Managerial economics

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MANAGERIAL ECONOMICS

UNIT-1

What is managerial economics? Discuss the characteristics and scope of managerial economics. How does economics theory contribute to managerial decision? Ans. Economics is a social science, which studies human behavior in relation to optimizing allocation of available resources to achieve the given ends. The application of economic science is all pervasive. More specifically economic laws and tools of economics analysis are applied a great deal in the progress of business decisions making. This has led to emergence of a separate branch of study called Managerial Economics. Managerial Economics is the study of economics theories, logic and tools of economics analysis that are used in the process of business decision making. Economic theory and technique of economics analysis are applied to analyze business problems, evaluate business option and opportunities with a view to arriving at appropriate business decisions. Managerial Economics is thus constituted as that part of economics knowledge, logic, theories, and analytical tools that are used for rational business decision making. Economics through, variously defined is essentially the study of logic, tools and technique of making optimum use of the available resources to achieve the given ends. Economics thus provides analytical tools and technique that managers need to achieve the goals of the organization they manage. Baumaol has pointed out there main contributions of economics theory to business. First one of the most important ! unexpected end of formula. Things which the economics theories can contribute to the management science is building analytical models which help to recognize of the structure of managerial problems, eliminate the minor details which might obstruct decision making and help to concentrate on the main issue. Secondly, economics theory contributes to the business analysis and set of analytical methods which may not be applied directly to specific business problems, but they do entrance the analytical capabilities of the business analyst. Thirdly, economics theories offer clarity to the various concepts used in business analysis, which enable the managers to avoid conceptual pitfalls. The areas of business issue to which economics theories can be directly applied may be broadly divided in two categories:- (a) Operational or Internal issue and (b) Environmental or External issue




(a) operational problems are of internal nature. They include all those problems which arise within the business organization and fall within in the preview and control of the management. Some of the basis internal issue are:-

(i) Choice of business and the nature of product i.e. what to produce; (ii) Choice of size of the firm i.e. how much to produce (iii) Choice of technology i.e. choosing the factor contribution; (iv) Choice of price i.e. how to price the common; (v) How to promote sales; (vi) How to face price competition ; (vii) How to decide on new investment; (viii) How to manage profit and capital; (ix) How to manage inventory i.e. stock of both finished goods and how

material. The microeconomic theories which deals most of these questions include:-

1. Theory of demand. 2. Theory of production and production decisions. 3. Analysis of market structure and pricing theory. 4. Profit analysis and profit management. 5. theory of capital and investment decisions.

(b) environmental issues certain to the general business environment in which a business opeerates. They are related to the overall economic, social and political atmosphere of the country. The factors which constitute economic environment of a country include the following factors:-

1. The type of economic system of the country. 2. General trend in production, employment, income, price, savings and

investments etc. 3. Structure of the trends in the working of financial institutes e.g. banks,

financial co-operations, insurance companies. 4. Magnitudes of trends in foreign trend. 5. Trends in labor and capital market. 6. Government’s economics policies e.g. industrial policy, monetary policy,

fiscal policy, price policy etc. 7. social factors like the value systems of the society, property, rights, customs

and habits. 8. social organization like trade unions, customers co- operatives and

producers union. 9. the degree of openness of the economy and influenceMNC’s.




What is the basic objectives of a firm? Explain the role and responsibilities on managerial economics? Ans. Conventional theory of firm assumes profit maximization is the sole objective of business firms. But recent researches on this issue reveal that the objectives the firms pursue are more than one. Some important objectives, other than profit maximization are:- (a) Maximization of the sales revenue. (b) Maximization of firm’s growth rate. (c) Maximization of managers utility function. (d) Making satisfactory rate of profit. (e) Long run survival of the firm. (f) Entry-prevention and risk evidence. Profit Business Objectives: Profit means different things to different people. To an accountant “profit” means and excess of revenue over all paid out costs including both manufacturing and overhead expenses. For all practical purpose, profit or business, income means profit in accounting sense plus non allowable expenses. Economist’s concept of profit is of “pure profit” called ‘economic profit’ or “just profit”. Pure profit is a return over and above opportunity cost, i.e. the income that a businessman might expect from the second best alternatives use of his resources. Sales revenue maximization: The reason behind sales revenue maximization revenue maximization objectives is the dichotomy between ownership and management in large business corporations. This dichotomy gives managers an opportunity to set their goal other than profit maximization goal, which most-owner businessman pursue. Give the opportunity, manager’s choose to maximize their own utility functions is maximizations of the sales revenue. The factors, which explain the pursuance of this goal by the manager’s are following: First, salary and other earnings of managers are more closely related to sales revenue than to profits. Second, banks and financial corporations look at sales revenue while financing the corporation. Third, trend in sales revenue is a readily available indicator of the performance of the firm.




