure 22.4.
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Where planned expenditure, represented by TE curve, equals total output, the

economy is in equilibrium at point E. Equilibrium is a situation where the different
forces at work are in balance. In macroeconomics, an equilibrium level of output is
one where the different forces of spending and output are in balance; in equilibrium,
the level of output persists there until there are changes in the equilibrium. Therefore,
the equilibrium level of GDP occurs at point E, where the planned spending equals to
planned production. At any other output, the total desired spending on consumption
and investment differs from the planned production. Any deviation of plans from actual
levels will cause businesses to change their production and employment levels, thereby
returning the system to equilibrium level of GDP.
A numerical example shall simplify why equilibrium level of output occurs when Economics for
planned spending and planned output are equal. Table 22.2 below shows a simple Managers : 287
Business Cycles example of consumption, saving and output. The break-even level of income, where
consumption equals income is $3000 billion. Each of $300 billion change in income is
assumed to lead to a $100 billion change in saving and a $200 billion change in
NOTES consumption. In other words, the MPC is assumed to be constant and equal to 2/3.
Column 5 & 6 are crucial ones. Column 5 shows the total GDP. It is simply column 1
copied again to column 5. The figure in column 6 represents total planned expenditures
at each level of GDP; that is, it equals the planned consumption spending plus planned
investment. It is C + I schedule from the table.
Table 22.2 GDP Determination where output equals planned spending
1 2 3= 2- 1 4 5 6=2+4 7
Level Planned Planned Planned Level Total Resulting

of GDP Consumption Savings Investment of GDP consumption tendency of
and output
Investment, TE
4,200 3,800 400 200 4,200 4,000 Contraction
3,900 3,600 300 200 3,900 3,800 Contraction
3,600 3,400 200 200 3,600 3,600 Equilibrium
3,300 3,200 100 200 3,300 3,400 Expansion
3,000 3,000 0 200 3,000 3,200 Expansion
2,700 2,800 -100 200 2,700 3,000 Expansion
Reading from top row of table, we see that if firms are initially producing $4200
billion of GDP, planned or desired spending [shown in column 6] is only $4000 billion.
In this situation, excess inventories will be accumulating. Firms will respond by reducing
their production levels and GDP will fall. In the opposite case, represented in the bottom
row of table, total spending is $3000 billion but output is only $2700 billion. Inventories
are being depleted and firms will expand operations, raising output.
As visible from the table, at equilibrium GDP level, where $3,600 that is being
produced is just equal to the households plan to consume and that firms plan to invest
i.e. $3,600. In upper rows, firms will be forced into unintended inventory investment
and will respond by cutting back production until equilibrium GDP is reached. At the
same time, in lower rows, tendency expansion of GDP toward equilibrium.
Thus, we observe from the table that, when business cycle as a whole are
temporarily producing more than they can profitably sell, they will reduce production
and GDP will fall. When they are selling more than their current production, the will
Economics for increase their output, and GDP will rise. Only when the level of actual output in column
Managers : 288 5 exactly equals planned expenditure (TE) in column (6) will the economy be in
equilibrium. This is point of equilibrium where neither contraction nor expansion takes Business Cycles
place.
22.6 Effect of Fiscal Policy on Output NOTES
The measures taken by government to invest more in the economy or taxation

also have multiplier effect on the economy and in the process business cycles are bound
to be affected. We shall now modify earlier analysis by adding G to C + I to get a new
total expenditure curve TE = C + I + G. This new schedule is describes the
macroeconomic equilibrium when government, with its spending and taxing is in picture.
To simplify in the beginning, we assume that taxes collected are held constant. Still,
GDP and disposable income would be differ by equal amount. Thus, after taking account
of such taxes, we shall plot the CC consumption schedule against GDP rather than DI.
(figure 22.5).
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The figure shows original no-tax consumption function as CC. While using same
table in the previous section we have consumption function at 3000 when GDP (and
DI) are 3000. As taxes are introduced of amount 300; at disposable income 3000, GDP
must be equal to 3000+300. Consumption is still 3000 when GDP is 3300 because DI
is 300. Therefore, we can plot consumption as function of GDP by shifting consumption
function rightward to the CC curve. The amount of rightward shift is UV; exactly
equal to the taxes i.e. 300.
In real world, government taxes are not constant and every time government
raises taxes, it reduces the disposable income and thus reduces our consumption; thus
affects aggregate demand.
This can be illustrated by a numerical example. We form a table 22.3 similar to in

the previous section to explain the same. The first column shows a reference level GDP Economics for
while second shows a fixe level of taxes, $300 billion. Disposable income in column Managers : 289
Business Cycles (3) is GDP less taxes. Planned consumption, taken as a function of DI, is shown in
column (4). Column (5) shows the fixed level of planned investment, while column (6)
exhibits the level of government purchases. To find planned expenditures, TE, in the
NOTES column (7), we add together the C, I, and G in columns (4) through (6).
Table 22.3: Government purchases, Taxes, and Investment also determines

