AMF 103 Managerial Economics Book

AMF103 MANAGERIAL ECONOMICS
PREFACE
This is an attempt to the integration of economic theory with business practices for
the purpose of facilitating Decision Making and Forward Planning by the
management. As economics provides as a set of concepts, these concepts furnish
us the tools and techniques of analysis. It is in this context economic analysis is an
aid to understand business practices in a given environment. As decision making
is a basic function of manager, economics is a valuable guide to the manager. In
the following we shall be discussing the decision making process of the
management and how managerial economics and its various tools and techniques
help a manager in this process.
Master of Finance & Control Copyright Amity university India Page 1

Index
S.I. NOS. CHAPTER TITLE PAGE NO.
Managerial Decision Making
Business Forecasting
Demand Analysis
Cost Analysis
Production Analysis
Objectives of the Firm
Pricing Policy of the Firm
Market Structure

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

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

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

A second and more detailed method is the following:

Identify the problem.
Diagnose the situation.
Collect and analyze data relevant to the issue.
Ascertain solution that may be used in solving the problem
Analyze these alternative solutions.
Select the approach that appears most likely to solve the problem
Implement it.
1.3 Management Decision Problems

Product Price and Output
Production Technique
Stock Levels
Advertising Media and intensity
Labor hiring and firing
Investment and Financing
A practical example can be found in the following:
1.4 Corporate Decision Making : Ford Introduces the Taurus

In late 1985 Ford Introduced the Taurus -a newly designed, aerodynamically
styled, front-wheel drive automobile. The car was a huge success at the time and
helped Ford almost to double its profits by 1987. The design and efficient
production of this car involved not only some impressive engineering advances,
but a lot of economics as well. Ford, had to think carefully about how the public
would react to the Taurus design. Would consumers be swayed by the styling and
performance of the car? How strong would demand depend on the price Ford

changed? Understanding consumer preferences and trade-offs and predicting

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

division be charged for engines it receives from another division? Should all the
parts be obtained from the upstream divisions, or other firms? All these decision
come under managerial decision taking process.
1.5 Types of Decision

Managers make many decisions, in order to answer the following questions:
What goods shall firm produce?
How should firm raise the necessary capital and what shall be its legal form.
What technique shall be adopted, and what shall be the scale of operations?
Where production is located?
How shall its product be distributed?
How shall resources be combined?
What shall be the size of output?
How shall it deal with its employees?
Managers make these decisions, and in order to obtain a clear understanding of the
decision making process, a classification system is useful. Three such systems are
available; each based on different types of decisions.
Organizational and personal decisions,
Basic and routine decisions
Programmed and non-programmed decisions.
Organizational decisions are those executives make in their official role as

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

1.6 Conditions Affecting Decision Making

In an ideal business situation, managers would have al of the information they
need to make decisions with certainty. Most business situations however are
characterized by incomplete or ambiguous information, which affects the level of
certainty with which a manager makes a decision. There are three conditions that
affect decision making:
Certainty
Risk
Uncertainty
Certainty is the condition that exists when decision makes are fully informed
about a problem its alternative solutions, and their respective outcomes. Under this
condition, individuals can anticipate, and even exercise some control over, events
and their outcomes.
In the context of decision making, risk is the condition .that exists when decision-
makers must rely on incomplete, yet reliable information. Under a state of risk, the
decision-maker does not know with certainty the future outcomes associated with
alternative courses of action; the results are subjects to chance. However, the
manager has enough information to determine the probabilities associated with
each alternative. He or she can then choose. The alternative that has the highest
probability of success.
Uncertainty is the condition that exists when little or no factual information is
available about a problem, its alternative solution, and their respective outcomes.
In a state of uncertainty, the decision-maker does not have enough information to
determine the probabilities associated with each alternative. In actually, the
decision-maker may have so little information that he or she may be unable even
to define the problem, let alone identify alternative solutions &possible outcomes.

1.7 The Steps of Decision Making

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

1.8 Selecting the Best Alternative

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

This is the step in the decision making process that transforms the selected
alternative from an abstract situation into reality. Implementing the decision
involves planning and executing the actions that must take place so that the
selected alternative can actually solve the problem.
1.10 Evaluating the Decision

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

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

1.11.1 The Classical Model

The classical model of decision making is a prescriptive approach that outlines
how managers should make decisions. Also called the rational model, the classical
model is based on economic assumptions and asserts that managers are logical,
rational individuals who make decision that are in the best interest of the
organization. The classical model is characterized by the following assumptions:
The manager has completed information about the decision situation and
operations under a condition of certainty.
The problem is clearly defined, and the decision-maker has knowledge of
all possible alternatives and their outcomes.
Through the use of quantitative techniques, rationality, and logic, the
decision-maker evaluates the alternatives and selects the optimum
alternative -the one that will maximize the decision situation by offering the
best solution to the problem.
1.11.2 The Administrative Model

The Administrative model of decision making is a descriptive approach that
outlines how managers actually do make decisions. Also called the organizational,
neoclassical, or behavioral model, the administrative model is based on the work
of economist Herbert A. Simon recognized that people do not always make
decisions with logic and rationality, and he introduced two concepts that have
become hallmarks of the administrative model- bounded rationality and satisfying.
Bounded rationality means that people have limits, or boundaries, to their
rationality. These limits exist because people are bound by their own values and
skills, incomplete information, and their own inability-due to time, resource, and
rational decisions. Because managers often lack the time of ability to process

complete information about complex decisions, they usually wind up having to

make decisions with only partial knowledge about alternative solutions and their
outcomes. this leads managers often forgo the six steps of decision making in
favor of a quicker, yet satisfying, process- satisficing. The Administrative model
of decision making also have some basic assumptions:
The manager has incomplete information about the decision situation and
operates under a condition of risk or uncertainty.
The problem is not clearly defined, and the decision-maker has limited
knowledge of possible alternatives and their outcomes.
The decision-maker satisfies by choosing the first satisfactory alternative-
one that will resolve the problem situation by offering a good solution to the
problem.
1.12 Decision Making Techniques

It is useful to examine some of the specific technique that has proved valuable in
the decision making process, two of which are marginal analysis and financial
analysis.
1.12.1 Marginal Analysis
The "marginal product" of a productive factor is the extra product or output added
by one extra unit of that factor, while other factors are being held constant.
Labors marginal product is the extra output you get when you add one unit of
Labor holding all other inputs constant. Similarly, land's marginal -product is the
change in total product resulting from one additional unit of land with all other
inputs held constant. The manager can use the concept to answer questions such as
how much more output will result if one more worker is hired? The answer often

called marginal physical product, provides a basis for determining whether or not
one new man will bring about profitable additional output.
1.12.2 Financial Analysis
The firms are supposed to safeguard their interest and avert the possibilities of risk
or try to minimize it. For this a firm needs to analyze the assets as well as
liabilities, efficiency of capital investment, choice of project and various vital
ratios. The cost benefit analysis ensures the firms to take prudent financial
decision.
1.13 Group Decision Techniques

There are several group decision techniques:
1.13.1 Brainstorming
Brainstorming is a technique in which group members spontaneously suggest keys
to solve a problem. Its primary purpose is to generate a multitude of creative
alternatives, regardless of the likelihood of their being implemented.
1.13.2 Nominal Group Technique
The Nominal Group Technique involves, the use of highly structured meeting
agenda and restricts discussion or interpersonal communication during the
decision making process. While the group members are all physically present,
they are required to operate independently.
1.13.3 Delphi Group Technique
The Delphi group Technique employs a written survey to gather expert opinions
from a number of people without holding a group meeting. Unlike in
brainstorming and nominal groups, Delphi group participants never meet fact to
face; in fact, they may be located in different cities and never see each other.

1.14 Decision Making Tools

The major decision- making tools are as under:
1.14.1 Linear Programming:

One of the most widely used techniques is that of linear programming. It has been
described as a technique for specifying how to use limited resources or capacities
of a business to obtain a particular objective, such as least cost, highest margin, or
least time, when those resources have alternative uses. It is a technique that
systematizes for certain conditions the process of selecting the most des able
course of action from a number of available courses of action, thereby giving
management information for making a more effective decision about the resources
under its control.
All linear programming problems must have two basic characteristics. First, two
or more activities must be competing for limited resources. Second, all
relationships in the problem must be linear.
Linear programming can be used in the solution of many kinds of allocation
decision problems, but its application is certainly limited. For example, to be
employed effectively the decision problem must be formulated in quantitative
terms. Nevertheless, the approach has many advantages and its application in the
area of business decision making is increasing.
1.14.2Inventory Control
A problem faced by managers is that of maintaining adequate inventories. On the
one hand, no one wants to have too many units available because there are costs
associated with carrying these customerss future business.
There are two types of costs that merit the manager's consideration. One way for
the manager to solve the inventory problem is to make certain assumptions

regarding future demand and then attempt a solution. Three of the most common
assumptions made in determining optimal inventory size are: demand is known
with certainty; the lead time necessary for recording goods is also known with
certainty; and the inventory will be depleted at a constant rate. Now, the manager
has to decide if he or she wishes to use what can be labeled a trial-and -error
approach, or if he wants to employ an OR (Operations Research) tool known as
the economic order quantity formula which can be given by:
OQ = {2DA} vr

Where:
D = expected annual demand
A = Administrative costs per order
V = Value per item
r = Estimate for taxes, insurance and other expenses
The EOQ formula is used by many firms in solving inventory control problems.
However, it is only one of many mathematical techniques that lave been
developed to help the manager make decisions.

Another important tool in taking one of the most economical decisions is

"Decision Trees"
Many managers weight alternatives base don their immediate or short-run results,
but a decision- tree format permits a more dynamic approach because it makes
some elements explicit that are generally implicit in other analyses. A decision
tree is a graphic method that the manager. can employ in identifying the
alternative courses of action available to him in solving a problem; assigning
payoff corresponding to each act-event combination.
For example, consider the case of a firm that has expansion funds and must decide
what to do with them. After careful analysis, three alternatives identified:
Use the money to buy a new company
expand the facilities of the current firm
put the money in a saving account
And wait for better opportunities. In deciding which alternative is best, the
company has gathered all the available information and constructed the decision
tree.
In the figure there are four important components. One is the decision point,
represented by a square, which indicates where the decision maker must choose a
course of action. second is a chance point, represented by a circle, which indicates
where a chance event is expected, such as solid economic growth, stagnation, or
high inflation. A third is the branch, represented by a line flowing from the chance
points, which indicates an event and its likelihood such as 0.5 per solid growth,
0.3 for stagnation or 0.2 for high inflation. Finally, at the far right is a payoff
associated with the each branch. It is called a conditional payoff since its
occurrence depends on certain conditions. For example, in figure the conditional

ROI (Return on Investment) associated with buying a new firm and having solid
economic growth is 15 per cent, but this return is conditional on the two preceding
factors (buying the firm and having solid growth).
In building a decision tree, the company will start by identifying the three
alternatives, the probabilities and events associated with each alternative, and the
amount of return that can be expected from each. Having then constructed the tree,
the firm will roll back it from right to left, analyzing as it goes.
This analysis is conducted, first by taking the conditional ROls at the far right of
the tree and multiplying them by the probability of their occurrence. For example,
if the company buys a new firm and there is solid growth in the economy, as seen
in figure, it will obtain a 15 per cent ROL However, the probability of such an
occurrence is 0.5 Likewise, the probabilities associated with stagnant growth,
where the return will be 9 percent, and high inflation, where the return will be 3
percent, are .3 and .2 respectively. In order to determine the expected return
associated with buying a new firm, each of the conditional ROls is multiplied by
its respective probability and the products are then totaled. For alternative one,
buying the firm, the calculation is as follows:
Conditional ROI Probability Expected Return
15.0 0.5 7.5
9.0 0.3 2.7
3.0 .02 0.6
10.8

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

10.0 0.5 5.0
12.0 0.3 3.6
4.0 0.2 0.8
9.4
For alternative three, expanding current facilities, the calculation is:

6.5 0.5 3.25
6.0 0.3 1.80
6.0 0.2 1.20
6.25
These expected returns are often placed over the chance points on the decision
tree. They can be determined only after the tree has been drawn and the analysis of
the branches has been conducted. The first alternative is the best, because it offers
the greatest expected return. In evaluating alternatives, decision these help the
manager identify both what can happen and the likelihood of its occurrence .In
building the tree we moved from left to right but in analyzing we moved from
right to left. In the final analysis the decision tree does not provide any definitive
answers. However, it does allow the manager to allow benefits against costs by
assigning probabilities to specific events and then ascertaining the respective
payoff.