Maximization of Firm’s growth rate: Managers maximize firm’s balance growth rate subject to managerial and financial constrains balance growth rate defined as: G=GD-GC Where GD = growth rate of demand of firm’s product & GC = growth rate of capital supply of capital to the firm. In simple words a firm growth rate is balanced when demand for its product and supply of capital to the firm increase at the same rate. Maximization of managerial utility function: The manager seek to maximize their own utility function subject to the minimum level of profit. Managers utility function is express as: G=S.M.ID Where S= additional expenditure of the staff M= managerial emoluments. ID= discretionary investments. The utility function which manager seek to maximize include both quantifiable variables like salary and slack earnings; non-quantifiable such as prestige, power, status, job security professional excellence etc. Long Run survival & Market share: according to some economist, the primary goal of the firm is long run survival. Some other economists have suggested that attainment and retention of constant market share is an additional objective of the firm’s . The firm’s may seek to maximize their profit in the long run through it is not certain. Entry prevention and risk –avoidance, yet another alternative objectives of the firm’s suggested by some economists is to prevent entry-prevention can be: a) Profit maximization in the long run. b) Securing a constant market share. c) Avoidance of risk caused by the un- predictable behavior of the new firm’s. Micro economist has a vital role to play in running of any business. Micro economists are concern with all the operational problems, which arise with in the business organization and fall in with in the preview and control of the management. Some basis internal issues with which micro-economist are concerns:

(I) Choice of business and nature of product i.e. what to produce (II) Choice of size of the firm’s i.e. how much to produce (III) Choice of technology i.e. choosing the factor combination. (IV) Choose of price i.e. how to price the commodity. (V) How to promote sales. (VI) How to face price competition. (VII) How to decide on new investments. (VIII) How to manage profit and capital




(IX) How to manage inventory i.e. stock to both finished & raw material.

These problems may also figure in forward planning. Micro economist deals with these questions and like confronted by managers of the enterprises.

Explain the following with examples. a) Short run v/s long run. b) Nature of marginal analysis.

Ans a) Short run & Long run: The concept of short run and long run is used in economic theories like production theory, cost theory etc. In production theory, short run refers to a period of time in which supply of certain inputs such as plant, building, machinery etc is fixed or is inelastic. In the short run therefore, increasing the use of only one variable input as labor and raw material can increase production of commodity. Suppose the expected annual return from the three alternatives uses of finance are:-

Alternative 1:- Expansion of the size of the firm Rs. 20 million. Alternative 2:- Setting up a new production unit Rs. 18 million. Alternative 3:- Buying shares in another firm Rs. 16 million.

All other steps being the same, rational decision-making would suggest invest the money in alternative-

1. This implies that the manager would have to sacrifice the annual return of Rs. 18 million expected from alternative.

2. In economic jargon Rs. 18 million is called annual opportunity cost of an annual income of Rs. Million.

Production :- suppose that a firm has a sum of Rs. 100000 which it has only two alternatives Uses. It can either buy a printing machine or alternatively a lathe machine, both having a productive life of 10 years. From the printing machine, the firm expects an annual income of Rs. 20,000 and from the lathe, Rs. 15,000. a profit maximizing firm would invest its money in the printing machine and forego