Equilibrium GDP
Output determination with government spending (billions of dollars)
1 2 3 4 5 6 7 8
Initial Taxes Disposable Planned Planned Government Total planned Resulting

level of T income consumption Investment expenditure expenditure tendency of
GDP DI C I G TE=C + I +G economy
4,200 300 3,900 3,600 200 200 4,000 Contraction
3,900 300 3,600 3,400 200 200 3,800 Contraction
3,600 300 3,300 3,200 200 200 3,600 Equilibrium
3,300 300 3,000 3,000 200 200 3,400 Expansion
3,000 300 2,700 2,800 200 200 3,200 Expansion
The government expenditure multiplier is the increase in GDP resulting from an

increase of $1 in government purchases of goods and services. An initial government
purchase of a good or service will set in motion a chain of spending; if the government
builds a road, the builders will spend some amount of their income on consumption
goods, which in turn will generate additional incomes, some of which will be spent. In
the simple model examined here, the ultimate effect on GDP of an extra dollar of G
will be the same as the effect of an extra dollar of I; the multipliers are both equal to 1/
(1-MPC). The figure 22.6 below shows how a change in G will result in a higher level
of GDP, with the increase being a multiple of the increase in government purchases.
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Economics for

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It means that an extra $100 billion of G, the C+I+G curve has been shifted by the Business Cycles
same amount. The ultimate increase in GDP is equal to $100 billion of primary spending
times the expenditure multiplier. In this case, because the MPC is 2/3, the multiplier is
3 (i.e. calculated as (1/1-MPC), so the equilibrium level of GDP rises by $300 billion. NOTES
This is referred as expenditure multiplier or investment multiplier. Similarly, if
government expenditure falls, with taxes and other influences held constant, GDP would
decline by the change G times the multiplier.
22.7 Limitations of Multiplier model
Multiplier models have been influential in business cycle theory; but it gives an
oversimplified view of the economy. One of the most significant omissions is the impact
of financial markets and monetary policy of the economy. It also omits the supply side
of the economy as represented by the interaction of spending with aggregate supply
and prices. Additionally, the simplest multiplier model also omits the interaction between
domestic economy and rest of the world. However, we can say that multiplier model is
the simplest model of the business cycle. It focuses primarily on spending changes as
the factors behind short-run output movements. In this approach, fiscal policy is often
used as tool to stabilize economy.
22.8 Real Business Cycles
In recent times, modern classical economists have stated an exciting field known
as real-business cycle theory. This was developed by Finn Kydland and Edward C
Prescott, who won noble prize for his body of work. His approach holds that business
cycles are primarily due to technological shocks.
In this approach, shocks to technology, investment or labour supply change the

potential output of the economy. In other words, the shocks shift a vertical aggregate Check Your Progress
supply curve. These supply shocks are transmitted into actual output by fluctuations of 5. What do you
aggregate supply and are completely independent of aggregate demand. In the similar understand by
manner, movement in the unemployment rate is the result of movement in natural rate multiplier effect? What
of unemployment due to either microeconomic force, such as intensity of sectoral shocks, are its limitations?
or to tax regulatory policies. Standard Keynesian monetary and fiscal policies have no 6. What do you
understand by real
effect on output or employment in RBC model; they affect only aggregate demand and
business cycle?
price level (shown figure 22.7)
Economics for
Managers : 291
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22.9 Summary
The variety of business cycle theories can be grouped into two main categories;
theories of shortages and theories of surplus. The shortage theory states that at full
employment, the economy faces shortages of various factor resources, resulting in
higher inflation and interest rates, lower profit margins, and decline in investment. The
surplus theory states that an increase in the marginal productivity of capital about the
cost of capital generates an investment boom, which eventually leads to excess capacity,
lower profit margin and a decline in investment. In the previous sections of this unit,
this phenomenon has been explained with the changes happening in business cycles
due to change in aggregate demand. Business cycles are recurring but not regular.
While a better understanding of monetary and fiscal policy may reduce the likelihood
and serverity of business cycles still the chance of another exogenous shock causing a
recession in the future, whether it be a war, energy shock or other unforeseen disturbance
remains significant.
22.10 Key Terms
Business cycles are defined as short-term fluctuations happening in the macroeconomic