END CHAPTER I QUIZZES :
Q.1. The Technique that employs a written survey to gather expert opinions from
a number of people without holding a group meeting is known as -
(a) Brainstorming
(b) The Delphi group Technique
(c) The Nominal Group Technique
(d) None of the above
Q.2. Approval of Plans is the best example of -
(a) Organizational decisions,
(b) Basic decisions
(c) Programme decisions.
(d) Both (a) & (c)
Q.3. Which sort of decision does not require the organizational support-
(a) Basic decision
(b) Routine decision
(C) Personal decision
(d) Organizational decision
Q.4 In the context of formulation of an investment decision on a project, the

availability of land, plant, machinery, raw materials and technical know how etc.
means-

(a) Technical Feasibility
(b) Financial feasibility
(c) Commercial feasibility
Q.5. The method of inventory valuation & thereupon decision making in which,
the cost of production is calculated on the assumption that the material which was
last to enter the inventory of the company was used first is
(a) LIFO
(b) FIFO
(c) F I LO
Q.6. Which out of following is significant threat in front of a manager in his

decision making related to technological up gradation?
(a) Conflict of Interest
(b) Time & Resource constraints
(c) Both A & B
Q.7. Knowing the problem, its possible alternative solutions and their respective
outcomes in the decision making process of a manager refers to the condition of
(a) Risky information,
(b) Certainty
(c) Uncertainty of probable action,
(d) Risk & Uncertainty

Q.8. Prescriptive approach that outlines how managers should make decisions is
(a) Administrative Model of decision making
(b) Rational Model of decision making
(c) Alternative Model of decision making
(d) Both (b) & (c)
Q.9. The use of highly structured meeting agenda and restricted discussion or
interpersonal communication during the decision making process is known as
(a) Nominal Group Technique,
(b) Brainstorming,
(c) Delphi Group Technique,
(d) Both (b) & (c)
Q.10. In identifying the alternative courses of action available to a manager while

solving a problem, a decision tree is
(a) More dynamic in nature,
(b) Graphical method,
(c) Assigns payoff corresponding to each act-event combination,
(d) All of the above.

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

1.8.2 Exponential smoothing technique
1.9 Risks in Demand Forecasting

1.1 Introduction
Estimation of demand for a product in a forecast year/ period is termed as Demand

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

Better planning and allocation of resources
Appropriate production scheduling
Inventory control
Determining appropriate pricing policies
Setting s les targets and establishing controls and incentives.
Planning a new unit or expanding existing one
Planning long term financial requirements
Planning Human Resource Development strategies.
1.3 Steps Involved in Forecasting
Identification of objective
Determining the nature of goods under consideration.
Selecting a proper method of forecasting.
Interpretation of results.
1.4 Period of forecasting

Short run forecasting: In short run forecasting, we look for factors which
bring fluctuation in demand pattern in the market for example weather
conditions like monsoon affecting the demand.
Medium run forecasting: In medium run forecasting is done basically for
timing of an activity like advertising expenditure.
Long run forecasting: It is done to ascertain the validity of trend. It is done
for decision like diversification.
1.5 Levels of Forecasting

Macroeconomic forecasting is concerned with business conditions of the
whole economy. It is measured with the help of indices like wholesale
price index, consumer price index.
Industry demand forecasting gives indication to firm regarding direction in
which the whole industry will be moving. It is used to decide the way the
firm should plan for future in relation to the industry.
Firm demand forecasting is done for planning companies overall operations
like sales forecasting etc.
Product line forecasting helps the firm to decide which of the product or
products should have priority in the allocation of firm's limited resources.

General purpose or specific purpose forecast helps the firm in taking
general factors into consideration while forecasting for demand.
Forecast of established product or a new product
Types of commodity for which forecast is to be done. Goods can be broadly
classified into capital goods, consumer durable and Non-durable consumer
goods. For each of these categories of goods there is a distinctive pattern of
demand.

1.6 Methods of Forecasting

1.6.1Qualitative Forecast
1.6.1.1 Survey techniques
Survey of business executives, plant and equipment, expenditure
plans. Basically compilation of expenditure plans of related
industries.
Survey of plans for inventory changes and sales expectations.
Survey of consumer expenditure plans.

1.6.1.2 Opinion pools

Consumer survey: In this method the consumers are contacted
personally to disclose their future purchase plans. This could be of
two types-Complete enumeration and sample survey.
Sales force opinion method: In this method people who are
closest to the market are asked for their opinion on future demand.
Then opinion of different people is compiled to get overall
demand forecast. This method has advantage that it is based on
first hand knowledge of sales people and also it is cheap and easy.
However the opinion of the concerned people could be biased or
twisted for their own benefit. Therefore a final ratification has to
be done by the head office.
Experts opinion method: In this method opinion of experts' in
the related field is solicited and the final forecast based on their
opinion. A special case in this method is the Delphi Technique. In
this different sets of experts are given the relevant problem
without each knowing about the other and their opinions or
conclusions are compared. If the opinion is matching then the
opinion is accepted other wise the experts are asked to sit together
and arrive at a narrow range. Thus the experts giving a very high
or a very low value are concerned and the group argues until it
comes up with a narrow range of value. This process is continued
till a sufficient range is reached. Then the mean of the upper and
lower values is computed to reach a point estimate.

1.6.2 Statistical Forecast
1.6.2.1 Trend projection method

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

plotting of the data on the graph and estimating where the trend line
lies. The line can be extrapolated and the forecast read from the
graph.
Trend through least squares method: This method uses statistical

formulae to find the trend line which best fits the available data. The
trend line is the estimating equation, which can be used for
forecasting demand by extrapolating the line for future and reading
the corresponding values of variables on the graph.
Time series analysis: This is an extension of linear regression which
attempts to build seasonal and cyclical variations into the estimating
equation. This method assumes that past data can be used to predict
future sales. This is one of the most frequently used forecasting

methods. It refers to he values of variable arrange chronologically by

days, weeks, months, quarters or years. The first step in time series
analysis is usually to plot past values of the variable that we seek to
forecast on vertical axis and the time on the horizontal axis in order to
visually inspect the movement of the time series over time. It
assumption is that the time series will continue to move as in the past.
For this reason time series analysis is often referred as "native
forecasting.
1.6.2.2 Barometric methods
Barometric methods are used to forecast or anticipate short term changes in
economic activity by using leading economic indicators. These indicators
are time series that tend to precede changes in the level of economic
activity. There are only three types of indicators:
Leading economic indicator: These indicators tend normally to
anticipate turning points in a business cycle. There are certain
problems associated with this method. The major problem is not
choosing the technique but choosing the relevant indicator for the
product in question. Secondly even if the relevant indicator is found
out the changes in factors may render the indicator redundant over
time. Thirdly the time lag between the indicator and forecast could be
so small that it could become useless.
Coincident indicators: These are indicators which move in step or
coincide with movements in general economic activity or business
cycle.
Lagging indicator: These are indicators which lag the movements in
economic activity or business cycle.

1.6.2.3 Regression method

It is one of the statistical tools to fore cast demand. In this estimating
equations are established and tests can be carried out to observe any
statistically significant. It involves following steps
Identification of variables which influence the demand for the good
whose function is under estimation.
Collection of historical data on all relevant variables.
Choosing an appropriate form of the function.
Estimation of the function
Regression method is popular because it is prescriptive as well as
descriptive. Also it is not as subjective or objective as other methods.
However if the variables chosen are wrong then the forecast will also
be wrong. A typical demand equation could be :
Log d = -12.4 + 1.78 log y -1.22 log 0 + 2.20 log v + 0.8 log g + 1.62
log e
Y = National income
O = groundnut oil price
V = Vanaspati price
G = ghee price
E = egg, fish and meat price
The above equation is a demand forecast equation for groundnut oil

1.6.2.4.Simultaneous equation method (Econometric Models)

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

complex that a multiple equation model may be required. This is
particularly used in forecasting micro variables or the demand and sales of
major sectors or industries. Multiple equation model for GNP
Ct = a1+b1GNPt+u1t
It =a2+b2IIt-1+U2t

GNPt= Ct+ It+Gt

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

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

1.6.2.5.1 Uses and shortcomings of input output forecasting
Input output analysis and forecasting has many uses and applications. It is
used by the firm to forecast the raw material, labor and capital requirement
needed to meet the forecasted change in the demand for their product. The
shortcomings are that the direct and total coefficients are assumed to be
fixed and thus do not allow input substitution. Input output tables are
usually available with a time lag of many years and while the input output
coefficients do not change very rapidly they can become very biased.
1.7 Reasons for fluctuations in time series data

Changes occur in secular trend i.e. long run increase or decrease in data
series.
1.7.1 Cyclical fluctuations
There are the major expansions and contractions in most economic time
series data that seem to re-occur every several years.. A typical cycle could
last 15-20 years.
1.7.2 Seasonal variation
This refers to regularly recurring fluctuations in economic activity during
each year e.g. a typical factor could be weather and social customs.
1.7.3 Irregular and random variation
This is the variations in the data series resulting from unique events like
wars, natural disasters or strikes. The total variation in the time series is the
result of all the above four factors operating together. They are usually
examined separately by qualitative techniques.

1.8 Smoothing Techniques

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

The simplest smoothing technique is the moving average. Here the
forecasted value of a time series in a given period is equal to the average
value of the time series in a number of previous periods. This method is
more useful the more erratic or random is the time-series data.
1.8.2 Exponential smoothing technique
This technique is used more frequently than simple averages in forecasting.
This method is a refined version of moving average method. The
disadvantage of moving average method is that it gives equal weightage to
the data related to different periods (i.e. months) in the past. According to
exponential smoothing method more recent the data the more relevant it is
for forecasting and therefore it would be more appropriate to give more
weightage to recent observations. The value given to weightage is normally
chosen to form a geometric progression.
With exponential smoothing, the forecast for period t +1 (i.e. Ft + 1) is a
weighted average of the actual and forecasted values of the time series in
period. The value of the time series at period t (i.e. At) is assigned the
weight of 1-w6. The greater the value of w, the greater is the weight given
to the value of the time series in period as opposed to previous periods.
Thus, the value of the forecast of the time series in period t +1l is Ft + 1 =

WA1 + (1-w) Ft.

In general, different values of W are tried, and the one that leads to the
forecast with smallest root-mean-square error (RMSE) is actually used in
forecasting.
1.9 Risks in Demand Forecasting
Demand forecasting faces two major risks
Overestimation of demand
Underestimation of demand
One risk arises from entirely unforeseen events such as war, political
upheavals and natural disasters. The second risk arises from inadequate
analysis of the market.
All these forecasting errors could possibly have been avoided

through:
Carefully defining the market for the product to include all potential
users of the market and considering the possibility of product
substitution.
Dividing total industry demand into its components and analyzing

each component separately.
Forecasting the main driver or user of the product in each segment of

the market and projecting how they are likely to change in the future.

