Managerial Economics can be defined as amalgamation of economic theory with business practices so as to ease decision-making and future planning

by management. Managerial Economics assists the managers of a firm in a rational solution of obstacles faced in the firms activities. It makes use of economic theory and concepts. It helps in formulating logical managerial decisions. The key of Managerial Economics is the micro-economic theory of the firm. It lessens the gap between economics in theory and economics in practice. Managerial Economics is a science dealing with effective use of scarce resources. It guides the managers in taking decisions relating to the firms customers, competitors, suppliers as well as relating to the internal functioning of a firm. It makes use of statistical and analytical tools to assess economic theories in solving practical business problems. Study of Managerial Economics helps in enhancement of analytical skills, assists in rational configuration as well as solution of problems. While microeconomics is the study of decisions made regarding the allocation of resources and prices of goods and services, macroeconomics is the field of economics that studies the behavior of the economy as a whole (i.e. entire industries and economies). Managerial Economics applies micro-economic tools to make business decisions. It deals with a firm. The use of Managerial Economics is not limited to profit-making firms and organizations. But it can also be used to help in decision-making process of non-profit organizations (hospitals, educational institutions, etc). It enables optimum utilization of scarce resources in such organizations as well as helps in achieving the goals in most efficient manner. Managerial Economics is of great help in price analysis, production analysis, capital budgeting, risk analysis and determination of demand. Managerial economics uses both Economic theory as well as Econometrics for rational managerial decision making. Econometrics is defined as use of statistical tools for assessing economic theories by empirically measuring relationship between economic variables. It uses factual data for solution of economic problems. Managerial Economics is associated with the economic theory which constitutes Theory of Firm. Theory of firm states that the primary aim of the firm is to maximize wealth. Decision making in managerial economics generally involves establishment of firms objectives, identification of problems involved in achievement of those objectives, development of various alternative solutions, selection of best alternative and finally implementation of the decision.

Business Strategy is closely related with the concept of Strategic Management which is defined as a process of specifying an organization's objectives, developing plans and policies to achieve these objectives and effectively allocating resources to implement the required plans and policies. Business Strategy can be defined as a constant process of strategizing and prioritizing the goals of a business such as to conform to its long term objectives of growth and expansion and a motive to capture a larger market share. It is a continuous and ongoing situation where the business assesses the industry trend in which the company is involved, the nature of its existing and potential competitors, new technologies and a constantly changing social, political and financial environment. Business strategies or strategic planning is undertaken by the top managerial authority of a business and is subject to dynamic changes. A business strategy would usually constitute a strategy formulation (evaluation of the present situation) and a strategy implementation (allocation of resources and assigning specific tasks to particular individuals). Business Strategies when formulated have the most important feature of assessing the strengths and weaknesses of the company, the opportunities that the future holds and reviewing the threats posed by competing business rivals. A business strategy can integrate all the aspects of a business' activities and can serve as a systematic and management tool for problem solving and product development strategies and the issues of market planning. Business Strategy and Managerial Economics is an interdisciplinary field of study of economics that encompasses the fields of both managerial economics and business strategy. The branch builds a bridge between the two closely interrelated fields of study in undertaking the most prudent business decisions in a competitive setting with a large number of firms where each of them act to maximize their revenue and profits. Business strategy and managerial economics as a branch of social science vis--vis economics is similar to theory of games which is extensively used to determine business decisions in a world of imperfect competition. The optimal solution in a situation of games occurs when each of the acting agents (business firms in this case) optimize their own strategies insuring against the best strategies of their rivals. Managerial economics or business economics is a division of economics that involves heavy application of microeconomic analysis in case of business decisions. It is drawn heavily from quantitative techniques such as regression and correlation and methods of Lagrangian calculus. One of the essential features of managerial economics as a true bridge between economic theory and economics in practice is the attempt to optimize business decisions subject to the business' objectives and the constraints imposed upon it by the scarcity of resources. This is where we find unison between business strategy and managerial economics. It is widely approached as an integration subject. Business strategy concentrates itself on the strategic planning techniques and business planning strategies to maximize its long term objectives. The long term objectives usually constitute growth objectives, maximization of sales and revenue in the long term and the constant effort to diversify its services. Business strategy is an ongoing and continuous process which undergoes continuous adaptations with changing objectives and plans and policies to achieve those objectives. The adaptations are made in view of the changing business environment with the with entry and exit of business firms and an assessment or review of its strategies annually or quarterly to face the competition meted out by the existing and potential competitors. Business strategy constitutes of strategy formulation and strategy implementation. While strategy formulation entails doing a situation analysis and competitor analysis and setting goals in accordance with this assessment, strategy implementation requires allocation of sufficient resources and establishing a chain of command or adhering by an alternative structure. Strategy implementation involves managing the process, monitoring the results and analyzing the efficiency and efficacy of the process and accommodating the necessary adjustments.

Development of its product and its effective marketing is one of the pillars of the business strategies for a business organization. Microeconomic considerations such as maximization of one's own returns can be looked at both from the point of view of business economics as well as studies of business strategies of different firms or companies. Business strategy and managerial economics works with great efficacy in the following aspects of economics : It is especially useful in analyzing the risk of a business decision and various uncertainty models, decision rules and risk quantification techniques comes under its ambit. Production efficiency, optimum factor allocation, costs and economies of scale can be analyzed using microeconomic techniques that come under its fold. Microeconomic methods coming under the ambit of business strategy and managerial economics can be used to evaluate pricing decisions such as transfer pricing, joint product pricing, price discrimination practices and the accounting for differences of price elasticity. Investment theory which can be formulated by business strategy and managerial economics can be helpful to deal with capital budgeting used to examine the capital purchasing and investment decisions of a business. Technically, Managerial Economics and Business Strategy encompasses the issues of the number of firms in the market, the extent of diffusion of technology and the extent of research and development undertaken by businesses to gain technological advantage, the demand conditions in the market and the behavior of consumers towards a particular brand, production efficiency in terms of economies of scale thus capturing market power, measures of industry concentration, profits of the business and whether production takes place at the socially optimum level. Business strategy and managerial economics also delves deep into the topics of integration and merger activity (horizontal or vertical integration or conglomerate mergers), antitrust policies, analysis of market failure in the presence of externalities and incomplete information.