the expected income from printing machine is the expected income from the lathe i.e. 15,000. Marketing:- Suppose a company can sell a basket of apples for Rs. 1000/- in foreign market for Rs. 600/- in domestic market. The company should exports its produce. Hence the opportunity cost from export market is the expected income from domestic market. The opportunity cost is also called alternate cost had the resources available to a person, a firm or a society been unlimited there would be no opportunity cost. But since resources are limited, hence opportunity cost can never be zero. The long run refers to a period of time in which the supply of all the inputs is elastic, but not enough to permit a change in technology that is, in the long run , all the inputs are variable. Therefore, in the end, Production or Commodity can be increased by employing more of both variable and fixed inputs. Short run costs are the costs that vary with the variation in input, the size of the firm remaining the same. In the other words, short run costs are the same as variable costs. Long run costs on the other hand, are the costs, which are incurred on the fixed assets like plant, machinery, building, etc. Ans. (b) Nature, Marginal Analysis:- The concept of marginal value is widely used in economic analysis, for example marginal utility, marginal cost and marginal revenue. Marginality concept assumes special significance where maximization or maximization problem is involved e.g. maximization of consumers utility, maximization of firm’s profit, minimization of cost etc. The terun “marginal” `refers to the change (increase or decrease) in the total of any quantity due to one unit change in its determinant e.g. the total cost of production of a commodity depends on the number of units produced . In this case “marginal cost” or (mc) can be defined as the change in total cost as result of producing one unit less of a commodity thus, Marginal cost (mc) = tcn - tcn –1

where tcn = total cost of producing n cost tcn –1 = total cost of producing n-1 units What do you understand by opportunity cost? Give suitable examples to illustrate the use of this concept in the context of managerial decisions relating to

a) production b) finance c) marketing can opportunity cost ever by zero?




Ans. The concept of opportunity cost is attributed to the alternate uses of scarce in relation to their demand to satisfy the ever growing human needs and the resources have alternative use. The scarcity and the alternative uses of resources give rise to the concept of opportunity cost. Opportunity cost of availing an opportunity is the expected income forgone from the second best opportunity of using the resources e.g. 1. finance :- suppose a firm has Rs. 100 million at its disposal and there are only three alternative uses:- Alternative:- (i) To expand the size of the firm (ii) To set Up a new production unit in another locality and (iii) To buy shares in another firm

DEMAND

The term demand implies a desire for a commodity backed by ability and willingness to pay for it. Unless a person has adequate purchasing power or resources and the preparedness to spend his resources, his desired for a commodity would not be considered as his demand. For e.g. if a man wants to buy a car but he does not have sufficient money to pay for it ----------------------------------------------- The desires without adequate purchasing power and willingness to pay do not affect the market nor do they generate production activity. A want with three attributes- desires to buy, willingness to pay and ability to pay – become effective demand. The term demand for a commodity (i.e. quantity demand) always has a reference to ‘a price’, ‘a period of time’ and a ‘place’ for e.g. the demand for Tv set B, 50,000 carries no meaning for a business. A meaningful statement regarding the demand for a commodity should be the annual demand for tv set in Delhi at an average price of Rs. 15,000 a piece is a meaning statement. Utility:- The consumer demand a commodity because they derive or expect to derive utility from that commodity. The expected utility from a commodity is the basis for demand for it. “Utility is the want satisfying property of a commodity”. From a consumer’s angle “ utility is the psychological feeling of satisfaction, pleasures, happiness as well being which a consumer derives from the consumption, possession or the use of commodity. The concept of a want satisfying property of a commodity is absolute in the sense that this property is ingrained in the commodity irrespective of whether one needs or not. For e.g. a pen has its own utility irrespective of whether a person is literate or illiterate. Another important attributes of the absolute concept of utility is that it is ‘ethically neutral’ because a commodity may satisfy a frivolous or socially immoral needs. E.g. alcohol, drugs etc. Utility B also post consumption phenomenon as one derives satisfaction from a commodity only when one consumers or uses it. TOTAL UTILITY:- It may be defined as the sum of the utilities derived by a consumer from the various units of goods and services to consumers. Suppose a consumer consumes




four units of a commodity, x, at a time and derives utility as u1, u2, u3 and u4. His total utility (Tun) from commodity x can be measured as:- Tun = u1 + u2 + u3 + u4. If a consumer consumes n number of commodities, his total utility, TUn will be the sum of total utilities derived from each commodity. For instance, if the consumption goods are x, y and z, and their respective utilities are Un, Uy and Uz, then Tun = Un + Uy + Uz.

MARGINAL UTILITY (MC):- It refers to the change in the total utility (i.e.Δtu) obtained from the consumption of an additional unit of a commodity. It may be expressed as:- MU= ΔTU ΔQ Where TU = total utility ΔQ= change in quantity consumed by one unit. Another way of expressing marginal utility (MU) when the number of units consumed is n, can be as follows:- MU of the nth unit = Tun – Tun-1.