END CHAPTER III QUIZZES :
1. Out of the given plannings, short run forecasting is required for
(a) Expansion of the existing units
(b) New unit planning
(c) Sales forecasting
(d) capital planning
2 This forecasting technique helps the firm to decide which of the

product or products should have priority in the allocation of firm's
limited resources.
(a) Product line forecasting
(b) Industry demand forecasting
(c) Firms demand forecasting
(d) Sales Forecasting
3. In Sales force opinion method, opinion of sales people is collected to

forecast the future demand, because
(a) They cannot deny from providing the information.
(b) They are paid by the company.
(c) They are the only experts of consumer behaviour.
(d) Sales People are closely associated with the market.
4. Reasons for fluctuations in time series data may occur due to

(a) Seasonal variation (c) Irregular and random
(b) Cyclical fluctuations variation (d) All of the

above

5. Which one is not a type of Barometric Indicator?
(a) Leading economic indicator
(b) Coincident indicators
(c) Lagging indicator
(d) Climate indicator
6. The disadvantage of this technique is that it gives equal weightage to

the data related to different periods (i.e. months) in the past.
(a) Moving average smoothing technique
(b) Exponential smoothing technique
(c) Input Output Forecasting
7. Which of the following step may help in avoiding or minimizing the

errors in business forecasting?
(a) Carefully defining the market for the product to include all
potential users of the market and considering the possibility of
product substitution.
(b) Dividing total industry demand into its components and analyzing
each component separately.
(c) Forecasting the main driver or user of the product in each segment
of the market and projecting how they are likely to change in the
future.
(d) All of the above

8. This forecasting technique incorporates or utilizes the best features

of other forecasting techniques such as trend and seasonal variation,
smoothing techniques and leading indicators.
(a) Regression Technique

(b) Econometric forecasting
( c) Barometric methods
9. Variation in Data occurring due to regularly recurring

fluctuations in economic activity during each year is
(a) Cyclical fluctuations
(b) Seasonal Variations
(c) Random Variation
(d) Irregular Variation
10. In this technique two types of matrices i.e. Direct Requirement

Matrix and Total Requirement Matrix are used to forecast the demand.
(a) Regression Technique
(b) Exponential smoothing technique
(c) Input Output Forecasting
(d) Econometric forecasting

CHAPTER III
DEMAND ANALYSIS
CONTENTS:
1.1 Meaning of Demand

1.2 Types of Demand
1.2.1 Individual and Market Demand
1.2.2 Autonomous and derived demand
1.2.3 Demand for durable and nondurable goods
1.2.4 Demand for firms product and industry
product
1.2.5 Demand for consumers and producers goods
1.3 Determinants of Demand
1.4 Demand Function
1.5 Law of Demand
1.6 Demand Schedule
1.7 Demand Curve
1.8 Shift of Demand Curve v/s Movement along the demand curve
1.9 Effect of a Price Change
1.10 Elasticities of Demand
1.10.1 The Price Elasticity of Demand
1.10.1.1 The relationship between marginal revenue
and price elasticity
1.10.1.2 Determinants of Price Elasticity of Demand
1.10.1.3 Price elasticity and Decision Making
1.11 Classification of Goods
1.12 Exceptions to the Law of Demand Upward Sloping
Demand Curve
1.13 Theory of Consumer Behaviour
1.13.1The Cardinal Utility Theory
1.13.1.1 Equilibrium of Consumer

1.13.2The Ordinal Utility Theory
1.13.2.1Equilibrium of Consumer
1.13.2.2 Properties of Indifference Curve
1.14 The consumer surplus

1.1 Meaning of Demand
Conceptually, demand can be defined as the desire for a good backed by the
ability and willingness to pay for it. The desire without adequate purchasing
power and willingness to pay do not become effective demand and only an
effective demand matters in economic analysis and business decisions.
1.2 Types of Demand
The demand for various commodities is generally classified on the basis of

the consumers of the product, suppliers of the product, nature of goods,
duration of the consumption of the commodity, interdependence of demand,
period of demand and nature of use of the commodity(intermediate or
final).
Individual and Market Demand
Autonomous and derived demand
Demand for durable and nondurable goods
Demand for firms product and industry product
Demand for consumers and producers goods
1.2.1 Individual and Market Demand
The quantity of a commodity which an individual is willing to buy at a

particular price during a specific time period given his money income, his
taste and prices of other commodities is called individuals demand for a
commodity. On the other hand market demand of a commodity is the
summation of individual demand by all the consumers. Market demand is a
multivariate relationship and determined by many factors simultaneously.
Some of the most important determinants of the market demand for a

particular commodity are its own price, consumers income, prices of other
commodities, consumers taste, income distribution, total population,
consumers wealth, credit availability, Government policy, past level of
income and past level of demand.
1.2.2 Autonomous and derived demand
The demand for a commodity that arises on its own out of a natural desire to
consume or possesses a commodity independent of the demand of other
commodities, which may be substitute or complementary or on the raw
material side or on the product side, the demand for the product is termed as
independent. Commodities like tea and vegetables do come on absolute
terms. On the other hand if the demand for a product is tied to the demand
for some parent product, the demand is termed as derived demand.
1.2.3 Demand for durable and nondurable goods
Durable goods are those whose total utility is not exhausted in a single or
short run use. Such goods can be used repeatedly over a period of time.
Durable goods may be consumer goods as well as producer goods. The
demand for durable goods changes over a relatively longer period.
Perishable (non-durable) goods are defined as those which can be used only
once. Their demand is of two types. Replacement of old products and
expansion of existing stock. The demand for nondurable goods depends
largely on their prices, consumer income and is subject to frequent change.

1.2.4 Demand for firms product and industry product
Firms demand denotes the demand for the products by a particular

company or firm whereas industry demand is the aggregation of demand for
the product of all the firms of an industry as a whole. A Clear understanding
of the relation between company and industry demand necessitates the
understanding of different market structures. These structures can be
differentiated the basis of product differentiation and number of sellers.
1.2.5 Demand for consumers and producers goods

Consumer goods are those, which are, meant for the final consumption by
the consumers or the end users. Producer's goods on the other hand are used
for the production of consumer goods or they are intermediate goods, which
are further processed upon to convert them into a form to be used by the end
user. Another distinction is that the demand for producers goods is derived
demand and it indirectly depends on the demand for the consumer goods
which the producer goods is used to produce. It may also be possible that
this demand may be accelerated or accentuated in the same proportion as
the change in the demand for the final consumer goods. A small change in
the demand for consumer goods may either completely wipes out the
demand for the producer goods or may accelerate it.
1.3 Determinants of Demand
Commoditys Own Price
Prices of related goods Substitutes and Complements
Income level of consumer
Tastes & Preferences
Expectations
Population
Other exogenous factors
1.4 Demand Function
The determinants of quantity demanded when summarized in the form of

functional notations are called a demand function. A typical demand
function can be specified as follows:
Dn = f( pn, p1, p2,.pn-1, Y,T, Ep, Ey, Ad. Exp., N, D, u)
Where pn = price of n product
P1Pn-1 = Prices of other products
Y = income level of consumers
T = Taste and preferences of consumers
Ep = expected prices
Ey = expected income
Ad. Exp. = advertising expenditure
N = number of consumers
D = distribution of consumers
u = other factors
1.5 Law of Demand
There is negative relationship between price of a product and quantity

demanded of that product, ceteris paribus i.e., other factors remaining
constant.

1.6 Demand Schedule
A demand schedule is one way of showing the relationship between

quantity demanded and price, all other things being held constant.
Price($ per Quantity demanded

dozen) (dozen per month)
0.50 7.0
1.00 5.0
1.50 3.5
2.00 2.5
2.50 1.5
3.00 1.0
1.7 Demand Curve
Demand curve is the graphical representation of the relationship between

price and quantity demanded of a good, all other things being held constant.
A demand curve is said to be linear when its slope is constant all along the
curve, whereas for a nonlinear or curvilinear curve the slope never remains
constant. The linear demand curve may be written in the form of;
Q b0 @b1 P

P P
Q Q
Linear Demand Non Linear Demand
Curve Curve
1.8 Shift of Demand Curve v/s Movement along the demand curve
A movement along the demand curve is in response to a change in price and

leads to expansion or Contraction of Demand. This is called Change in
Quantity Demanded. On the other hand Shift in the demand curve either
upward or downward is in response to a change in one of the other
determinants of demand.

1.9 Effect of a Price Change
Price Effect
Income Effect A price change causes Real Income to change and

therefore consumption of both goods changes
Substitution Effect Price change of one good causes the relative

price of the two goods to change and consumers substitute the
relatively cheaper good for the more expensive one.
1.10 Elasticities of Demand
There are as many elasticities of demand as its determinants. The most

important of these elasticities are:
Price elasticity of demand
Income elasticity of demand
Cross elasticity of demand
1.10.1 The Price Elasticity of Demand
The price elasticity is a measure of the responsiveness of demand to

changes in the commoditys own price. For very small changes in price
point elasticity of demand is used as a measure of responsiveness of
demand and arc elasticity of demand is the suitable measure for
comparatively large changes in price.
The point elasticity of demand is defined as the proportionate change in the

quantity demanded resulting from a very small proportionate change in
price. Symbolically it is written as;
dQ dP dQ P
e p ffffffffffD fffffffffOr e p ffffffffffAfffff
Q P dP Q

If the demand curve is linear

Q bo @b1 p
Its slope is dQ/ dP @b1 Asubstituting in the elasticity formula we obtain
Pfffff
e p @b1 A
Q
Which implies that the elasticity changes at the various points of the linear
demand curve?
The range of values of the elasticity is

0 ep 1
If e p 0, the demand is perfectly inelastic.

If ep 1 , the demand is perfectly elastic
If e p 1, the demand is unitary elastic, total expenditure remain constant

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

1.10.1.1 The relationship between marginal revenue and price elasticity
The marginal revenue is related to the price elasticity with the formula
f g
1fff
MR p 1 @
e
This is a crucial relationship for the theory of pricing
Proof
The total revenue is

D b cE
TR PQ f Q Q
The MR is
pQ dQ dP dP
MR d fffffffffff P ffffffffff Q ffffffffff P Q ffffffffff
dQ dQ dQ dQ
The price elasticity of demand is defined as

dQ
e p @ ffffffffff fffffff
dP Q
Rearranging we obtain
P dP
fffffffff ffffffffff
@
eQ dQ
Substituting dP/ dQ in the expression of the MR we have

dP
ffffffffff P
fffffffff Pfffff
MR P Q P @Q P@
dQ eQ e
f g
1fff
MR p 1 @
e
We may summarize this relationship as follows:
If the demand is inelastic (e < 1) an increase in price leads to an

increase in total revenue and vice versa.
If the demand is elastic (e>1) an increase in price will lead to a

decrease in total revenue and vice versa.
If the demand has unitary elasticity (e =1), total revenue is not

affected by changes in price.
1.10.1.2 Determinants of Price Elasticity of Demand
Number and availability of Substitutes
The proportion of income spent on the particular commodity
Nature of the need that the product satisfies
Length of time period under consideration
The number of uses to which a commodity can be put
1.10.1.3 Price elasticity and Decision Making
Information about price elasticities can be extremely useful to

managers as they contemplate pricing decisions.
If demand is inelastic at the current price, a price decrease will result

in a decrease in total revenue.
Alternatively, reducing the price of a product with elastic demand

would cause revenue to increase.
Remember TR = P*Q

1.10.2 The income elasticity of demand
The income elasticity of demand is defined as the proportionate change in

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

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

exy ffffffffffffD ffffffffffff ffffffffffff
y y
A
Qx P y dP y Qx
1.11 Classification of Goods

Normal Goods Demand Increases as Income increases
Inferior Goods Demand decreases as consumer Income increases

Basic Necessities Commodities like salt, food grains etc for which
demand is relatively inelastic and does not vary with income after a
point
1.12 Exceptions to the Law of Demand Upward Sloping Demand

Curve
Giffen Goods a subclass of Inferior goods for which the income

effect outweighs the substitution effect
Veblen Products / Snob effect Goods that have a snob value

attached to them for which demand actually increases as price goes
up
Speculative Effect In periods of rising prices, anticipation of future

increases may cause consumers to demand more
Bandwagon Effect Occurs when people demand a commodity only

because others are demanding it and in order to be fashionable
Emergencies like war, famine etc.
1.13 Theory of Consumer Behaviour
The consumer is assumed to be rational. Given his income and the market
prices of the various commodities, he plans the spending of his income so
as to attain the highest possible satisfaction or utility. This is the axiom of
utility maximization. In order to attain this objective the consumer must be
able to compare the utility of the various baskets of goods which he can
buy with his income. There are two basic approaches to compare the
utilities, the cardinalist approach and the ordinalist approach.