Production function
In microeconomics and macroeconomics, a production function is a function that specifies the output of a firm, an industry, or an entire economy for all combinations of inputs. This function is an assumed technological relationship, based on the current state of engineering knowledge; it does not represent the result of economic choices, but rather is an externally given entity that influences economic decision-making. Almost all economic theories presuppose a production function, either on the firm level or the aggregate level. In this sense, the production function is one of the key concepts of mainstream neoclassical theories. Some non-mainstream economists, however, reject the very concept of an aggregate production function.[1][2]

Concept of production functions

In micro-economics, a production function is a function that specifies the output of a firm for all combinations of inputs. A meta-production function (sometimes metaproduction function) compares the practice of the existing entities converting inputs into output to determine the most efficient practice production function of the existing entities, whether the most efficient feasible practice production or the most efficient actual practice production.[3]clarification needed In either case, the maximum output of a technologically-determined production process is a mathematical function of one or more inputs. Put another way, given the set of all technically feasible combinations of output and inputs, only the combinations encompassing a maximum output for a specified set of inputs would constitute the production function. Alternatively, a production function can be defined as the specification of the minimum input requirements needed to produce designated quantities of output, given available technology. It is usually presumed that unique production functions can be constructed for every production technology. By assuming that the maximum output technologically possible from a given set of inputs is achieved, economists using a production function in analysis are abstracting from the engineering and managerial problems inherently associated with a particular production process. The engineering and managerial problems of technical efficiency are assumed to be solved, so that analysis can focus on the problems of allocative efficiency. The firm is assumed to be making allocative choices concerning how much of each input factor to use and how much output to produce, given the cost (purchase price) of each factor, the selling price of the output, and the technological determinants represented by the production function. A decision frame in which one or more inputs are held constant may be used; for example, (physical) capital may be assumed to be fixed (constant) in the short run, and labour and possibly other inputs such as raw materials variable, while in the long run, the quantities of both capital and the other factors that may be chosen by the firm are variable. In the long run, the firm may even have a choice of technologies, represented by various possible production functions. The relationship of output to inputs is non-monetary; that is, a production function relates physical inputs to physical outputs, and prices and costs are not reflected in the function. But the

production function is not a full model of the production process: it deliberately abstracts from inherent aspects of physical production processes that some would argue are essential, including error, entropy or waste. Moreover, production functions do not ordinarily model the business processes, either, ignoring the role of management. (For a primer on the fundamental elements of microeconomic production theory, see production theory basics). The primary purpose of the production function is to address allocative efficiency in the use of factor inputs in production and the resulting distribution of income to those factors. Under certain assumptions, the production function can be used to derive a marginal product for each factor, which implies an ideal division of the income generated from output into an income due to each input factor of production.

Specifying the production function

A production function can be expressed in a functional form as the right side of

where: quantity of output quantities of factor inputs (such as capital, labour, land or raw materials).

If Q is not a matrix (i.e. a scalar, a vector, or even a diagonal matrix), then this form does not encompass joint production, which is a production process that has multiple co-products. On the other hand, if f maps from Rn to Rk then it is a joint production function expressing the determination of k different types of output based on the joint usage of the specified quantities of the n inputs. One formulation, unlikely to be relevant in practice, is as a linear function:

where

and

are parameters that are determined empirically.

Another is as a Cobb-Douglas production function:

The Leontief production function applies to situations in which inputs must be used in fixed proportions; starting from those proportions, if usage of one input is increased without another being increased, output will not change. This production function is given by

Other forms include the constant elasticity of substitution production function (CES), which is a generalized form of the Cobb-Douglas function, and the quadratic production function. The best form of the equation to use and the values of the parameters ( ) vary from company to company and industry to industry. In a short run production function at least one of the 's (inputs) is fixed. In the long run all factor inputs are variable at the discretion of management.

Production function as a graph

Quadratic Production Function

Any of these equations can be plotted on a graph. A typical (quadratic) production function is shown in the following diagram under the assumption of a single variable input (or fixed ratios of inputs so the can be treated as a single variable). All points above the production function are unobtainable with current technology, all points below are technically feasible, and all points on the function show the maximum quantity of output obtainable at the specified level of usage of

the input. From the origin, through points A, B, and C, the production function is rising, indicating that as additional units of inputs are used, the quantity of output also increases. Beyond point C, the employment of additional units of inputs produces no additional output (in fact, total output starts to decline); the variable input is being used too intensively. With too much variable input use relative to the available fixed inputs, the company is experiencing negative marginal returns to variable inputs, and diminishing total returns. In the diagram this is illustrated by the negative marginal physical product curve (MPP) beyond point Z, and the declining production function beyond point C. From the origin to point A, the firm is experiencing increasing returns to variable inputs: As additional inputs are employed, output increases at an increasing rate. Both marginal physical product (MPP, the derivative of the production function) and average physical product (APP, the ratio of output to the variable input) are rising. The inflection point A defines the point beyond which there are diminishing marginal returns, as can be seen from the declining MPP curve beyond point X. From point A to point C, the firm is experiencing positive but decreasing marginal returns to the variable input. As additional units of the input are employed, output increases but at a decreasing rate. Point B is the point beyond which there are diminishing average returns, as shown by the declining slope of the average physical product curve (APP) beyond point Y. Point B is just tangent to the steepest ray from the origin hence the average physical product is at a maximum. Beyond point B, mathematical necessity requires that the marginal curve must be below the average curve (See production theory basics for further explanation.).

Stages of production
To simplify the interpretation of a production function, it is common to divide its range into 3 stages. In Stage 1 (from the origin to point B) the variable input is being used with increasing output per unit, the latter reaching a maximum at point B (since the average physical product is at its maximum at that point). Because the output per unit of the variable input is improving throughout stage 1, a price-taking firm will always operate beyond this stage. In Stage 2, output increases at a decreasing rate, and the average and marginal physical product are declining. However, the average product of fixed inputs (not shown) is still rising, because output is rising while fixed input usage is constant. In this stage, the employment of additional variable inputs increases the output per unit of fixed input but decreases the output per unit of the variable input. The optimum input/output combination for the price-taking firm will be in stage 2, although a firm facing a downward-sloped demand curve might find it most profitable to operate in Stage 1. In Stage 3, too much variable input is being used relative to the available fixed inputs: variable inputs are over-utilized in the sense that their presence on the margin obstructs the production process rather than enhancing it. The output per unit of both the fixed and the variable input declines throughout this stage. At the boundary between stage 2 and stage 3, the highest possible output is being obtained from the fixed input.

Shifting a production function

By definition, in the long run the firm can change its scale of operations by adjusting the level of inputs that are fixed in the short run, thereby shifting the production function upward as plotted against the variable input. If fixed inputs are lumpy, adjustments to the scale of operations may be more significant than what is required to merely balance production capacity with demand. For example, you may only need to increase production by a million units per year to keep up with demand, but the production equipment upgrades that are available may involve increasing productive capacity by 2 million units per year.

Shifting a Production Function

If a firm is operating at a profit-maximizing level in stage one, it might, in the long run, choose to reduce its scale of operations (by selling capital equipment). By reducing the amount of fixed capital inputs, the production function will shift down. The beginning of stage 2 shifts from B1 to B2. The (unchanged) profit-maximizing output level will now be in stage 2.