The law of diminishing marginal utility:- This law states that as the quantity consumed of a commodity increases, the utility derived from each successive unit decreases, consumption of all other commodities remaining the same. In simple words, when a person consumes more and more units of a commodity per unit time, keeping the consumption of all other commodities constant, the utility which he derives from the successive units of consumption goes on diminishing. _______________________________________________________________________ NO OF UNITS TOTAL UTILITY MARGINAL CONSUMED UTILITY

1 30 30 2 50 20 3 60 10 4 65 5 5 60 -5 6 45 -15




Utility-MU&TU Quantity MU ASSUMPTION:- The law of diminishing marginal utility holds only under certain conditions. These are:-

1) the unit of the consumer goods must be a standard one. If the units are excessively small or large, the law may not hold.

2) The consumer’s taste or preference must remain same during the period of consumption.

3) There must be continuity in consumption, where a break in continuity is necessary, the time interval between the consumption of two units must appropriately short.

4) The mental conditions of the consumer must remain normal during the period of consumption.

Economist distinguish between cardinal utility and ordinal utility. The numbers 1, 2,3, 4, etc are cardinal numbers; these numbers are specific as:- For e.g. the number 4 is twice the number 2. the cardinal number system permits addition and subtraction on the other hand, the number 1st, 2nd, 3rd, 4th etc are known as ordinal numbers. These numbers are ranked and numbered; but the ranking itself does not tell us the size of the number. Utility can be expressed only ordinarlly, relatively or in terms of ‘less than’ or ‘more than’. It is therefore, possible to list the goods and services in order of their preferibility or desirability. CARDINAL UTILITY:- Neo-classical economists built up the theory of consumption that utility is cardinally measurable. It implies that utility can be assigned a cardinal number like 1, 2, 3 etc. They coined and used the term ‘util’ meaning ‘units’ of utility. In their economic analysis, they assumed:-

1) Than one ‘util’ equals to one unit of money. And 2) That utility of money remains constant.




Utility of a product for a person can be measured in terms of price he is willing to pay for it. If the student is willing to pay 50 paise for cup of tea, we can say that the utility which he expects from a cup of tea is equal to 50 paise. If he willing to 50 paise for a cup of tea, Rs.1.00 for a packet of cigarettes and Rs.2.00 for a notebook, it means that the utility from 2 cups to tea is equal to a packet of cigarettes and utility from 2 packets of cigarettes or from 4 cups of tea is equal to the utility which this consumers gets from a notebook. The cardinal utility approach to consumer analysis makes the following assumptions:- a) Rationality:- It is assumed that the consumer is a rational being in the sense that he

satisfies he wants in the order of their preference. That is, he or she buys that commodity first yields the highest utility and that last which gives the least utility.

b) Limited Money Income:- The consumer has limited money income to spend on the goods and services he or she chooses to consume. Limitedness of income, along with utility maximization objectives makes the choice between inevitable.

c) Maximization of Satisfaction:- Every rational consumer intends to maximize his/her satisfaction from his/her given money.

d) Diminishing Marginal Utility:- following the law of diminishing marginal utility, it is assumed that the utility gained from the successive units of a commodity consumed decreases as a consumer consumed larger quantity of the commodity.

e) Constant Marginal Utility of Money:- The cardinal utility approach assumed that marginal utility of money remains constant whatever the lever of consumer’s income. This assumption is necessary to keep the scale of measuring rod of utility fixed.

f) Utility Is Additive: - cardinality assumed not only that utility is cardinally measurable but also that utility derived from various goods and service consumed by a consumer can be added together to obtain the total utility. In other words, the consumer has a utility function which may be expressed as:-

U =F ( X1, X2, X3, ---------XN) When x1, x2------xn denoted the total quantities of the various goods consumed. Given the utility function, totally utility obtained from n item can be expressed as:- UN = U1 (X1) + U2 (X2) +U3 (X3) +-----+UN (XN)

This is the utility function which the consumers aims to maximize. CONSUMER EQUILIBRIUM:- One commodity model suppose that a consumer with certain money income consumes only one commodity x. Since both his money income and commodity x have utility for him, he can either spend his money income on commodity x or retain in it in the form of asset. If the marginal utility of commodity x (MUn) is greater than marginal utility of money (MUm) as asset, a utility maximizing consumer will exchange his money income from the commodity.