1.13.1The Cardinal Utility Theory
The cardinal school stated that utility can be measured. Under certainty i.e.,
complete knowledge of market conditions and income levels over the
planning period utility can be measured in monetary units, called utils.
There are certain assumptions of cardinal utility theory.
Rationality of consumer
Constant marginal utility of money
Diminishing marginal utility
Total utility is additive
1.13.1.1 Equilibrium of Consumer
Assuming the simple model of a single commodity x, the consumer can

either buy x or retain his money income y. Under these conditions the
consumer is in equilibrium when the marginal utility of x is equated to its
market price.
MU x Px
If there are more commodities, the condition for the equilibrium is the
equality of the ratios of the marginal utilities of the individual commodities
to their prices.
MU
ffffffffffffffff MU y MU n
x
ffffffffffffffff ffffffffffffffff
Px Py Pn
1.13.2The Ordinal Utility Theory
The ordinalist school postulated the utility is not measurable, but is an

ordinal magnitude. It suffices for the consumer to be able to rank the
various baskets of goods according to the satisfaction derived. The main

ordinal theory is known as the indifference-curve theory is based on certain

assumptions.
Rationality of consumer
Utility is ordinal
Diminishing Marginal rate of substitution
Consistency and transitivity of choice
Total utility depends on the quantities of the commodities consumed
1.13.2.1Equilibrium of Consumer
The consumer is in equilibrium when he maximizes his utility, given his

income and the market prices. Two conditions must be fulfilled for the
consumer to be in equilibrium.
The first condition is that the marginal rate of substitution be equal to the
ratio of commodity prices. This is necessary but not sufficient condition.
MU
ffffffffffffffff Pffffffff
MRS x ,y x
x
MU y P y
The second condition is that the indifference curve be convex to the origin.
This condition is fulfilled by the axiom of diminishing marginal rate of
substitution of x for y and vice versa.
At the point of tangency (point

e) the slopes of the budget line ( P x / P y ) and of the indifference curve

( MRS x ,y MU x / MU y ) are equal:
MU
ffffffffffffffff Pffffffff
MRS x ,y x
x
MU y P y
1.13.2.2 Properties of Indifference Curve
An indifference curve has a negative slope
The further away from the origin an indifference curve lies, the
higher the utility it denotes
Indifference curve do not intersect
The indifference curves are convex to the origin
1.14 The consumer surplus
Consumer surplus is equal to the difference between the amount of money

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

Consumer surplus = PCA

END CHAPTER III QUIZZES :
Q.1. The demand curve of a normal commodity is
(a) Upward Sloping
(b) Downward sloping
(c) Horizontal
(d) Vertical
Q.2 What happens to demand when price of the commodity falls
(a) Demand expands
(b) Demand contracts
(c) No change
(d) Can expand or contract
Q.3 In case of substitute goods if the price of commodity x increases the

demand of commodity y
(a) Remain constant
(b) Increases
(c) Decreases
(d) Fluctuates
Q.4 At a downward sloping demand curve the price elasticity of demand is
(a) Equal to unity
(b) Varies at different points
(c) Equal to zero
(d) Equal to infinity

Q.5 According to the cardinal approach the marginal utility of money
(a) Increases
(b) Decreases
(c) Remain constant
(d) Fluctuates
Q.6 The shape of indifference curve is
(a) Upward Sloping and concave to the origin
(b) Downward sloping and concave to the origin
(c) Upward Sloping and convex to the origin
(d) Downward sloping and convex to the origin
Q.7 The shape of indifference curve implies
(a) Diminishing MRSxy
(b) Increasing MRSxy
(c) Constant MRSxy
(d) Infinite MRSxy
Q.8 The marginal utility from successive consumption of normal good
(a) Increases
(b) Decreases
(c) Remain constant
(d) Undefined

Q.9 According to the ordinal approach consumers equilibrium is where

MU
ffffffffffffffff Px
(a) x
1 ffffffff
MU y Py
MU
ffffffffffffffff
x Pffffffff
(b) < x
MU y P y
MU
ffffffffffffffff Px
(c) x
ffffffff
MU y P y
MU
ffffffffffffffff
x Pffffffff
(d) > x
MU y P y
Q.10 Given the demand function Q = 90-3p and P = 6, Q=?
(a) Q = 67
(b) Q = 72
(c) Q = 108
(d) Q = 81

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

1.1 Introduction
Cost functions are derived functions from the production function which
describes the available efficient methods of production at any one time. The
cost of production is an important factor in almost all the business analysis
and decisions, especially those related to locating the weak points in
production management, minimizing the cost, finding the optimum level of
output, determination of price and dealers margin, estimation of the cost of
business operation. The cost concepts can be grouped under two categories
on the basis of their nature and purpose.
1.2 Accounting Cost Concepts
1.2.1 Opportunity vs. Actual Cost
The opportunity cost may be defined as the expected returns from the
second best use of the resources which are foregone due to the scarcity of
resources. It is also called alternative cost. The concept of economic rent or
economic profit is associated with it. On the other hand actual Cost
considers only explicit cost, the out of pocket cost for items such as wages,
salaries, materials, and property rentals.
1.2.2 Explicit cost vs. Implicit cost
Explicit costs are cash expenses for the payment of wages, salaries,
material, license fee, insurance premium, depreciation charges and are
recorded in normal accounting practices. In contrast implicit costs are non
cash expenses. Opportunity cost is an important example of implicit cost.
The explicit and implicit costs together make the economic cost.

1.3 Analytical Cost Concepts
1.3.1 Sunk vs. Incremental cost
The sunk costs are those which cannot be altered, increased or decreased, by
varying the rate of output. A sunk cost is an expenditure that has been made
and cannot be recovered since it accord to the prior commitment.
Incremental cost is the change in cost tied to a managerial decision
associated with expansion of output or addition of new variety of product.
1.3.2 Fixed and Variable Costs
Fixed costs are those which are fixed in volume for a certain given output. It
does not vary with variation in the output for a certain scale. The fixed costs
include the cost of managerial and administrative staff, depreciation of fixed
assets, maintenance of land etc. Fixed costs are associated with the short
run. Variable costs are those which vary with the variation in the total
output. It include cost of raw material, cost of direct labor, running cost of
fixed capital such as fuel, repairs, routine maintenance etc.
1.3.3 Total, Average and Marginal Costs
1.3.3.1 Total Cost
Total cost is the total expenditure incurred on the production. It connotes

both explicit and implicit money expenditure and include fixed and variable
costs.
b c
C f X,T,P f ,K

Where C total cost
X output
T technology
P f prices of factors
K fixed factors
TC TFC TVC
Total Cost Curves
1.3.3.2 Average cost
Average cost is obtained by dividing the total cost by the total output.
TC
ffffffffff
AC
Q
Average cost further can be categorized as average fixed cost (AFC) and
average variable cost (AVC).

TFC
fffffffffffffff
AFC
Q
TVC
fffffffffffffff
AVC
Q
Average cost curves
1.3.3.3 Marginal Cost
Marginal cost is the change in the total cost for producing an extra unit of
output.
MC TC/Q
Marginal Cost
Curve

1.4 Properties of Short Run Cost Curves
Short run cost curves get their shape from the marginal productivity
of the variable factor
If capital is held constant (short run) then the marginal product of

labor gives the short run cost curves their shape.
The levels of cost curves are determined by market price of factor

along with technology.
AFC falls continuously
MC equals AVC and ATC at their minimum
Minimum AVC occurs at a lower output than minimum ATC due to

FC

1.5 Short-Run Output Decision
Firm sets output at Q1, where MC=MR subject to checking the average
condition:
If P > ATC, the firm produces Q1 at a profit
If ATC > P > AVC, the firm produces Q1 at a loss
P < AVC, the firm produces zero output
1.6 Long-Run Cost Function
The long-run total cost curve describes the minimum cost of producing each
output level when the firm is free to vary all input levels. One of the first
decisions to be made by the owner/manager of a firm is to decide the scale
of operation (size of the firm).

1.6.1 Long Run Average Cost Curve
In the Long Run, plant size is variable, and the firm is able to adjust
its scale of operations according to demand
Therefore, corresponding to each different scale of operation is a

relevant Short Run Cost Curve.
The Long Run Average Cost Curve is then an envelope of the

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

1.7.1 Economies of Scale
The economies of scale are classified as
Internal economies of scale
External economies of scale
1.7.1.1Internal economies of scale
Internal economies of scale are advantages that a firm gains from increasing
the scale of its own operations. Whereas external economies of scale are
advantages that a firm gains from the expansion and size of the industry as
whole industrial clusters. It is important to note that internal economies of
scale determine the shape of the LRAC curve while the position of this
curve depends on external economies such as change in technology and
changes of factor prices in the industry as a whole.
Technological advantage
Advantages of division of labor and specialization
Economies in marketing
Managerial economies
Economies in transport and storage
1.7.1.2 External economies of scale
Large scale purchase of raw material
Large scale acquisition of external finance
Massive advertisement campaign
Growth of ancillary industries and Change of factor prices in the

industry
1.7.2 Diseconomies of Scale
Like economies, diseconomies may be internal or external.
1.7.2.1 Internal diseconomies of scale
Managerial inefficiency
Labor inefficiency
1.7.2.2 External diseconomies of scale
Natural constraints especially in agriculture and extractive industries
Pressure on inputs market due to increasing demand
Pressure on inputs prices due to bulk purchase

END CHAPTER IV QUIZZES
1. Change in the total cost for producing an extra unit of output is know as
A: Incremental Cost
B: Marginal Cost
C: Variable cost
D: Both A & B
2. Over a range of output, Marginal Cost equates with

A: First AVC and then ATC
B: First ATC and then AVC
C: Never equates with ATC
D: Never Equates with AVC
3. The shape of SATC necessarily reflects the operation of

A: Law of Variable Proportion,
B: Economies of Scale,
C: Diseconomies of scale
D: None of the above
4. When MC is rising and is more than AVC

A: The ATC may be rising
B: The ATC may be falling
C: Either of the two cases mentioned above is possible,
D: Difficult to say as information is inadequate.
5. The nature and shape of AFC is

A: A rectangular Hyperbola
B: A horizontal Line
C: It is U shaped
D: A vertical Line
6. Which one of the statement is correct

A: All costs are variable costs in the long run except LMC
B: TFC is inverse SShaped reflecting Laws of Returns.
C: Over a very long range of Operation, AFC is Zero.
D: None of the above is correct.

7. Explicit cost is also known as

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

change}
A: The above statement is correct.

B: The above statement is incorrect.
C: The statement is Vague & irrelevant
D: The above statement is partially true.
9. Gain from the increasing scale of production can be viewed as

A: External economies of scale
B: Internal economies of scale
C: Externalities
D: Internalities
10.An Envelop Curve is drawn from

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

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

1.1Production Function
The creation of any good or service that has value to either producers or
consumers is termed as production. Production function is a technical
relation between factor inputs and outputs. It describes the laws of
proportion that is the transformation of factor inputs into outputs at any
particular time period. The production function includes all the technically
efficient methods of production.
b c
X f L, K, R, S, v, y
` a
X f L
In the process of production, the manager is concerned with efficiency in

the use of inputs (Labor, Capital, Land and Entrepreneurship)
Technical Efficiency Occurs when it is not possible to increase output

without increasing inputs
Economic Efficiency Occurs when a given output is being produced at

the lowest possible cost. Improvement of Technology is reflected in an
upward shift in the Production Function. The same amount of input leads to
a higher output
Q
` a
f1 L
` a
f L
L
1.2 Short Run Analysis
Short Run is the period of time in which one (or more) of the factors of
production employed in a production process is fixed or incapable of being
varied. We usually assume Capital (K) to be fixed and analyze how output
varies with changes in Labor (L)
` a
X f L
1.2.1 Marginal Product of Labor
The change in output resulting from a very small change in Labor keeping
all other factors constant.
MPL = X L
If MP > 0, total production is rising
If MP < 0, total production is falling
Total production is maximum when MP = 0

1.2.2 Average Product of labor
APL = X / L
If MP > AP, then AP is rising
If MP < AP, then AP is falling
MP = AP when AP is maximum
APL
MPL L

1.3 Laws of Production
The laws of production analyze the technically possible ways of increasing

the level of production. Output may increase in various ways. In the short
run output may be increased by using more of the variable factors while
keeping other constant. This is referred to as Law of variable proportions.
While in long run output expansion may be achieved by varying all factors
and it is known as laws of returns to scale.
1.3.1 Law of variable proportions
In general if one of the factors of productions (usually capital K) is fixed

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

APL
L
MPL
Stage I Capital is Stage II Addition to
Underutilized and TP due to increase in Stage III Fixed Input capacity
Successive units of L continues to be is reached and additional L
L add greater positive but is falling causes output to decline
Amounts to TP with each unit
1.3.2 Laws of Returns to Scale
In the long run expansion of output may be achieved by varying all factors
by the same proportion or by different proportions. The laws of returns to
scale refer to the effects of scale relationship. Three types of returns to scale
are observed.
Constant returns to scale
Increasing returns to scale
Decreasing returns to scale
1.3.2.1 Constant returns to scale
If the quantity of all inputs used in the production is increased by a given

proportion and we have output increased in the same proportion; it is
termed as constant returns to scale.