Homogeneous and homothetic production functions

There are two special classes of production functions that are often analyzed. The production function is said to be homogeneous of degree n, if given any positive constant , . If , the function exhibits increasing returns to scale, and it exhibits decreasing returns to scale if . If it is homogeneous of degree 1, it exhibits constant returns to scale. The presence of increasing returns means that a one percent increase in the usage levels of all inputs would result in a greater than one percent increase in output; the presence of decreasing returns means that it would result in a less than one

percent increase in output. Constant returns to scale is the in-between case. In the Cobb-Douglas production function referred to above, returns to scale are increasing if , decreasing if , and constant if . If a production function is homogeneous of degree one, it is sometimes called "linearly homogeneous". A linearly homogeneous production function with inputs capital and labour has the properties that the marginal and average physical products of both capital and labour can be expressed as functions of the capital-labour ratio alone. Moreover, in this case if each input is paid at a rate equal to its marginal product, the firm's revenues will be exactly exhausted and there will be no excess economic profit.[4]:pp.412-414 Homothetic functions are functions whose marginal technical rate of substitution (the slope of the isoquant, a curve drawn through the set of points in say labour-capital space at which the same quantity of output is produced for varying combinations of the inputs) is homogeneous of degree zero. Due to this, along rays coming from the origin, the slopes of the isoquants will be the same. Homothetic functions are of the form monotonically increasing function (the derivative of function is positive ( is a homogeneous function of any degree. where is a )), and the

Aggregate production functions

In macroeconomics, aggregate production functions for whole nations are sometimes constructed. In theory they are the summation of all the production functions of individual producers; however there are methodological problems associated with aggregate production functions, and economists have debated extensively whether the concept is valid.[2]

Criticisms of production functions

There are two major criticisms of the standard form of the production function. On the history of production functions, see Mishra (2007).[5]
On the concept of capital

During the 1950s, '60s, and '70s there was a lively debate about the theoretical soundness of production functions. (See the Capital controversy.) Although the criticism was directed primarily at aggregate production functions, microeconomic production functions were also put under scrutiny. The debate began in 1953 when Joan Robinson criticized the way the factor input capital was measured and how the notion of factor proportions had distracted economists. According to the argument, it is impossible to conceive of capital in such a way that its quantity is independent of the rates of interest and wages. The problem is that this independence is a precondition of constructing an isoquant. Further, the slope of the isoquant helps determine relative factor prices, but the curve cannot be constructed (and its slope measured) unless the prices are known beforehand.

On the empirical relevance

As a result of the criticism on their weak theoretical grounds, it has been claimed that empirical results firmly support the use of neoclassical well behaved aggregate production functions. Nevertheless, Anwar Shaikh[6] has demonstrated that they also have no empirical relevance, as long as alleged good fit outcomes from an accounting identity, not from any underlying laws of production/distribution.

Returns to scale
From Wikipedia, the free encyclopedia Jump to: navigation, search

In economics, returns to scale and economies of scale are related terms that describe what happens as the scale of production increases in the long run, when all input levels including physical capital usage are variable (chosen by the firm). They are different terms and should not be used interchangeably. The term returns to scale arises in the context of a firm's production function. It refers to changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor). If output increases by that same proportional change then there are constant returns to scale (CRS). If output increases by less than that proportional change, there are decreasing returns to scale (DRS). If output increases by more than that proportional change, there are increasing returns to scale (IRS). Thus the returns to scale faced by a firm are purely technologically imposed and are not influenced by economic decisions or by market conditions.[citation needed] A firm's production function could exhibit different types of returns to scale in different ranges of output. Typically, there could be increasing returns at relatively low output levels, decreasing returns at relatively high output levels, and constant returns at one output level between those ranges.[citation needed]

Example
When all inputs increase by a factor of 2, new values for output will be:

Twice the previous output if there are constant returns to scale (CRS) Less than twice the previous output if there are decreasing returns to scale (DRS) More than twice the previous output if there are increasing returns to scale (IRS)

Assuming that the factor costs are constant (that is, that the firm is a perfect competitor in all input markets), a firm experiencing constant returns will have constant long-run average costs, a firm experiencing decreasing returns will have increasing long-run average costs, and a firm experiencing increasing returns will have decreasing long-run average costs.[1][2][3] However, this relationship breaks down if the firm is not a perfect competitor in the input markets. For example, if there are increasing returns to scale in some range of output levels, but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input's per-unit cost, then the firm could have diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of

scale in some range of output levels even if it has decreasing returns in production in that output range.

Network effect
Network externalities resemble economies of scale, but they are not considered such because they are a function of the number of users of a good or service in an industry, not of the production efficiency within a business. Economies of scale external to the firm (or industry wide scale economies) are only considered examples of network externalities if they are driven by demand side economies.

Formal definitions
Formally, a production function

is defined to have:

constant returns to scale if (for any constant a greater than 0) increasing returns to scale if (for any constant decreasing returns to scale if (for any constant

a a

greater greater

than than

1) 1)

where K and L are factors of production, capital and labor, res

Production Optimization
To maximize the performance and bottom-line contribution of operational assets, organizations need to move beyond traditional operating approaches and embrace new methods and technologies that enable the highest possible production yield at the lowest possible cost, while operating in a safe and environmentally conscious manner. Invensys Operations Management provides a wide range of solutions aimed at addressing this challenge, combining our extensive global expertise and experience with state of the art modeling and simulation software. The results are immediate and significant, including improved yield, reduced energy consumption, reduced emissions and higher availability. Our solutions include integration with your business systems to provide real-time business intelligence, allowing you to optimize profitability in real time. Our consulting and services team work with you throughout the process identifying opportunities for improvement, designing and implementing the required solutions and then continuing with you to ensure that the expected returns are met and exceeded.

Key Benefits

Return on investment in 3 months or less Improved availability and reliability Improved production yield and economic value Reduced energy consumption and emissions Allows you to predict and proactively address issues and opportunities

Key Capabilities

First principle rigorous modeling software Packaged solutions for specific optimization challenges Proven global expertise solution design, implementation and ongoing improvements Integration with existing systems maximizing your return

Request More Information

Related Success Stories

China Ministry of Railways Starting with a 100-mile line for the 2008 Beijing Olympics, the China Ministry of Railways has chosen Wonderware software to expand the countrys national railway system.

Break-even (economics)
The Break-Even Point'

In economics & business, specifically cost accounting, the break-even point (BEP) is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has "broken even". A profit or a loss has not been made, although opportunity costs have been "paid", and capital has received the risk-adjusted, expected return.[1] For example, if a business sells fewer than 200 tables each month, it will make a loss, if it sells more, it will be a profit. With this information, the business managers will then need to see if they expect to be able to make and sell 200 tables per month. If they think they cannot sell that many, to ensure viability they could:
1. Try to reduce the fixed costs (by renegotiating rent for example, or keeping better control of telephone bills or other costs) 2. Try to reduce variable costs (the price it pays for the tables by finding a new supplier) 3. Increase the selling price of their tables.