variables i.e. total national output, income and employment usually lasting
2-10 years, marked by widespread of expansion or contraction in most sectors
of the economy.
Five phases of business cycles include peak, contraction, trough, recovery and expansion
Exogenous theory of business cycles states that business fluctuations are caused due to
the factors outside the economic system, For e.g. oil prices, gold prices,
wars, technological breakthroughs etc.
Internal theory of business cycles states that business fluctuations are caused due to the
Economics for factors lying within the economic system itself. For e.g. speculative booms
Managers : 292 or false expectations
Aggregate demand curve shifts right with increase in aggregate demand variables Business Cycles
resulting expansion in the economy and shifts downward to the left with
decline in aggregate demand resulting in the depression or slowdown in the
economy.
NOTES
Movement along the aggregate demand curve takes place when there is change in price
level and other factors (such as money supply, tax policy, or military spending)
remain constant whereas there is shift in aggregate demand curve when other
factors are no longer constant.
Multiplier model The mechanism by which changing in spending (investment/
government expenditure) gets translated change in output and employment
(GDP). This approach is known as Keynesian multiplier model. These
changes (positive and negative both) do bring in the change in aggregate
demand and produce the frequent and sometimes unpredictable fluctuations
in output, prices, and employment level of business cycles. It is calculated as
M = 1/1-MPC (where MPC is marginal propensity to consume)
Real Business Cycles is relatively new theory developed by modern classical economists
which states that business cycles are primarily due to technological shocks.
22.11 Questions and Excercices

1. Define business cycle and explain various stages of business cycles.
2. What is the difference between movements along the aggregate demand curve
and shifts of the aggregate demand curve?
3. The mechanism, by which, change in spending gets translated change in output
and employment? How Keynes referred this mechanism. Explain.
4. How fiscal policy does affect multiplier model? What are the limitations of this
model?
5. What impact does aggregate demand has on business cycle and which factors do
have impact on aggregate demand?
6. In recent, time which new theory has been developed by economists of Radical
business cycles. State the difference between RBC and Keynesian multiplier model?

(5th Editon), 2005.
3. Macroeconomic : Theory and Policy, D. N. Dwivedi (8th Reprint), 2013. Economics for
Managers : 293

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Yashwantrao MBA 103

Economics for Managers

Director (I/C), School of Commerce & Management : Dr. Prakash Deshmukh

NATIONAL ADVISORY BOARD

Dr. Pandit Palande Prof. Devanath Tirupati, Dr. Surendra Patole

Authors & Editor

Instructional Technology Editing & Programme Co-ordinator

Copyright Yashwantrao Chavan Maharashtra Open University, Nashik.

This is an introductory unit that focuses on the definition of economics and

1.1 Unit Objectives

After studying this unit, you should be able to-

1.2 Economics: An Introduction

1.3 Managerial Economics

As given in Figure 1.1, managerial economics is a field of study which leads to

ECONOMIC THEORY DECISION SCIENCE

Microeconomic Game theory

Nature of managerial economics

Scope of managerial economics

Production Theory and Input-Output Analysis

1.4 Basic Concepts

Microeconomics and Macroeconomics Check Your Progress

1.5 Plan for the books

How to study the units?

1.7 Key Terms

Economics : is about the allocation of scarce resources/means to unlimited wants/

Industry : comprises of firms producing substitutable or similar products.

Opportunity cost of input : is the next best alternative (choices) sacrificed or

1.8 Questions and Excercises

2. How is economics like a science?

3. What is the positive and normative statement? Give an example of each.

5. What do you understand by Managerial Economics? Explain

After studying this unit, you should be able to-

2.2 Supply and Demand

Demand and Supply Side of the Market

where; QD = Quantity Demanded; P = Price

Where; QS = Quantity Supplied; P = Price

2.3 Market Equilibrium

Market Equilibrium Price

Consider the following linear supply function and demand function:

Where QS is quantity supplied; P is price and QD is Quantity demanded.

Price Quantity Supplied Quantity Demanded

Changes in Market Equilibrium

Samuelson discussed about the role of government - as a "Visible Hand." In an

Besides all these imperfections, perfectly competitive market also experience

2.6 Key Terms

Demand Curve: graphical representation of the relationship between the quantity of a

Supply Curve: graphical representation of the relationship between the quantity of a

NOTES 2.7 Questions and Excercises

Price ($) Supply (Million Tonnes) Demand (Million Tonnes)

ii) If P = $25, which of the following is true?

1. R.S. Pindyck and D.L. Rubinfeld.Microeconomics (7th Edition), Pearson

2. Dominick Salvator, Managerial Economics, Sixth Edition, Oxford: New

3. Craig H. Peterson, W. Cris Lewis, and Sudhir K Jain, Managerial

3.1 Unit Objectives

After studying this unit, you should be able to-

Demand is the amount of commodity that a consumer purchases or is ready to

Table 3.1 Demand Schedule

Price of cold-drink per bottle Bottles of cold-drinks demanded

Fig. 3.1 Demmand curve

Reasons for downward slope of the demand curve

MUn = TUn TUn-1 (3.1)

where MU is marginal utility, TU is total utility and n is the number of units

Exceptions to the Law of Demand

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