1.3.2.2 Increasing returns to scale
If output increases by a greater proportion in comparison to a change in the

scale of inputs it is termed as increasing Returns to Scale. The causes of
increasing returns to scale are:
Specialization of labor
Inventory Economies
Managerial indivisibilities
Technical indivisibilities

1.3.2.3 Diminishing Returns to Scale
If output increases by a smaller proportion in comparison to the change in

the scale of inputs, it is described as diminishing returns to scale. The
reasons of diminishing returns to scale are:
Managerial inefficiency
Exhaustible natural resources
Increased bureaucratic
Labor inefficiency
Pressure on inputs market due to increasing demand
Pressure on inputs prices due to bulk purchase

1.4 Isoquant
An isoquant is the locus of all the technically efficient methods or all the
combinations of factors of production for producing a given level of output
given the state of technology.
A higher isoquant refers to a larger output, while a lower isoquant

refers to a smaller output.
The slope of Isoquant shows diminishing marginal rate of input

substitution.
C shaped isoquants are common and imply imperfect

substitutability
Isoquants may take various shapes depending on the degree of

substitutability of inputs. However continuous isoquants (an approximation
to the realistic form of kinked isoquant) has mostly been adopted because
they are mathematically simpler to be handled. In case the two inputs are

imperfectly substitutable, the optimal combination of inputs depends on the

degree of substitutability and on the relative prices of the inputs.
The degree of imperfection in substitutability is measured with marginal

rate of technical substitution (MRTS):
MRTS l ,k @K/L X/L D X/K
MP
fffffffffffffff
MRTS l ,k l
MP k
1.5 Equilibrium of the Firm
A profit maximizing firm will be using optimal amount of an input at the

point at which the monetary value of the inputs marginal product is equal
to the additional cost of using that input. Monetary value of the input is;
b c
MP l Px MP l

Profit Maximization requires

w Px CMP l
Px Price of final output
w Wage rate (Cost of input)
1.6 Isocost
The isocost line is the locus of all combinations of factors the firm can
purchase with a given monetary cost outlay. If a firm uses only L & K, the
total cost or expenditure of the firm can be represented by:
C wL rK
One can solve Optimization problem for the combination of inputs that
either minimizes total cost subject to a given constraint on output
OR
maximizes output subject to a given total cost constraint.
1.7 Isocost Curve and Optimal Combination of L and K

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

MP k r
1.8 Production with Two(or more) Outputs-Economies of Scope
Economies of scope exist when the unit cost of producing two or

more products/services jointly is lower than producing them
separately, producing related products, and the products that are
complementary.
The average total cost of production decreases as a result of

increasing the number of different goods produced

END CHAPTER V QUIZZES :
Q.1. Production function states
(a) Qualitative relationship between input and output
(b) Quantitative relationship between input and output
(c) Technical relationship between input and output
(d) No relationship between input and output
Q.2 Total output is maximum where
(a) Marginal production is maximum
(b) Marginal production is zero
(c) Average production is maximum
(d) Average production is zero
Q.3 The law of variable proportions states that given at least one input
constant the marginal product of variable factor
(a) Increases
(b) Decreases
(c) Remain constant
(d) Fluctuates
Q.4 Returns to scale means
(a) Change in output due to change in one variable factor of

production
(b) Change in output due to change in one constant factor of

production

(c) Change in output due to change in all variable factors of

production
(d) Change in output due to change in all constant factor of

production
Q.5 The slope of isoquant is called
(a) Marginal rate of technical substitution
(b) Marginal rate of factor substitution
(c) Marginal rate of production substitution
(d) Marginal rate of input substitution
Q.6 The shape of isoquant curve is
(a) Upward Sloping and concave to the origin
(b) Downward sloping and concave to the origin
(c) Upward Sloping and convex to the origin
(d) Downward sloping and convex to the origin
Q.7 Economies of scale are related with
(a) Size of plant
(b) Size of fixed factor
(c) Size of variable factor
(d) Choice of technique

Q.8 which of the statements is false
(a) At the point of producers equilibrium, the isoquant is tangent to

the
Isocost line
(b) Constant returns to scale means proportionate change in output

due to
Proportionate change in inputs
(c) When average product falls, marginal product also falls and lies
below
Average product
(d) The elasticity of technical substitution is measured by the slope

of
Isoquant
Q.9 Producers equilibrium is where

MP
fffffffffffffff
l wfffff
(a) >
MP k r
MP
fffffffffffffff
l wfffff
(b) <
MP k r
MP
fffffffffffffff wfffff
(c) l

MP k r
MP
fffffffffffffff w
(d) l
1 fffff
MP k r

Q.10 Which of the statements about the Isocost line is false
(a) The budget constraint of the producer
(b) The budget constraint of the seller
(c) Shows all the combinations of inputs which may be purchased
(d) It touches both the axis compulsorily

CHAPTER VI
PRICING POLICY OF THE FIRM
CONTENTS:
1.1 Introduction
1.2 Objectives of Pricing Policies
1.3 Factors affecting Pricing Policies
1.4 Price Forecasting
1.5 Prospective supply and demand
1.5.1 Prospective Supply
1.5.2 Prospective Demand
1.6 Pricing Methods
1.6.1 Introduction
1.6.1.1 Skimming Pricing
1.6.1.2 Penetration Pricing
1.6.2 Growth
1.6.3 Maturity
1.6.4 Saturation
1.6.5 Decline
1.7 The various Pricing methods are:
1.7.1 Cost-plus or full-cost pricing:
1.7.2 Rate of Return pricing
1.7.3 Marginal cost pricing
1.7.4 Limit Pricing
1.7.5 Going Rate Pricing

1.7.6 Team pricing
1.7.7 Mark-up and Mark - down pricing
1.7.8 Peak Load Pricing

1.1 Introduction
Managerial decision making consists of a number of procedures at each
individual stage of the product manufacturing. They are related to the
product development depending on the market requirement, product
manufacturing, product distribution and marketing of the same to realize the
company's sales targets.
One of the important factors which assist the company in realizing its
profits through targeted sales is the Pricing Policy, it formulates. As a result
the method of the company's Pricing Policy plays an important role in the
Managerial decision making. Price, in fact, is the source of revenue which
the firm seeks to maximize. Also it is the most important device a firm can
use to expand its clientele base. The company should fix the price
reasonably because if the price is set too high, it may lead it to loose its
market share. On the other hand, if the price is set too low the company may
not recover its cost. so the right choice of the Price fixation would depend
on number of factors and wide variety of conditions prevailing in the
market. Moreover the pricing decisions have to be reviewed and formulated
from time to time.
Some of the factors which affect the choice of the pricing policies are:
Business Objectives: This relates to rate of growth, establishing and
increasing its market share and maintenance of control and finally
profit realization. All these concepts play an important role in pricing
policy formulation.
Competition level: It is important for a company to offer the product
which satisfies the wants and desires of the consumer than the one
which sells at the lowest price.

4P's: Pricing happens to be one of the core concepts of marketing but

a firm must consider it together with Product, Place & Promotion.
Price sensitivity: Factors like variability in the consumer behavior
consumer income level, marketing effect, nature of product and after
sales service among others affect the price sensitivity.
Available information: The demand supply gap goes a long way in
affecting the choice of the pricing policy determination for as
company.
Pricing hence is more a matter of judgment since every pricing
situation is different from each other and as such there is no formula
existing for the price fixation.
1.2 Objectives of Pricing Policies

Pricing policies form an integral part of the company's overall
business strategy. Some of the important objectives, which the
company should take into consideration, are:
Profit maximization for the company's products
Relation of long term goals of the company.
Successfully thwart the competitors.
Flexibility in pricing to meet the changes in the market.
Achieving a satisfactory rate of return
1.3 Factors affecting Pricing Policies

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

Cost involved
Demand elasticity
Consumer psychology
Price changes
Type of product
Competitors in the market
Product segmentation and positioning.
Market structure and promotional policies
Degree of integration
Business Expansion
Complementary and substitution products and
Other considerations
a. Individual
b. Firm's
c. Economic
1.4 Price Forecasting

A Business unit is constantly faced with the risk of a substantial change in
the prices of raw materials as 'well as its products, these changes may be a
part of general economic fluctuations but, at times the prices may change
during the period of economic stability also The first step towards
successful price forecasting is the understanding of nature of the commodity
and its market. We should have the knowledge of the demand -supply
conditions, i.e.

Demand elasticity: Where the demand is elastic; a given change in

supply will bring a less sever change in price than where the demand
is inelastic.
Change in supply of commodity: When the change in demand for
commodity takes place price change will depend on the supply
conditions, which in turn will depend on the conditions of production
e.g. supply manufactured product can be altered according to the
demand condition. The price tends to vary for that product where the
supply of a product cannot be in accordance with that of demand.
Influence of supply and demand on the price: There are many
products particularly agricultural, whose demands remains constant
but where the supply may change continuously. So that analysis
should be made from the supply side and for the manufactured
product the rapid demand change can be matched with the supply
adjustments.
Related Commodities: The prices of many manufactured goods
depend on prices of raw material particularly on the current prices.
The manufacturer while pricing the product will take only this pricing
into consideration.
Type of product: The price of commodity will depend on the other
one specially if it is a by product. In that case supply of that by
product will depend on the main product and not on its (By-product's)
demand conditions.
Supply - Controllable and predictable: It may be possible for the
supply of a commodity to change substantially but this change may

be unpredictable and beyond control e.g. an increase in the supply of

crude oil will depend on the oil striking capacity.
Competitive situations: In case where a dominant producer leads the
market, his probable price policy becomes a significant factor in
making the price forecast. In case of a severe price competition,
resorting to the price cutting would be frequent and uncertain,
specially in the buyer's market.
1.5 Prospective supply and demand

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

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

commodity and the willingness of the buyer to buy the commodity and their
purchasing power. An analysis of a price movement of a commodity over a
period of time will reveal certain fluctuation. These fluctuations and their
relationships are helpful in price forecasting. Some of the fluctuations
observed are:
Seasonal price variation: These are common in case of number of
commodities notably agricultural and food products such variations
would take place in markets having seasonal cycles. These variations
may take place due to seasonal fluctuation in the price of raw
materials also.
Cyclical price variation: During the business cycle, price of all
commodities would generally record fluctuations. So it becomes
essential to realize this effect on the commodities in different ways.
The general business conditions influence the commodity prices
through changes in the demand supply relationships in the market for
each individual commodity.
Cob -Web Cycle: These cycles occur on account of the cumulative
effect of the price expectations of the millions of independent
producers. When farmers expect higher prices in future, they plan
independently to producer more. Also new ones enter the field.
As a result, the aggregate output, when the future date arrives, is so
large that the price falls. When the prices fall, all the producers plan
to produce less, once they have suffered losses on the account of non-
materialization of their expected prices. This time the cumulative
effect of smaller output plan leads to the shortage of products which
in turn increases the prices.

1.6 Pricing Methods

Before we proceed with the various pricing methods, it is essential for us to
understand the Life cycle concept. Many products generally have a
characteristic known as 'Perishable distinctiveness. The product cycle
begins with the invention of a new product followed by patent protection
and further development to make it saleable. This is usually followed by a
rapid expansion in its sales as the product gains its market acceptance. Then
the competitor enters the field with the imitation and the rival products and
the distinctiveness of the new product starts diminishing. The speed of
degeneration differs from product to product. The innovation of new
product and its degeneration into a common product is termed as Life Cycle
of the Product."
There are five distinct stages in the Life Cycle of the product'. They are as
follows:
1.6.1 Introduction
Research or engineering skills lead to the product development. There are
high promotional costs involved, volume of sales is low and there may be
heavy losses.
Pricing Policies in Introductory phase largely depend on the close
substitutes available in the market. Generally two kinds of pricing policies
are suggested,
1.6.1.1 Skimming Pricing: This pricing strategy is adopted when close
substitutes of a new product are not available in the market. To extract the
consumer surplus, setting up a very high price initially and then a
subsequent lowering of prices in a series of reduction.