Any of these would reduce the break even point. In other words, the business would not need to sell so many tables to make sure it could pay its fixed costs.

Computation
In the linear Cost-Volume-Profit Analysis model,[2] the break-even point (in terms of Unit Sales (X)) can be directly computed in terms of Total Revenue (TR) and Total Costs (TC) as:

where:

TFC is Total Fixed Costs, P is Unit Sale Price, and V is Unit Variable Cost.

The Break-Even Point can alternatively be computed as the point where Contribution equals Fixed Costs.

The quantity is of interest in its own right, and is called the Unit Contribution Margin (C): it is the marginal profit per unit, or alternatively the portion of each sale that contributes to Fixed Costs. Thus the break-even point can be more simply computed as the point where Total Contribution = Total Fixed Cost:

In currency units (sales proceeds) to reach break-even, one can use the above calculation and multiply by Price, or equivalently use the Contribution Margin Ratio (Unit Contribution Margin over Price) to compute it as: R=C, Where R is revenue generated, C is cost incurred i.e. Fixed costs + Variable Costs or Q * P(Price per unit) = TFC + Q * VC(Price per unit), Q * P - Q * VC = TFC, Q * (P - VC) = TFC, or, Break Even Analysis Q = TFC/c/s ratio=Break Even

Margin of Safety
Margin of safety represents the strength of the business. It enables a business to know what is the exact amount it has gained or lost and whether they are over or below the break even point.[3] margin of safety = (current output - breakeven output) margin of safety% = (current output - breakeven output)/current output x 100 When dealing with budgets you would instead replace "Current output" with "Budgeted output". If P/V ratio is given then profit/ PV ratio

Break Even Analysis

By inserting different prices into the formula, you will obtain a number of break even points, one for each possible price charged. If the firm changes the selling price for its product, from $2 to $2.30, in the example above, then it would have to sell only (1000/(2.3 - 0.6))= 589 units to break even, rather than 715.

To make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC in the diagram) which shows the total cost associated with each possible level of output, the fixed cost curve (FC) which shows the costs that do not vary with output level, and finally the various total revenue lines (R1, R2, and R3) which show the total amount of revenue received at each output level, given the price you will be charging. The break even points (A,B,C) are the points of intersection between the total cost curve (TC) and a total revenue curve (R1, R2, or R3). The break even quantity at each selling price can be read off the horizontal axis and the break even price at each selling price can be read off the vertical axis. The total cost, total revenue, and fixed cost curves can each be constructed with simple formulae. For example, the total revenue curve is simply the product of selling price times quantity for each output quantity. The data used in these formulae come either from accounting records or from various estimation techniques such as regression analysis.
Application

The break-even point is one of the simplest yet least used analytical tools in management. It helps to provide a dynamic view of the relationships between sales, costs and profits. A better understanding of break-even, for example, is expressing break-even sales as a percentage of actual salescan give managers a chance to understand when to expect to break even (by linking the percent to when in the week/month this percent of sales might occur). The break-even point is a special case of Target Income Sales, where Target Income is 0 (breaking even). This is very important for financial analysis.

Limitations

Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices. It assumes that fixed costs (FC) are constant. Although this is true in the short run, an increase in the scale of production is likely to cause fixed costs to rise. It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. (i.e. linearity) It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period). In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant).

Price discrimination
From Wikipedia, the free encyclopedia Jump to: navigation, search

Price discrimination or price differentiation[1] exists when sales of identical goods or services are transacted at different prices from the same provider.[2] In a theoretical market with perfect information, perfect substitutes, and no transaction costs or prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of monopolistic and oligopolistic markets,[3] where market power can be exercised. Otherwise, the moment the seller tries to sell the same good at different prices, the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price but with a tiny discount. However, product heterogeneity, market frictions or high fixed costs (which make marginal-cost pricing unsustainable in the long run) can allow for some degree of differential pricing to different consumers, even in fully competitive retail or industrial markets. Price discrimination also occurs when the same price is charged to customers which have different supply costs. The effects of price discrimination on social efficiency are unclear; typically such behavior leads to lower prices for some consumers and higher prices for others. Output can be expanded when price discrimination is very efficient, but output can also decline when discrimination is more effective at extracting surplus from high-valued users than expanding sales to low valued users. Even if output remains constant, price discrimination can reduce efficiency by misallocating output among consumers. Price discrimination requires market segmentation and some means to discourage discount customers from becoming resellers and, by extension, competitors. This usually entails using one or more means of preventing any resale, keeping the different price groups separate, making price comparisons difficult, or restricting pricing information. The boundary set up by the marketer to keep segments separate are referred to as a rate fence. Price discrimination is thus very common in services where resale is not possible; an example is student discounts at museums. Price discrimination in intellectual property is also enforced by law and by technology. In the market for DVDs, DVD players are designed - by law - with chips to prevent an inexpensive copy of the DVD (for example legally purchased in India) from being used in a higher price market (like the US). The Digital Millennium Copyright Act has provisions to outlaw circumventing of such devices to protect the enhanced monopoly profits that copyright holders can obtain from price discrimination against higher price market segments. Price discrimination can also be seen where the requirement that goods be identical is relaxed. For example, so-called "premium products" (including relatively simple products, such as cappuccino compared to regular coffee) have a price differential that is not explained by the cost of production. Some economists have argued that this is a form of price discrimination exercised by providing a means for consumers to reveal their willingness to pay.

Types of price discrimination

First degree price discrimination

This type of price discrimination is primarily theoretical because it requires the seller of a good or service to know the absolute maximum price (or reservation price) that every consumer is willing to pay. By knowing the reservation price, the seller is able to absorb the entire market surplus, thus taking all of the consumer's surplus from the consumer and transforming it into revenues. From a social welfare perspective though, first degree price discrimination is not necessarily undesirable. That is, the market is entirely efficient and there is no deadweight loss to society. In a market with first degree price discrimination, the seller(s) simply captures all surplus. This type of market does not exist much in reality, hence it is primarily theoretical. Examples of where this might be observed are in markets where consumers bid for tenders, though still, in this case, the practice of collusive tendering undermines efficiency.
Second degree price discrimination

In second degree price discrimination, price varies according to quantity sold. Larger quantities are available at a lower unit price. This is particularly widespread in sales to industrial customers, where bulk buyers enjoy higher discounts. Additionally to second degree price discrimination, sellers are not able to differentiate between different types of consumers. Thus, the suppliers will provide incentives for the consumers to differentiate themselves according to preference. As above, quantity "discounts", or non-linear pricing, is a means by which suppliers use consumer preference to distinguish classes of consumers. This allows the supplier to set different prices to the different groups and capture a larger portion of the total market surplus. In reality, different pricing may apply to differences in product quality as well as quantity. For example, airlines often offer multiple classes of seats on flights, such as first class and economy class. This is a way to differentiate consumers based on preference, and therefore allows the airline to capture more consumer's surplus.
Third degree price discrimination