By assumption MUn is subject to diminishing returns (assumption-d), where as marginal utility of money (MUm) as an asset remains constant (assumptin-e). Therefore, the consumer will exchange his money income on commodity x so long as MUm =1 (constant). The utility-maximizing consumer reaches his equilibrium i.e. the level of maximum satisfaction, where MUn =Pn (MUm). Alternatively the consumer reaches equilibrium point where, MUn -------- =1 Pn (MUm) E pn(mun) pn

mun

O Qn Consumer Equilibrium The horizontal line Pn (MUm) shows the constant utility of money weighted by the price of commodity x i.e. (Pn) and MUn curve represents the diminishing marginal utility of commodity x. The pn (MUm ) line and MUn curve intersect each other at point E. point E indicates that at quantity OQn consumed, MUn =Pn(Mum).Therefore, the consumer is in equilibrium at point E. At any point beyond E, MUn > Pn (MUm ). Therefore if the consumer exchanges his money for commodity x, he will increase his total satisfaction because he gain in terms of MUn is greater than his loss in terms of MUm . this condition exists till he reaches point E. and, at any point below E, MUn Pn (MUm ).Therefore if he consumes more than OQn , he loses more utility than he gains. He is therefore a net loser. The consumer can, therefore, increase, his satisfaction by reducing his consumption. This means that any point other than E, consumer’s total satisfaction is less than maximum. Therefore point E is the point of equilibrium. (iii) Consumer’s Equilibrium: Multiple Commodity Model The law of Equi-Marginal Utility:- In real life, consumer consumes multiple number of goods and services. The law of equi –marginal utility explains the consumer’s equilibrium in a multi – commodity model. This law states that a consumers consumes various goods in such quantities that MU derived per




unit of expenditure on each good is the same. In other words, a rational consumer spends his income on various goods he consumes in such a manner that each rupee spent on each good yields the same MU. A rational and utility maximizing consumer consumes commodities in the order of their utilities. He first pick up the commodity which yields the highest utility followed by the commodity yielding the second highest utility and so on. He switches his expenditure from one commodity to the another accordance with their marginal utilities. He continues to switch his expenditure from one commodity to other till he reaches a stage where MU of each commodity is the same per unit of expenditure. This is the stage of consumer’s equilibrium. Suppose that a consumer consumes only two commodities X and Y, their prices being Pn and Py respectively. Following the equilibrium rule of the single commodity case, the consumer will distribute his income between commodities X and Y, so that:- MUn = Pn (MUm ) Muy = Py (MUm ) and, Give these conditions, the consumer is in equilibrium where, MUn MUy

-------- ----------- =1 = --------------------- Pn (MUm ) Py (MUm ) MUx MUy ---------- = ---------- Pn Py Or , MUn Pn

---------- = ---------- MUy Py

In order to achieve his equilibrium, what a utility maximizing consumer intends to equalize is not the marginal utility of each commodity he consumes, but the marginal utility per unit of his money expenditure on his various goods and services.

THE INDIFFERENCE CURVE : ANALYSIS OF DEMAND




The indifference approach starts with the assumption that consumers are rational and aware of their preference of any two or more goods. A scale of preference consists of number of alternative combinations of two goods which give the consumer the same consumers amount of satisfaction. Since all the alternative combinations of the two goods give the consumer same satisfaction, he can choose any one of them. If he chooses one combination, he is indifferent about the other combinations. TEA (CUPS) BISCUIT(UNITS) RATE OF SATISFACTION _______________________________________________________________________ 1 20 2 2 15 1.5 3 12 1.3 4 10 1.2 5 09 1.1 It is assumed that the various combinations of tea and biscuits yield the same satisfaction. The curve plotted against the various combinations is known as indifference curve. The curve shows the various combinations (A, B, C, D etc.) which will yield the consumers the same satisfaction. An indifference curve is also known as an ISO utility curve, as every point on the indifference curve represents the same utility to the consumer. 20 A 15 B C 12 D E 10 9 5