1.6.1.2 Penetration Pricing: This pricing policy is generally adopted in

case of the availability of close substitutes of the new product in the market.
To penetrate in the market, initially a lower price is designed, as soon the
product captures the market, price is gradually raised up.
1.6.2 Growth
Due to the cumulative effects of introduction stage the product begins to
make rapid sales gain. High and sharply rising profits may be witnessed.
Consumer satisfaction has to be ensured.
1.6.3 Maturity
Sales growth continue, but at a diminishing rate, because of the declining
number of the potential customers who remain unaware of the product or
have taken no action. Profit margin slips despite rise in the sale.
During Maturity stage, firm should move in the direction of Product
improvement and market segmentation.
1.6.4 Saturation
Sales reach and remain on a plate marked by the level of the replacement
demand. There is a little additional demand to be stimulated.
1.6.5 Decline
Sales begin to diminish absolutely as the customers begin to tire of the
product and the product is gradually edged out by better products or the
substitutes.
The life cycle broadly gives the different stages through which a product
passes through. There are changes taking place in the price and promotional
elasticity of demand as also in the production and distribution cost of the
product. Pricing Policy, therefore, must be properly adjusted over the
various phases of the life cycle of the product.
1.7 The various Pricing methods are:

Marginal cost pricing,
Full Cost method pricing,
Limit pricing
Mark-up and Mark-down pricing,
Rate of Return pricing,
Going rate pricing,
Team pricing,
Value pricing,
Position based pricing,
Exports pricing,
Dual pricing
Administered pricing,
Skimming pricing,
Penetration pricing,
Peak load priding,
Charm pricing,
Discrimination pricing.,
Product mix pricing
1.7.1 Cost-plus or full-cost pricing:

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

It is a refined variant of full cost pricing. Under this method a firm starts
with a rate of return they consider satisfactory and then set a price that
allows them to earn that return when there plant utilization is at some
standard rat. In other words the company determines the standard cost at
standard volume and adds the margins necessary to return a target rate of
profit over the long run.
This can be broadly grouped under the following:
1. Fixing prices to maintain constant percentage mark up over the
cost,
2. Fixing prices to maintain the profit as constant percentage of sale,

3. Fixing prices to maintain a constant return on the investment
capital.
Example: Most products are priced I this way for instance Philips audio
systems are currently priced based on what the manufacturers estimate the
returns to be.
1.7.3 Marginal cost pricing

Both under the full cost pricing and rate of return pricing, the prices are
based on total cost comprising fixed and variable cost. Under marginal cost
pricing, the fixed costs are ignored and prices determined on the basis of
marginal cost. The firm uses only those costs that are directly attributable to
the output of a specific product. With marginal cost pricing, the firm seeks
to fix its prices so as to maximise its total contribution to fixed cost and
profit. Unless the manufacturer's products are in direct competition with
each other, this objective is achieved by considering each product in
isolation and fixing its price at a level which is calculated to maximize its
total contribution.
With marginal cost pricing, the prices are never rendered up-competitively
because of a higher fixed cost are higher than those of the competitor. The
firm's prices will be rendered un- competitive by high variable cost, and
these are controllable in short run marginal cost more accurately reflects
future as distinct from present cost level and relationship. This method also
helps the manufacturer to develop a far more aggressive pricing policy than
the full cost pricing.
In a period of business recession, firm's using marginal cost pricing may
lower prices in order retain its market share. This may lead other firms to
reduce their prices leading to cut- throat competition. The price cut may be
up to such an extent that the fixed cost is not covered and thus a fair return
on the investment is not obtained.
Example: Nestle Tea is priced based on this method.
1.7.4 Limit Pricing
Bain explained why firms over a long period of time were keeping their
price at a level of demand where the elasticity was below unity, that is, they
did not charge the price which would maximize their revenue. Traditional
theory was concerned only with actual entry of the firms and not the
potential entry. Bain argued that in the long run because of the existence of
barrier to entry the price do not fall to the level of LAC. This behaviour can
be explained by assuming that there are barriers to entry and the existing
firms do not set the monopoly price but the limit price, i.e., the highest price
that the established firms believe they can charge without inducing entry.
The level at which limit will be set depends on the estimation of the costs of
the potential entrant, market elasticity of demand, shape and level of LAC,
size of the market and number of firms in the industry.
1.7.5 Going Rate Pricing

Here instead of cost, the emphasis is on the market. The firm adjusts its own
price policy to general pricing structure in the industry. This may seem to
be a rational pricing policy when the costs are difficult to measure. Many
cases of this type are situations of price leadership. Where price leadership
is well established, charging according to what competitors are charging, is
the only safe policy.
It must be noted that this pricing is not quiet the same as accepting the price
impersonally set by a near perfect market. Whether it would seem that the
firm has some power to set its own price and could be a price maker if it
chooses to face all the consequences.
Example: Since Nescafe is the market leader in the instant coffee segment,
hence every manufacturer wanting to enter this segment has to be Nescafe's line.
1.7.6 Team pricing
According to this method, the companies sometimes assign special roles to
the various products they sell. Some items may be used as promotional
items which are priced and advertised with prime purpose of attracting the
customers and other may be intended to make up for the low margin
obtained on the promotional items.
Example: Several retailers give free items with certain items. Pantaloon,
Allen Solly & Van Heusen are examples, for instance with a Van Heusen
Blazer you can choose Van Heusen tie for free.
1.7.7 Mark-up and Mark - down pricing

When a retailer follows the practice of fixing the price over the one at which
he has obtained the product, such that it covers the cost and leaves a
reasonable profit margin he is said to follow the mark-up policy. In case
certain goods are not sold within a reasonable time, the retailer pulls the
price down i.e. "marks down" the product price.
Example: During Diwali as the day approaches the firecracker prices
increase and on the diwali afternoon the prices are significantly marked
down.
1.7.8 Peak Load Pricing

There are certain perishable products which are being demanded in varying
quantities at different point of time. E.g. During evening hours, restaurants
face peak demand and during day time, the demand falls. For these kinds of
products, a double pricing system is adopted. A higher price, called peak-
load price is charged during the peak-load period and a lower price is
charged during the off-peak period
END CHAPTER VI QUIZZES :
1. Under marginal cost pricing, which cost is ignored
(a) Variable Cost
(b) Fixed Cost
(c) Marginal cost
(d) Opportunity Cost
2 Cost- Plus pricing methods ignores
(a) Labor cost
(b) Percentage for profit
(c) Demand for the product
(d) Supply price of Raw materials
3. Setting up higher prices initially to extract the consumer surplus is

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

standard volume and adds the margins necessary to return a target
rate of profit over the long run:
(a) Rate of Return pricing
(b) Cost plus Pricing
(c) Marginal cost Pricing
(d) Mark up Pricing
8. Which factor affects the determination of Price for a product
(a) Demand elasticity

(b) Consumer psychology
( c) Price changes
(d) all of the above
9. In case certain goods are not sold within a reasonable time, the
retailer pulls the price down, it is known as
(a) Adjustment pricing
(b) Administered pricing
(c) Mark-down pricing
(d) Mark-up pricing
10. This pricing strategy acts as a barrier to entry to new firms
(a) Limit Pricing
(b) Administered Pricing
(c) Peak Load Pricing
(d) Skimming Pricing
CHAPTER VII
OBJECTIVES OF THE FIRM
CONTENTS:
1.1 Introduction
1.2 Baumols Sales Revenue Maximization Theory
1.3 Marriss model of the managerial enterprise
1.4 Williamson Model of Managerial Discretion
1.5 Satisficing Behavior Theory of the Firm
1.1 Introduction
Traditional theories of the firm advocated that profit maximization is the

goal of the firms. This objective was based on the single entity of ownership
and management. With the course of development simple business activities
turned into complex organizations dealing with specialized and classified
activities. This development has led to the separation of ownership and
management. Further with this division the utility functions of both parties
faced confrontation in certain areas and profit maximization did not remain
the single objective of the firm. In this wake several objectives were
identified and proved to be true in real business practices. Coordination and
compromise between organizational parameters of concern and their
managerial counterparts is necessary. Organization could aim at profits, net
worth, growth and diversification and managers may aim at Salary, Perks,
Promotion, Job Security and Career.
1.2 Baumols Sales Revenue Maximisation Theory
Managers rewards are more closely linked to Sales rather than

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

Constraint.
Profit constraint is exogenously determined by the demand and

expectations of the shareholders, banks and other financial
institutions.
A Sales Revenue Maximizing firm, in general, produces a greater

output than a Profit Maximizing Firm and sells at a price lower than
the profit maximizer.
The maximum sales revenue will be where e = 1 (and hence MR = 0)

and will be earned only if the profit constraint is not operative.
If the profit constraint is operative the sales revenue maximizer will

operate in the area where price elasticity is greater than unity.
Q = Profit Maximizing Output
QS = Sales Maximizing Output
QRS = Constrained Sales Maximizing Output
= Profit Curve
1.3 Marriss model of the managerial enterprise
The growth of an organization depends on the separate but

interdependent Utility functions of both owners and managers
Utility of Owners Profits, market Share, Public Esteem etc.
Utility of Managers Salaries, Status, Job Security etc.
Long Term goal of an organization is assumed to be Balanced Rate

of Growth
Job Security is important for Managers which imposes a constraint on

the diversification and growth of the firm
On the other hand, there is a trade off between retained profits

(reinvested for growth) and profits declared as dividends.
1.4 Williamson Model of Managerial Discretion
Managers have discretion in pursuing policies which maximize their own

utility rather than attempting the maximization of profits which maximizes
the utility of owners. This is attained by the expense preference such as staff
expenditure on emoluments, funds available for discretionary investment. It
gives managers a positive satisfaction because these expenditures are a
source of security and reflect the power, status, prestige and professional
achievement of managers. It emphasizes the ability of managers to
maximize their own Utility function (Owners Utility acts as a constraint).
b c
U m f S, M, I d
Where
S staff expenditure
M managerial emoluments
Id discretionary investment
An important aspect is the non pecuniary components of the

Managers Utility reflected in Emoluments and Managerial Slack in
the form of expense accounts, luxurious offices etc.
Also important are the funds available to managers for Discretionary