In third degree price discrimination, price varies by attributes such as location or by customer segment, or in the most extreme case, by the individual customer's identity; where the attribute in question is used as a proxy for ability/willingness to pay. Additionally to third degree price discrimination, the supplier(s) of a market where this type of discrimination is exhibited are capable of differentiating between consumer classes. Examples of this differentiation are student or senior discounts. For example, a student or a senior consumer will have a different willingness to pay than an average consumer, where the reservation price is presumably lower because of budget constraints. Thus, the supplier sets a lower price for that consumer because the student or senior has a more elastic price elasticity of demand (see the discussion of price elasticity of demand as it applies to revenues from the first degree price

discrimination, above). The supplier is once again capable of capturing more market surplus than would be possible without price discrimination. Note that it is not always advantageous to the company to price discriminate even if it is possible, especially for second and third degree discrimination. In some circumstances, the demands of different classes of consumers will encourage suppliers to ignore one or more classes and target entirely to the rest. Whether it is profitable to price discriminate is determined by the specifics of a particular market.
Fourth degree price discrimination

In fourth degree price discrimination, prices are the same for different customers, however costs to the organization may vary. For example, one may buy a plane ticket, but call ahead to order a vegetarian meal, possibly costing the company more to provide, but your ticket has no greater cost to you. This is also known as reverse price discrimination, as the effects are reflected on the producer.

Modern taxonomy
The first/second/third degree taxonomy of price discrimination is due to Pigou (Economics of Welfare, 4th edition, 1932). See, e.g., modern taxonomy of price discrimination. However, these categories are not mutually exclusive or exhaustive. Ivan Png (Managerial Economics, 2nd edition, 2002) suggests an alternative taxonomy:

Complete discrimination -- where each user purchases up to the point where the user's marginal benefit equals the marginal cost of the item; Direct segmentation -- where the seller can condition price on some attribute (like age or gender) that directly segments the buyers; Indirect segmentation -- where the seller relies on some proxy (e.g., package size, usage quantity, coupon) to structure a choice that indirectly segments the buyers.

The hierarchycomplete/direct/indirectis in decreasing order of

profitability and information requirement.

Complete price discrimination is most profitable, and requires the seller to have the most information about buyers. Indirect segmentation is least profitable, and requires the seller to have the least information about buyers.

Two part tariff

the two part tariff is another form of price discrimination where the producer charges an initial fee then a secondary fee for the use of the product, an example of this is razors, you pay an initial cost for the Gillet razor and then pay for the replacement blades, this pricing strategy works because it shifts the demand curve to the right since you have already paid for the initial blade holder you will buy the blades which are now cheaper than buying a disposable razor, the formulea for profit from a two part tariff is =PQ+nT-C1(Q)-C2(n) where is profit P is price Q is quantity n is number of customers (who pay tariff) C is cost so re written it is = (price x quantity + number of people x tariff) - the cost of producing that quantity - the cost of producing the tariff (blade holders)

Sales revenue without and with Price Discrimination

The purpose of price discrimination is generally to capture the market's consumer surplus. This surplus arises because, in a market with a single clearing price, some customers (the very low price elasticity segment) would have been prepared to pay more than the single market price. Price discrimination transfers some of this surplus from the consumer to the producer/marketer. Strictly, a consumer surplus need not exist, for example where some below-cost selling is beneficial due to fixed costs or economies of scale. An example is a high-speed internet connection shared by two consumers in a single building; if one is willing to pay less than half the cost, and the other willing to make up the rest but not to pay the entire cost, then price discrimination is necessary for the purchase to take place. It can be proved mathematically that a firm facing a downward sloping demand curve that is convex to the origin will always obtain higher revenues under price discrimination than under a single price strategy. This can also be shown diagrammatically. In the top diagram, a single price (P) is available to all customers. The amount of revenue is represented by area P, A, Q, O. The consumer surplus is the area above line segment P, A but below the demand curve (D). With price discrimination, (the bottom diagram), the demand curve is divided into two segments (D1 and D2). A higher price (P1) is charged to the low elasticity segment, and a lower price (P2) is charged to the high elasticity segment. The total revenue from the first segment is equal to the area P1,B, Q1,O. The total revenue from the second segment is equal to the area E, C,Q2,Q1. The sum of these areas will always be greater than the area without discrimination assuming the demand curve resembles a rectangular hyperbola with unitary elasticity. The more prices that are introduced, the greater the sum of the revenue areas, and the more of the consumer surplus is captured by the producer.

Note that the above requires both first and second degree price discrimination: the right segment corresponds partly to different people than the left segment, partly to the same people, willing to buy more if the product is cheaper. It is very useful for the price discriminator to determine the optimum prices in each market segment. This is done in the next diagram where each segment is considered as a separate market with its own demand curve. As usual, the profit maximizing output (Qt) is determined by the intersection of the marginal cost curve (MC) with the marginal revenue curve for the total market (MRt).

Multiple Market Price Determination

The firm decides what amount of the total output to sell in each market by looking at the intersection of marginal cost with marginal revenue (profit maximization). This output is then divided between the two markets, at the equilibrium marginal revenue level. Therefore, the optimum outputs are Qa and Qb. From the demand curve in each market we can determine the profit maximizing prices of Pa and Pb. It is also important to note that the marginal revenue in both markets at the optimal output levels must be equal, otherwise the firm could profit from transferring output over to whichever market is offering higher marginal revenue.

Examples of price discrimination

Retail price discrimination

In certain circumstances, it is a violation of the Robinson-Patman Act, (a 1936 Federal U.S. antitrust statute) for manufacturers of goods to sell their products to similarly situated retailers at different prices based solely on the volume of products purchased.
Travel industry

Airlines and other travel companies use differentiated pricing regularly, as they sell travel products and services simultaneously to different market segments. This is often done by assigning capacity to various booking classes, which sell for different prices and which may be linked to fare restrictions. The restrictions or "fences" help ensure that market segments buy in the booking class range that has been established for them. For example, schedule-sensitive business passengers who are willing to pay $300 for a seat from city A to city B cannot purchase a $150 ticket because the $150 booking class contains a requirement for a Saturday night stay, or a 15-day advance purchase, or another fare rule that discourages, minimizes, or effectively prevents a sale to business passengers. Notice however that in this example "the seat" is not really always the same product. That is, the business person who purchases the $300 ticket may be willing to do so in return for a seat on a high-demand morning flight, for full refundability if the ticket is not used, and for the ability to upgrade to first class if space is available for a nominal fee. On the same flight are price-sensitive passengers who are not willing to pay $300, but who are willing to fly on a lower-demand flight (say one leaving an hour earlier), or via a connection city (not a non-stop flight), and who are willing to forgo refundability. On the other hand, an airline may also apply differential pricing to "the same seat" over time, e.g. by discounting the price for an early or late booking (without changing any other fare condition). This could present an arbitrage opportunity in the absence of any restriction on reselling. However, passenger name changes are typically prevented or financially penalized by contract. Since airlines often fly multi-leg flights, and since no-show rates vary by segment, competition for the seat has to take in the spatial dynamics of the product. Someone trying to fly A-B is competing with people trying to fly A-C through city B on the same aircraft. This is one reason airlines use yield management technology to determine how many seats to allot for A-B passengers, B-C passengers, and A-B-C passengers, at their varying fares and with varying demands and no-show rates. With the rise of the Internet and the growth of low fare airlines, airfare pricing transparency has become far more pronounced. Passengers discovered it is quite easy to compare fares across different flights or different airlines. This helped put pressure on airlines to lower fares. Meanwhile, in the recession following the September 11, 2001, attacks on the U.S., business travelers and corporate buyers made it clear to airlines that they were not going to be buying air travel at rates high enough to subsidize lower fares for non-business travelers. This prediction