Investment
1.5 Satisficing Behaviour Theory of the Firm

Behavioral economists argue that any corporation is composed of
various groups
a. Employees
b. Managers
c. Shareholders
d. Customers
Each group has different goals such as production goal, inventory
goal, sales goal, profit goal etc.
People possess limited cognitive ability and so can exercise only
Bounded Rationality when making decisions in complex uncertain
situations.
Decisions are taken in conditions of uncertainty and ignorance.
Rather than an exhaustive search for the best or ideal solution,
decision makers seek an acceptable or satisfactory outcome.
Maximizing behavior may be replaced by Satisficing, i.e., setting
minimum acceptable levels of achievement.
END CHAPTER QUIZZES :
Q.1. Traditionally the objective of the firm was
a) Sales maximization
b) Profit maximization
c) Barriers to new entrants
d) Maximization of managers utility function
Q.2 The equilibrium of the traditional firm is where
(a) MR > MC
(b) MR = MC
(c) MR < MC
(d) MR MC
Q.3 Sales revenue maximizer is successful when
a) Profit constraint is too high
b) Profit constraint is non operative
c) Profit constraint is zero
d) Profit constraint is too low
Q.4 Which of the statements is false about sales revenue

maximisation
a) Output is more than profit maximiser
b) Prices are lower than profit maximizer
c) Sales revenue is maximum where elasticity = 1
d) Prices are higher than profit maximizer
Q.5 According to Marris the utility functions of manager and owner

are
a) Always same
b) Always separate
c) Interdependent
d) Separate but interdependent
Q.6 Maximisation of balanced rate of growth means
a) (a) g < gd < gc
b) (b) g gd gc
c) (c) g > gd > gc
d) (d) g a
6 gd a
6 gc
Q.7 The relationship between discretionary investment and managers

utility maximization is
a) Positively high
b) Positively low
c) Negatively high
d) Negatively low
Q.8 Owners utility maximization is determined by
a) Revenue maximization
b) Profit maximization
c) Investment maximization
d) Prices maximization
Q.9 Satisficing behavior theory states that
a) Firm is a coalition of harmonized interest groups
b) Firm is a coalition of conflicting interest groups
c) Firm is not a coalition of interest groups
d) Firm is a single goal entity
Q.10 Satisficing behavior theory focuses on
a) Decision making process of small single product firms under

imperfect market conditions
b) Decision making process of large multiproduct firms under

imperfect market conditions
c) Decision making process of large multiproduct firms under

perfect market conditions
d) Decision making process of small single product firms under

perfect market conditions
CHAPTER VIII
MARKET STRUCTURE
CONTENTS:
1.1 Introduction
1.2 Meaning of market
1.3 Classification of Market Structure
1.3.1 Perfect Competition
1.3.1.1 Price Output Determination Under Perfect
Competition
1.3.1.2 Equilibrium in Short Run
1.3.1.3 Perfect Competition in the Long Run
1.3.1.4 Perfect Competition and Plant Size
1.3.1.5 Perfect Competition and the LR Supply Curve
1.3.1.6 Long Run Equilibrium
1.3.2 Monopoly Market
1.3.2.1 Why do Monopolies exist?
1.3.2.2 Equilibrium of the Firm
1.3.2.3 Price Discrimination
1.3.3 Monopolistic Competition
1.3.3.1 Structure
1.3.3.2 Short Run Equilibrium
1.3.3.4 Efficiency under Monopolistic Competition
1.3.4 Oligopoly Market
1.3.4.1 Structure
1.3.4.2 Mutual Interdependence
1.3.4.3 Collusion is difficult if
1.3.4.4 Explicit Collusion Cartels
1.3.4.5 Sweezeys Model of Kinked Demand Curve
1.3.4.6 Price Stability with a Kinked Demand
Curve
1.3.4.7 Tacit Collusion: Price Leadership
1.3.4.7.1 Dominant Firm Price Leadership
1.3.4.7.2 Barometric Price Leadership
1.1 Introduction
Maximization of output or optimization of cost or optimization of resource
allocation is only one aspect of the profit maximizing behavior of the firm.
Another and equally important aspect of Profit Maximization is to find the
price from the set of prices revealed by the demand schedule that is in
agreement with the profit maximization objective of the firm.
The profit maximizing price does not necessarily coincide with minimum
cost of production. Besides, the level of profit-maximizing price also
depends on the nature of competition prevailing in the market. Therefore,
while determining the price for its product, a firm has to take into account
the degree of competition.
1.2 Meaning of market
A market is a group of people and firms which are in contact with one
another for the purpose of buying and selling some product. It is not
necessary that every member of the market be in contact with each other.
Market structure refers to the number and size distribution of buyers and
sellers in the market for a good or service. The market structure for a
product not includes firms and individuals currently engaged in Buying and
selling but also the potential entrants.
1.3 Classification of Market Structure

On the basis of the degree of competition, Markets are traditionally
classified as:
Perfect Competition
Imperfect Competition
1.3.1 Perfect Competition
Characteristics of Perfect Competition:
Large number of small sellers and buyers: The number of buyer as
well as seller is so large that the share of each buyer in total market
demand and the share of each seller in total market supply is
insignificant and hence no individual buyer or seller can influence the
market price.
Homogeneous products: Products supplied by the firms are identical
and are regarded as perfect substitute to each other.
Perfect mobility of factors of production: For a market to be
perfectly competitive, the factors of production must be in the
position of moving freely into or out of the industry and from one
firm to another.
Free entry and free exit of the firms: No legal or otherwise
restrictions on the entry and exit of the firms.
Perfect dissemination of the information: to the buyers and sellers.
No government intervention and Absence of collusion.
Examples: Agricultural commodities and Stock market
1.3.1.1 Price Output Determination Under Perfect Competition
In a perfectly competitive market, where large number of sellers selling

homogeneous product, no single seller can influence the market price.
Similarly, each buyer has too small share in total market demand to
influence the price. Market Price is therefore determined by the market

demand and market supply for the industry and is given for each individual
firm and for each buyer. Thus, a seller in a perfectly competitive market is a
price-taker not a price maker. This means the individual firm will face a
horizontal demand curve. It will be horizontal at the market price,
established by supply and demand on the market as a whole.
1.3.1.2 Equilibrium in Short Run
A Short run is a period in which firms can neither change their size nor quit,
nor can new firms enter the industry. Firms can increase (or decrease) the
supply of the product by increasing (or decreasing) the variable inputs.
Therefore, supply curve is elastic in short run.
The determination of market price in the short run is illustrated in the Fig.
4.1(a) and adjustment of output by the firms to the market price and firms
equilibrium are shown in Fig. 4.2(b). Fig. 4.1(a) shows the price
determination for the industry by the demand curve D and supply curve S at
the price OP. This price is fixed for all the firms in the industry. Given the
Price OP, an individual firm can produce and sell any quantity at this price.
To determine the profit maximizing output, firms cost curves are required
to be studied.
The process of firms output determination and its equilibrium are shown in
the Fig 4.2(b). Profit maximizing condition for a firm is MR=MC. Since
price is fixed at OP, firms average revenue AR= OP and also if AR is
given, MR=AR. Firms upward sloping MC curve intersects MR
1.3.1.3 Perfect Competition in the Long Run
In the long run, entry and exit become possible. Why? Because potential
firms can buy fixed inputs and become actual firms. And existing firms can
sell off or stop renting their fixed inputs and go out of business.
Firms will choose to enter the industry if the existing firms in the industry
are making economic profits. The profits are an incentive to enter. As a
result the total market supply will increase and, therefore, the market supply
curve must shift to the right. It drives down the price on the market, thereby
reducing the profits of each firm.
Now the firms are making profits, but smaller profits than before. But if
there are still economic profits being made, more firms will enter. This must
continue until there are no economic profits. What has to be true when
profits equal zero?
TR = TC
p*q = qATC
p* = ATC
So entry finally stops when firms are producing at their lowest average total
cost. Here is a diagram of the final, long-run equilibrium under perfect
competition:
What if typical firm is making losses? Then the reverse process will take
place. Firms will exit the market, causing a left shift of market supply,
causing a rise in market price, causing a reduction of losses. This continues
until losses are zero. Thus, Long Run competitive equilibrium consists of
two conditions:
p* = MC
p* = minimum ATC
The first condition is caused purely by profit maximization, and its true in
both the SR and the LR. The second condition, however, is caused by entry
and exit in the LR. It wont necessarily be true in the SR.
These two conditions have important efficiency implications. Marginal-cost
pricing (p*= MC) means that consumers who buy the product face the true
opportunity cost of their choices. They will only buy the good if the value to
them is greater than the price, which represents the value of the resources
that went into making the product. Minimum average cost pricing (p* =
minimum ATC) means that the product is being made at the lowest average
cost possible, so that no resources are being wasted in its production.
The conclusion that firms make zero profit in the LR may seem odd, given
the profits that many firms earn in reality. What could explain the difference
between theory and reality? (1) Reality may differ from the perfectly
competitive model, and to that extent economic profits can be made. But
also, (2) the profits we generally hear about are accounting profits, not
economic profits. To find out whether these profitable firms are really
making economic profits, wed need more information about their implicit
costs.
Finally, (3) we may be observing short-run profits, not long-run profits.
1.3.1.4 Perfect Competition and Plant Size

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

As we have seen, changes in demand in a PC market create profits and
losses for firms. In the SR, this has no effect on the supply curve; but in the
LR, firms enter for profits and leave to escape losses, leading to supply
curve shifts. We want to use this information to derive a LR supply curve.
A LR supply curve, just like a SR supply curve, shows the total quantity
that will be supplied in a market at different prices; but unlike the SR
supply curve, it shows the quantity supplied after all long-term changes,
including entry and exit of firms, have been taken into account.
In the basic supply-and-demand framework, notice that we can use demand
curves and equilibrium points to trace out the supply curve. If you look at
three
different demand curves, and then mark the equilibrium point on each one,
you can
connect the equilibrium points to find where the supply curve must be.
Now were going to use the same basic technique to trace out the LR supply
curve. We can do this by changing demand, and then finding the
equilibrium points after allowing LR adjustments, including entry and exit.
Start with an initial (short-run) supply and demand. If we are in long-run
equilibrium, profits are zero. Now, let demand shift to the right. In the
short-run, price rises a lot. But the higher price creates profits, and profits
attract entry in the long run. So eventually supply shifts to the right as well,
pushing price back down (though possibly not as low as it was before).
Once profits are back to zero again, youre in a new long-run equilibrium.
Do this all again to find a third long run equilibrium, and then connect the
dots to get the long-run supply curve.
The interpretation of the LR supply curve is pretty much the same as the SR
supply
curve: it shows the willingness of producers to sell at each price. But the LR
supply
curve measures this willingness in the broadest sense, including all firms
that might
potentially supply this product.
Notice that the LR supply curve is flatter than the SR supply curve. This
must be so,
since the LR supply curve takes into account the quantity responses of all
firms, not just the ones currently in the market, but potential firms as well. It
is even possible that the LR supply curve can be downward-sloping. Why?
Consider what must happen if entry and exit do not affect the cost curves of
individual firms. Then after all adjustment to a change in demand has taken
place, the market price must have returned to the lowest point on the
LRATC, which is exactly where it was before. So in this case, the LR
supply curve must be horizontal. We call this a constant--cost industry. This
is most likely to be the case when the industry in question constitutes only a
small portion of the demand for its inputs.
If the industry in question has a large impact on the markets for its inputs,
then the LR supply curve may slope upward or downward. If the effect of
entry into the industry is to bid up the price of inputs, so that a firms cost
curves rise as a result of the entry of new firms, then the market price after
adjustment will be higher than it was before. In this case, the LR supply
curve must be upward-sloping as in the picture above; this is called an
increasing-cost industry, which results from external diseconomies. On the
other hand, if entry into the industry creates a greater demand for inputs that
allows those inputs to be produced through mass production techniques
(i.e., at lower average cost), then the industry can benefit from lower costs
of production. In this case, the LR supply curve is downward-sloping. This
is called a decreasing-cost industry, which results from external economies.
They face a perfectly elastic demand curve Market prices change only if
demand and supply change

Normal profit is necessary to attract and maintain capital investment
Marginal Analysis
MR = MC => Normal Profits
Output will settle at the point where;
P = MC = AC = MR
1.3.1.7 Supply Curve under Perfect Competition

Short Run Firm Supply MC curve is the SR supply curve so long as
P > AVC
Long Run firm Supply LMC curve is the LR supply curve so long
as P > ATC
In the LR, the firm must cover all necessary costs of production and
earn a normal profit
1.3.2 Monopoly Market
A monopoly market is one in which there is only one seller of a product

having no close substitutes. The firm has substantial control over the price.
Further, if product is differentiated and if there are no threats of new firms
entering the same business, a monopoly firm can manage to earn excessive
profits over a long period.
Only one firm produces the product
Low cross elasticity of demand between the monopolists product and
any other product; that is no close substitute products.
Substantial barriers to entry that prevents competition from entering
the industry.
1.3.2.1 Why do Monopolies exist?