has come true, as vast numbers of business travelers are buying airfares only in economy class for business travel. There are sometimes group discounts on rail tickets and passes. This may be in view of the alternative of going by car together.
Coupons

The use of coupons in retail is an attempt to distinguish customers by their reserve price. The assumption is that people who go through the trouble of collecting coupons have greater price sensitivity than those who do not. Thus, making coupons available enables, for instance, breakfast cereal makers to charge higher prices to price-insensitive customers, while still making some profit off customers who are more price-sensitive.
Premium pricing

For certain products, premium products are priced at a level (compared to "regular" or "economy" products) that is well beyond their marginal cost of production. For example, a coffee chain may price regular coffee at $1, but "premium" coffee at $2.50 (where the respective costs of production may be $0.90 and $1.25). Economists such as Tim Harford in the Undercover Economist have argued that this is a form of price discrimination: by providing a choice between a regular and premium product, consumers are being asked to reveal their degree of price sensitivity (or willingness to pay) for comparable products. Similar techniques are used in pricing business class airline tickets and premium alcoholic drinks, for example. This effect can lead to (seemingly) perverse incentives for the producer. If, for example, potential business class customers will pay a large price differential only if economy class seats are uncomfortable while economy class customers are more sensitive to price than comfort, airlines may have substantial incentives to purposely make economy seating uncomfortable. In the example of coffee, a restaurant may gain more economic profit by making poor quality regular coffeemore profit is gained from up-selling to premium customers than is lost from customers who refuse to purchase inexpensive but poor quality coffee. In such cases, the net social utility should also account for the "lost" utility to consumers of the regular product, although determining the magnitude of this foregone utility may not be feasible.
Segmentation by age group and student status

Many movie theaters, amusement parks, tourist attractions, and other places have different admission prices per market segment: typical groupings are Youth, Student, Adult, and Senior. Each of these groups typically have a much different demand curve. Children, people living on student wages, and people living on retirement generally have much less disposable income.
Discounts for members of certain occupations

Many businesses, especially in the Southern United States, offer reduced prices to active military members. In addition to increased sales to the target group, businesses benefit from the resulting

positive publicity, leading to increased sales to the general public. Less publicized are discounts to other service workers such as police; off-duty police customers in high-crime areas are said to constitute free security.[citation needed]
Employee discounts

Most people feel that discounts businesses give to their own employees are an employee benefit (and is often listed as such in the employee handbook). However, some might construe this as a form of price discrimination.
Retail incentives

A variety of incentive techniques may be used to increase market share or revenues at the retail level. These include discount coupons, rebates, bulk and quantity pricing, seasonal discounts, and frequent buyer discounts.
Incentives for industrial buyers

Many methods exist to incentivize wholesale or industrial buyers. These may be quite targeted, as they are designed to generate specific activity, such as buying more frequently, buying more regularly, buying in bigger quantities, buying new products with established ones, and so on. Thus, there are bulk discounts, special pricing for long-term commitments, non-peak discounts, discounts on high-demand goods to incentivize buying lower-demand goods, rebates, and many others. This can help the relations between the firms involved.
Sex-based examples

Many sex-based price differences are held to be illegal but still occur often in countries such as the United States and the United Kingdom.
"Ladies' night"

Many North American and European nightclubs feature a "ladies' night" in which women are offered discount or free drinks, or are absolved from payment of cover charges. This differs from conventional price discrimination in that the primary motive is not, usually, to increase revenue at the expense of consumer surplus, but to increase the club's attractiveness to the market side more willing to pay (men), for the benefit of the other (women). (See also two-sided market)
Dry cleaning

Dry cleaners typically charge higher prices for the laundering of women's clothes than for men's. Some US communities have reacted by outlawing the practice. Dry cleaners justify the price differences because women's clothes typically require far more time to press than men's clothes due to more pleating. This qualifies an example of price discrimination if at least part of the reason for the higher pricing is really the dry cleaner's belief that women will be willing to pay more than men.

Haircutting

Women's haircuts are often more expensive than men's haircuts because women generally have longer, more complex hairstyles whereas men generally have shorter hairstyles. Some salons have modified their pricing to reflect "long hair" versus "short hair" or style instead of sex. This situation has been common practice in barber shops for decades.
Automobile Insurance

Males have traditionally been charged higher rates than women for automobile insurance, and much higher rates for under-30s. This disparity is especially prevalent for males under the age of 25.
Financial aid in education

Financial aid as offered by U.S. colleges and universities is a form of price discrimination that is widely accepted, and completely legal.
Haggling

Many cultures involve haggling in market transactions inflated prices are posted, but the customer can negotiate with the vendor. In the United States, haggling is rare to non-existent in retail, but common when automobiles and homes are sold. Negotiation often requires knowledge, confidence, and the ability to manage confrontational personalities, and vendors know that many customers will pay higher prices in order to avoid negotiating.
International price discrimination

Pharmaceutical companies may charge customers living in wealthier countries (such as the United States) a much higher price than for identical drugs in poorer nations, as is the case with the sale of anti-retroviral drugs in Africa. Since the purchasing power of African consumers is much lower, sales would be extremely limited without price discrimination. The ability of pharmaceutical companies to maintain price differences between countries is often either reinforced or hindered by national drugs laws and regulations, or the lack thereof. Although not common in modern times, governments have traditionally raised revenues from tariffs. When these are not flat tariffs, the government effectively sets the prices of goods that are not produced locally and are only imported. Even online sales for non material goods, which do not have to be shipped, may change according to the geographic location of the buyer. A song in Apple's iTunes costs 79 pence (1.49 USD) for Britons but only 99 cents for Americans. (~50% more for the same song) These differences may arise because of changes in exchange rates that occur much more frequently than changes in prices, or they may arise because the license-holders (in this case, record companies) are enforcing their existing pricing policy on new licensees or intermediaries.

Academic pricing Main article: Academic software pricing

Companies will often offer discounted software to students and faculty at K-12 and university levels. These may be labeled as academic versions, but perform the same as the full price retail software. Academic versions of the most expensive software suites may be priced as little as one fifth or less of retail price. Some academic software may have differing licenses than retail versions, usually disallowing their use in activities for profit or expiring the license after a given number of months. This also has the characteristics of an "initial offer" - that is, the profits from an academic customer may come partly in the form of future non-academic sales due to vendor lock-in. For example, an accounting student buys academically priced Microsoft Excel, and as a result of getting used to it, continues to use it throughout a future career, the future editions of which he buys at full price, instead of moving to the fully compatible OpenOffice.org equivalent application.
Dual pricing

Even within a country, differentiated pricing may be established to ensure that citizens receive lower prices than non-citizens; this is known as dual pricing. This is particularly common for goods that are subsidized or otherwise provided by the state (and hence paid by taxpayers). Thus, in places such as Switzerland, Finland, Thailand, and India, citizens may purchase special fare tickets for public transportation that are available only to citizens. Many countries also maintain separate admission charges for museums, national parks and similar facilities, the usually professed reason being that citizens should be able to educate themselves and enjoy the country's natural wonders cheaply, but other visitors should pay the market rate. Certain places in Thailand will often have one price for tourists and another for native Thais. The Grand Palace in Bangkok, for example, charges admission to foreign tourists, but Thai citizens are allowed free entry. Many publicly run universities in the United States are subsidized by taxpayers of the state in which they are located; residents of said state are frequently given a discount on tuition as a result.
Wage discrimination

Wage discrimination is when the price of equivalent labor is discriminated among different groups of workers. This may be seen as just one kind of price discrimination or as an example of its inverse, one buyer buying identical goods at different rates.

Universal pricing
Universal pricing is the opposite of price discrimination one price is offered for the good or service. This is usually preferred by consumers over tiered pricing.[citation needed] For example, the European Union is currently making efforts to set a single-price protocol for automobile sales.[citation needed]

Two necessary conditions for price discrimination

There are two conditions that must be met if a price discrimination scheme is to work. First the firm must be able to identify market segments by their price elasticity of demand and second the firms must be able to enforce the scheme.[4] For example, airlines routinely engage in price discrimination by charging high prices for customers with relatively inelastic demand - business travelers - and discount prices for tourist who have relatively elastic demand. The airlines enforce the scheme by making the tickets non-transferable thus preventing a tourist from buying a ticket at a discounted price and selling it to a business traveler (arbitrage). Airlines must also prevent business travelers from directly buying discount tickets. Airlines accomplish this by imposing advance ticketing requirements or minimum stay requirements conditions that it would be difficult for average business traveler to meet.[5]

User-controlled price discrimination

While the conventional theory of price discrimination generally assumes that prices are set by the seller, there is a variant form in which prices are set by the buyer, such as in the form of pay what you want pricing. Such user-controlled price discrimination exploits similar ability to adapt to varying demand curves or individual price sensitivities, and may avoid the negative perceptions of price discrimination as imposed by a seller.

Profit maximization

In economics, profit maximization is the short run or long run process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. The total revenuetotal cost perspective relies on the fact that profit equals revenue minus cost and focuses on minimizing this difference, and the marginal revenuemarginal cost perspective is based on the fact that total profit reaches its maximum point where marginal revenue equals marginal cost.

Basic definitions
Any costs incurred by a firm may be classed into two groups: fixed costs and variable costs. Fixed costs, which occur only in the short run, are incurred by the business at any level of output, including zero output. These may include equipment maintenance, rent, wages of employees whose numbers cannot be increased or decreased in the short run, and general upkeep. Variable costs change with the level of output, increasing as more product is generated. Materials consumed during production often have the largest impact on this category, which also includes the wages of employees who can be hired and laid off in the span of time (long run or short run) under consideration. Fixed cost and variable cost, combined, equal total cost. Revenue is the amount of money that a company receives from its normal business activities, usually from the sale of goods and services (as opposed to monies from security sales such as equity shares or debt issuances). Marginal cost and revenue, depending on whether the calculus approach is taken or not, are defined as either the change in cost or revenue as each additional unit is produced, or the derivative of cost or revenue with respect to the quantity of output. For instance, taking the first definition, if it costs a firm 400 USD to produce 5 units and 480 USD to produce 6, the marginal cost of the sixth unit is 80 dollars.

Profit Maximization - The Totals Approach

To obtain the profit maximising output quantity, we start by recognizing that profit is equal to total revenue (TR) minus total cost (TC). Given a table of costs and revenues at each quantity, we can either compute equations or plot the data directly on a graph. The profit-maximizing output is the one at which this difference reaches its maximum. In the accompanying diagram, the linear total revenue curve represents the case in which the firm is a perfect competitor in the goods market, and thus cannot set its own selling price. The profit-maximizing output level is represented as the one at which total revenue is the height of C and total cost is the height of B; the maximal profit is measured as CB. This output level is also the one at which the total profit curve is at its maximum.

If, contrary to what is assumed in the graph, the firm is not a perfect competitor in the output market, the price to sell the product at can be read off the demand curve at the firm's optimal quantity of output.
Profit maximization using the marginal approach

An alternative perspective relies on the relationship that, for each unit sold, marginal profit (M) equals marginal revenue (MR) minus marginal cost (MC). Then, if marginal revenue is greater than marginal cost at some level of output, marginal profit is positive and thus a greater quantity should be produced, and if marginal revenue is less than marginal cost, marginal profit is negative and a lesser quantity should be produced. At the output level at which marginal revenue equals marginal cost, marginal profit is zero and this quantity is the one that maximizes profit.[1] Since total profit increases when marginal profit is positive and total profit decreases when marginal profit is negative, it must reach a maximum where marginal profit is zero - or where marginal cost equals marginal revenue - and where lower or higher output levels give lower profit levels.[1] In calculus terms, the correct intersection of MC and MR will occur when:[1]

The intersection of MR and MC is shown in the next diagram as point A. If the industry is perfectly competitive (as is assumed in the diagram), the firm faces a demand curve (D) that is identical to its marginal revenue curve (MR), and this is a horizontal line at a price determined by industry supply and demand. Average total costs are represented by curve ATC. Total economic profit are represented by the area of the rectangle PABC. The optimum quantity (Q) is the same as the optimum quantity in the first diagram. If the firm is operating in a non-competitive market, changes would have to be made to the diagrams. For example, the marginal revenue curve would have a negative gradient, due to the overall market demand curve. In a non-competitive environment, more complicated profit maximization solutions involve the use of game theory.