Barriers to Entry
a) Control of scarce resources or input
b) Economies of scale natural monopolies
c) Technological superiority
d) Govt. created barriers
e) Patents
1.3.2.2 Equilibrium of the Firm
Monopoly firms ability to set price is limited by the demand

elasticity
Supernormal profits may be earned in the Long Run since there is no
entry
P > competitive price
Q < competitive quantity
The monopolist will always try to operate on the elastic portion of the
demand curve
1.3.2.3 Price Discrimination

Price discrimination means selling the same or slightly differentiated
product to different sections of consumers at different prices. The necessary
conditions for price discrimination are:
Different markets must be separable
The elasticity of demand must be different in different markets
There must be imperfect competition in the market
Profit maximizing output is much larger than the quantity demanded
in a single market
Price discrimination can be categorized into three types:
First degree of price discrimination Charging two different prices in
different markets having demand curves with different elasticities.
Second degree of price discrimination Charging more than two
different prices from each customers block
Third degree of price discrimination Charging different prices from
each consumer. The demand curve becomes the marginal revenue
curve of the seller.
1.3.3 Monopolistic Competition
It implies a market structure with a large number of firms selling

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

control over price.
1.3.3.1 Structure
Several firms in the market.
Producing differentiated products.
Free entry and exit.
Full and symmetric information.
Consumers have brand preference but can be induced to change
brands
Advertising often plays a big role in monopolistically competitive
markets
1.3.3.2 Short Run Equilibrium

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

Free Entry and Exit drive Long Run Profits to the level of Normal
profits
Firm demand will be tangent to its LR Average Cost Curve
1.3.3.4 Efficiency under Monopolistic Competition

Excess Capacity under Monopolistic Competition
Compared to perfect competition:
less will be sold at a higher price
firms will not be producing at the least-cost point (i.e. min AC) =>
firms have excess capacity
On the other hand it is often argued that these wastes are insignificant
and perhaps well compensated to the consumer by the greater variety
of products to choose.
1.3.4 Oligopoly Market

It is a market structure in which a small number of firms account for the
whole industry's output. The product may or may not be differentiated. For
example only 5 or 6 firms in India constitute 100% of the integrated steel
industry's output. All of them market almost identical products. On the other
hand, passenger car industry with only three firms is characterized by
marked differentiation in products The nature of products is such that very
often one finds entry of new firms difficult. Oligopoly is characterized by
vigorous competition where firms manipulate both prices and volumes in an
attempt to outsmart their rivals. No generalization can be made about
profitability scenarios.
1.3.4.1 Structure
In an oligopoly there are very few sellers of the good.
The product may be differentiated among the sellers (e.g.
automobiles) or homogeneous (e.g. petrol).
Homogenous product Pure Oligopoly
Entry is often limited
by legal restrictions (e.g. banking in most of the world)
by a very large minimum efficient scale
by strategic behavior.
1.3.4.2 Mutual Interdependence

The essence of an oligopolistic industry is the need for each firm to
consider how its own actions affect the decisions of its relatively few
competitors
To predict the outcome in such a market, economists need to model
the interaction between firms.
Oligopoly may be characterized by Collusion Cartels Or Non -
Cooperation
1.3.4.3 Collusion is difficult if

There are many firms in the industry
The product is not standardized
Demand and cost conditions are changing rapidly
There are no barriers to entry
Firms have surplus capacity
1.3.4.4 Explicit Collusion Cartels
A Cartel is a formal organization of sellers that seeks to restrict
competition
Maximum possible profits that can accrue as a result of a cartel is the
amount that would prevail under Monopoly
If the firms compete vigorously on the basis of price, lowest possible
equilibrium price that could prevail is the competitive price and
output
1.3.4.5 Sweezeys Model of Kinked Demand Curve

Explains Price Rigidity under Oligopoly
Starts with a predetermined Price Output
Demand Curve is kinked at current price:
The firm may expect rivals to respond if it reduces its price so,
demand in response to a price reduction is likely to be relatively
inelastic
For a price rise, rivals are less likely to react, so demand may be
relatively elastic
1.3.4.6 Price Stability with a Kinked Demand Curve

For any MC between a and b, the profit maximizing price and output
remain unchanged.
1.3.4.7 Tacit Collusion : Price Leadership

One firm sets the price and others follow three types of leaders:
Dominant firm price leadership
Barometric Price Leadership
Price Leadership by a low cost firm
1.3.4.7.1 Dominant Firm Price Leadership

Dominant Firm sets the price for the industry but lets followers sell
all they want at that price
The Dominant firm will provide the rest of the market demand
Followers, like in Perfect Competition, accept the price as given
1.3.4.7.2 Barometric Price Leadership

There is no one dominant firm
Price changes are in response to changes in some underlying market
conditions, obvious to all the firms
The critical requirement for being a leader is the ability to interpret
market conditions and propose price changes that other firms are
willing to follow
END CHAPTER QUIZZES
Q.1. Banking Sector is an example of
(a) Perfect Market
(b) Monopolistic Market
(c) Oligopoly Market
(d) Monopoly Market
Q.2 Which is not the characteristic of a perfect market
(a) Large number of small buyers and sellers
(b) Restricted entry and exit
(c) Homogeneous Products
(d) Free mobility of factors of production
Q.3. Profit maximizing condition for a firm is
(a) MR=MC.
(b) MR>MC
(c) MR<MC
(d) MC = AC
Q.4. In a Monopoly market, Barriers to Entry may be existing due to
(a) Control of scarce resources or input

(b) Technological superiority
(c) Patents
(d) All of the above
Q.5. Sweezeys Model of Kinked Demand Curve determines
(a) Price Rigidity in Oligopoly market
(b) Price discrimination in Monopoly market
(c) Profit maximizing Output in Oligopoly market
(d) Profit maximizing Output in Monopoly market
Q.6. A formal organization of sellers that seeks to restrict competition

is known as
(a) Sellers Association
(b) Cartel
(c) Trade Union
(d) Trade Association
Q.7. Which condition is false in case of a monopoly firm to earn

excessive profits over a long period
(a) Only one firm produces the product
(b) Low cross elasticity of demand between the monopolists product
and any other product; that is no close substitute products.
(c) Free entry of new firms
(d) Substantial barriers to entry that prevents competition from
entering the industry.
Q.8. Price Discrimination under Monopoly is not possible if
(a) Different markets are separable.

(b) Elasticity of demand is same in different markets.
( c) Market is imperfect.
(d) Elasticity of demand is different in different markets.
Q.9. In a Perfectly competitive market, in long run, firm earns

(a) Abnormal Profits
(b) Supernormal Profits
(c) Normal Profits
(d) Economic Profits
Q.10. Demand curve of a firm in perfect competitive market is
(a) Upward sloping
(b) Downward sloping
(c) Horizontal
(d) Vertical
KEY TO END CHAPTER QUIZZES
Chapter I Managerial Decision Making
1 (b ); 2(a ); 3(c ); 4(a ); 5(a ); 6(c ); 7(b ); 8(b ); 9(a ); 10(d )
Chapter II Business Forecasting
1 (c ); 2(a ); 3(d ); 4(d ); 5(d ); 6(a ); 7(d ); 8(b ); 9(b ); 10(c )
Chapter III Demand Analysis
1 (b ); 2(a ); 3(b ); 4(b ); 5(c ); 6(d ); 7(a ); 8(b ); 9(c ); 10(b )
Chapter IV Cost Analysis
1 (b ); 2(a ); 3(a ); 4(c ); 5(a ); 6(b ); 7(c ); 8(a ); 9(b ); 10(a )
Chapter V Production Analysis
1 (c ); 2(b ); 3(b ); 4(b ); 5(a ); 6(d ); 7(a ); 8(d ); 9(c ); 10(b )
Chapter VI Pricing Policy of the Firm
1 (b ); 2(c ); 3(c ); 4(b ); 5(b ); 6(b ); 7(a ); 8(d ); 9(c ); 10(a )
Chapter VII Objectives of the firm
1 (b ); 2(b ); 3(b ); 4(d ); 5(d ); 6(b ); 7(a ); 8(b ); 9(b ); 10(b )
Chapter VIII Market Structure
1 (c ); 2(b ); 3(a ); 4(d ); 5(a ); 6(b ); 7(c ); 8(b ); 9(c ); 10(c )
BIBLIOGRAPHY
Parl R Ferguson,Glenys J Ferguson(2000), Business Economics,

Macmillan, London.
K. E. Boulding(1948), Economic Analysis Harper and Bros., New York.
Koutsoyiannis,A.(1979), Modern Microeconomics, Macmillan, London.
K. E. Boulding(1966), Economic Analysis: Microeconomics Harper and
Bros., New York.
Browning, E.K. and Browning, J.M., Microeconomic Theory and
Application, Scott Foresman and Co., London.
Stigler George J.(1966), The Theory of Price, Macmillan, New York.
Mansfield,E.(1970), Microeconomics- Theory and Application, W.W.
Norton and Co., New York.
RH Dholakia and A.N Oza(1997), Microeconomics for Management
Studies, Oxford University Press.
Ivan Png(2004), Managerial Economics, 2nd Edition, Blackwell
Publishers.
Baumol, William, J.(1972), Economics Theory and Operations Analysis,
Prentice Hall of India, New Delhi.
Pindyek & Rubinfield(2004), Microeconomics, Prentice Hall of India,
New Delhi.
Mansfield,E.(1996), Managerial Economics- Theory Application, and
Cases, W.W. Norton and Co., New York.
Salvatore,D.(1989), Managerial Economics, McGraw Hill, New York.
Cris Lewis & Peterson(2002), Managerial Economics, Tata McGraw

Hill.
Ferguson, C.F.(1972), Microeconomic Theory, 3rd edn., Richard D.
Irwin, Homewood 3rd
Sloman(2004) Economics, 3rd edition, Prentice hall of India.
Shapiro, Edward, Macroeconomic Analysis, Harcourt Brace
Jovanovich, New York.
Gregory , N. Mankiw, Macroeconomics, 4th Edition, Macmillan,
London.
Dornbusch, R. and Fischer, S., Macroeconomics, 6th Edn., McGraw Hill,
New York.

AMF 103 Managerial Economics Book

Caricato da

Informazioni sul documento

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

AMF 103 Managerial Economics Book

Caricato da

Copyright:

Formati disponibili

AMF103 MANAGERIAL ECONOMICS

Master of Finance & Control Copyright Amity university India Page 1

S.I. NOS. CHAPTER TITLE PAGE NO.

Managerial Decision Making

Objectives of the Firm

Pricing Policy of the Firm

Master of Finance & Control Copyright Amity university India Page 2

MANAGERIAL DECISION MAKING

Master of Finance & Control Copyright Amity university India Page 3

1.2 Decision Making Process

Master of Finance & Control Copyright Amity university India Page 4

A second and more detailed method is the following:

1.3 Management Decision Problems

1.4 Corporate Decision Making : Ford Introduces the Taurus

Master of Finance & Control Copyright Amity university India Page 5

changed? Understanding consumer preferences and trade-offs and predicting

Master of Finance & Control Copyright Amity university India Page 6

1.5 Types of Decision

Organizational decisions are those executives make in their official role as

Master of Finance & Control Copyright Amity university India Page 8

1.6 Conditions Affecting Decision Making

Master of Finance & Control Copyright Amity university India Page 9

1.7 The Steps of Decision Making

Master of Finance & Control Copyright Amity university India Page 10

1.8 Selecting the Best Alternative

1.9 Implementing the Decision

1.10 Evaluating the Decision

1.11 Decision Making Model

Master of Finance & Control Copyright Amity university India Page 11

1.11.1 The Classical Model

1.11.2 The Administrative Model

Master of Finance & Control Copyright Amity university India Page 12

complete information about complex decisions, they usually wind up having to

1.12 Decision Making Techniques

Master of Finance & Control Copyright Amity university India Page 13

1.13 Group Decision Techniques

Master of Finance & Control Copyright Amity university India Page 14

1.14 Decision Making Tools

1.14.1 Linear Programming:

Master of Finance & Control Copyright Amity university India Page 15

Master of Finance & Control Copyright Amity university India Page 16

Master of Finance & Control Copyright Amity university India Page 17

Another important tool in taking one of the most economical decisions is

Master of Finance & Control Copyright Amity university India Page 18

Master of Finance & Control Copyright Amity university India Page 19

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

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

Master of Finance & Control Copyright Amity university India Page 20

END CHAPTER I QUIZZES :

(b) The Delphi group Technique

(c) The Nominal Group Technique

(d) None of the above

Q.2. Approval of Plans is the best example of -

(a) Organizational decisions,

(b) Basic decisions

(c) Programme decisions.

(d) Both (a) & (c)

(a) Basic decision

(b) Routine decision

(C) Personal decision

(d) Organizational decision

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

Master of Finance & Control Copyright Amity university India Page 21

(a) Technical Feasibility