Case in which maximizing revenue is equivalent

In some cases a firm's demand and cost conditions are such that marginal profits are greater than zero for all levels of production up to a certain maximum.[2] In this case marginal profit plunges to zero immediately after that maximum is reached; hence the M = 0 rule implies that output should be produced at the maximum level, which also happens to be the level that maximizes revenue.[2] In other words the profit maximizing quantity and price can be determined by setting marginal revenue equal to zero, which occurs at the maximal level of output. Marginal revenue equals zero when the total revenue curve has reached its maximum value. An example would be a scheduled airline flight. The marginal costs of flying one more passenger on the flight are negligible until all the seats are filled. The airline would maximize profit by filling all the seats. The airline would determine the conditions by maximizing revenues.

Changes in total costs and profit maximization

A firm maximizes profit by operating where marginal revenue equal marginal costs. A change in fixed costs has no effect on the profit maximizing output or price.[3] The firm merely treats short term fixed costs as sunk costs and continues to operate as before.[4] This can be confirmed graphically. Using the diagram illustrating the total costtotal revenue perspective, the firm maximizes profit at the point where the slopes of the total cost line and total revenue line are equal.[2] An increase in fixed cost would cause the total cost curve to shift up by the amount of the change.[2] There would be no effect on the total revenue curve or the shape of the total cost curve. Consequently, the profit maximizing point would remain the same. This point can also be illustrated using the diagram for the marginal revenuemarginal cost perspective. A change in fixed cost would have no effect on the position or shape of these curves.[2]

Markup pricing
In addition to using methods to determine a firm's optimal level of output, a firm that is not perfectly competitive can equivalently set price to maximize profit (since setting price along a given demand curve involves picking a preferred point on that curve, which is equivalent to picking a preferred quantity to produce and sell). The profit maximization conditions can be expressed in a "more easily applicable" form or rule of thumb than the above perspectives use.[5] The first step is to rewrite the expression for marginal revenue as MR = TR/Q =(PQ+QP)/Q=P+QP/Q, where P and Q refer to the midpoints between the old and new values of price and quantity respectively.[5] The marginal revenue from an "incremental unit of quantity" has two parts: first, the revenue the firm gains from selling the additional units or PQ. The additional units are called the marginal units.[6] Producing one extra unit and selling it at price P brings in revenue of P. Moreover, one must consider "the revenue the firm loses on the units it could have sold at the higher price"[6]that is, if the price of all units had not been pulled down by the effort to sell more units. These units that have lost revenue are called the inframarginal units.[6] That is, selling the extra unit results in a small drop in price which reduces the revenue for all units sold by the amount Q(P/Q). Thus MR = P + Q(P/Q) = P +P (Q/P)((P/Q) = P + P/(PED), where PED is the price elasticity of demand characterizing the demand curve of the firms' customers, which is negative. Then setting MC = MR gives MC = P + P/PED so (P - MC)/P = - 1/PED and P = MC/[1 + (1/PED)]. Thus the optimal markup rule is:
(P - MC)/P = 1/ (- PED) or P = [PED/(1 + PED)]MC.[7][8]

In words, the rule is that the size of the markup is inversely related to the price elasticity of demand for the good.[7] The optimal markup rule also implies that a non-competitive firm will produce on the elastic region of its market demand curve. Marginal cost is positive. The term PED/(1+PED) would be positive so P>0 only if PED is between -1 and - that is, if demand is elastic at that level of

output.[9] The intuition behind this result is that, if demand is inelastic at some value Q1 then a decrease in Q would increase P more than proportionately, thereby increasing revenue PQ; since lower Q would also lead to lower total cost, profit would go up due to the combination of increased revenue and decreased cost. Thus Q1 does not give the highest possible profit.

Marginal product of labor, marginal revenue product of labor, and profit maximization
The general rule is that firm maximizes profit by producing that quantity of output where marginal revenue equals marginal costs. The profit maximization issue can also be approached from the input side. That is, what is the profit maximizing usage of the variable input? [10] To maximize profit the firm should increase usage of the input "up to the point where the input's marginal revenue product equals its marginal costs".[11] So mathematically the profit maximizing rule is MRPL = MCL, where the subscript L refers to the commonly assumed variable input, labor. The marginal revenue product is the change in total revenue per unit change in the variable input. That is MRPL = TR/L. MRPL is the product of marginal revenue and the marginal product of labor or MRPL = MR x MPL.

Capital budgeting
Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.[1] Many formal methods are used in capital budgeting, including the techniques such as These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.

Net present value

Main article: Net present value

Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). (First applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams: Theory.) This valuation requires estimating the size and timing of all the incremental cash flows from the project. (These future cash highest NPV(GE).) The NPV is greatly affected by the discount rate, so selecting the proper rate sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is the Minimum acceptable rate of return on an investment. This should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. Managers may use models such as the CAPM or the APT to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole.

Internal rate of return

Main article: Internal rate of return

The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV. In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally cannot be solved analytically but only via iterations. One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used. Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV[citation needed], although they should be used in concert. In a budget-constrained environment, efficiency measures should be used to maximize the overall NPV of the firm. Some managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.

Equivalent annuity method

Main article: Equivalent annual cost

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form it is known as the equivalent annual cost (EAC) method and is the cost per year of owning and operating an asset over its entire lifespan. It is often used when comparing investment projects of unequal lifespans. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated. The use of the EAC method implies that the project will be replaced by an identical project. Alternatively the chain method can be used with the NPV method under the assumption that the projects will be replaced with the same cash flows each time. To compare projects of unequal length, say 3 years and 4 years, the projects are chained together, i.e. four repetitions of the 3 year project are compare to three repetitions of the 4 year project. The chain method and the EAC method give mathematically equivalent answers.

The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.Y

Real options
Main article: Real options analysis

Real options analysis has become important since the 1970s as option pricing models have gotten more sophisticated. The discounted cash flow methods essentially value projects as if they were risky bonds, with the promised cash flows known. But managers will have many choices of how to increase future cash inflows, or to decrease future cash outflows. In other words, managers get to manage the projects - not simply accept or reject them. Real options analysis try to value the choices - the option value - that the managers will have in the future and adds these values to the NPV.

Ranked Projects
The real value of capital budgeting is to rank projects. Most organizations have many projects that could potentially be financially rewarding. Once it has been determined that a particular project has exceeded its hurdle, then it should be ranked against peer projects (e.g. - highest Profitability index to lowest Profitability index). The highest ranking projects should be implemented until the budgeted capital has been expended.

Funding Sources
When a corporation determines its capital budget, it must acquire said funds. Three methods are generally available to publicly traded corporations: corporate bonds, preferred stock, and common stock. The ideal mix of those funding sources is determined by the financial managers of the firm and is related to the amount of financial risk that corporation is willing to undertake. Corporate bonds entail the lowest financial risk and therefore generally have the lowest interest rate. Preferred stock have no financial risk but dividends, including all in arrears, must be paid to the preferred stockholders before any cash disbursements can be made to common stockholders; they generally have interest rates higher than those of corporate bonds. Finally, common stocks entail no financial risk but are the most expensive way to finance capital projects.The Internal Rate of Return is very important.