1 1 2 3 4 5 Tea (In cups) The Principal Of Diminishing Marginal rate of substitution:- Every indifference curve represents one satisfaction. It implies that one commodity can be substituted for another without changing the amount of utility received. The indifference curve slops downwards from left to right to indicate that more cups of tea will be accompanied by less units of biscuits so that total satisfaction may remain the same. As more units of tea are added, fewer units of biscuits need to be given up, so as to maintain the same satisfaction. The rate of substitution can be defined as the rate at which a consumer can exchange a very small amount of one commodity for a very small amount of another commodity, without affecting the total utility. It is maintained that, in general, the rate of substitution between any two commodities should be declining. Hence it is called the law of diminishing marginal rate of substitution. The law can be expressed in three steps:- FIRST, if the total utility has to be maintained at the same level, the addition of one commodity in the combinations of two commodities must be accompanied by a reduction in the other commodity. For e.g. if one commodity is increased while the other is kept constant, the total utility will increase. An increasing of one commodity must necessarily be accompanied by a reduction in the other. This explain why the indifference curve slopes downward from left to right. SECOND, this step involves the commodity which is increased will have diminishing marginal utility for, according to the law of diminishing marginal utility, the larger the number of units of a commodity a person has, the less will be the utility to him of the additional units. In other words, when a consumer has more and more of one commodity in a combination of two goods, he will attach less and less significance to that commodity. If the consumer is prepared to substitute one cup of tea for five biscuits, then in the next step, one cup of tea is not substitute for five biscuits but for something less. THIRD, It involves the commodity, which is reduced v/2 when a consumer has less of any commodity, he attaches more significance to that commodity. If the consumer, therefore, is




prepared to give up 5 biscuits for an additional cup of tea, he will not be prepared to do so latter. Since biscuits have greater significance for him, and tea less, the consumer will not be prepared to give up the same numbers of biscuits for a cup of tea. Thus the principal of diminishing marginal rate of substitution can be explained by three facts:-

a) one commodity must be decreased while the other is increased if the consumer has to have the same satisfaction.

b) The commodity which is increased has lower marginal significance and therefore, cannot substitute for the same amount of the other commodity but only for fewer units of the other. In other words, the rate of substitution will decline.

c) The commodity which is decreased has higher marginal significance and therefore, Can’t be substituted in the same ratio by the other commodity, the rate of substitution will again decline.

EXCEPTIONAL RATES OF SUBSTITUTION While normally, the marginal rate of substitution between any two goods is diminishing, there can be two exceptions. On the one extreme, there can be constant rate of substitution and, on the other hand, infinite rate of substitution. Between two goods which are regarded as perfect substitutes, the rate of substitution will not be diminishing but will not be uniform or constant. Suppose that coffee and tea are perfect substitutes and that the rate of substitution is 1 cup of coffee is equal to 2 cup of tea. An addition to one cup of coffee will be accommodated by a reduction of two cups of tea, in every case. There are some commodities, which are complimentary in nature and between which number substitution exists. In other words, consumer may want fixed quantities of both the commodities to give him some satisfaction. It is the impossible to maintain the same satisfaction by the addition of some units of X commodity at the expense of Y commodity. The rate of substitution in this case is said to be infinite, that is to say. The addition of one more unit of X will be at the expenses of infinite units of Y if the same amount of satisfaction has to be maintained.

PROPERTIES OF INDIFFERENCE CURVES




Indifference curves has three properties:-

a) They always slope downwards from left to right. b) They are convex to the point of origin of the two axes. c) They never interest or touch each other.

I) INDIFFERENCE CURVE SLOPE DOWNWARDS FROM LEFT TO RIGHT:- All indifference curves necessarily slope downwards from left to right. This is based on the assumption that different combinations of two goods give the consumer the same amount of satisfaction. If one commodity is added, the other commodity has to be decreased. Hence the upward slopping indifference curve is impossible. e.g. 1cups of tea +5 biscuits. 2 cups of tea + 10 biscuits. 3 cups of tea + 20 biscuits. These combination of tea and biscuits can’t give the same level of satisfaction because the second combination will give the consumer more satisfaction than the first, as it is more of both goods, and third combination will give more satisfaction than the second. As long as we assume that an indifference curve represents only one satisfaction, it can’t slope upwards.

II) CONVEX TO THE POINT OF ORIGIN:- The convexity of indifference curve implies two properties:-

a) The two commodities are imperfect substitutes for one another. b) The marginal rate of substitution (MRS) between two goods decreases

as a consumer moves along an indifference curve. This characteristics of indifference curve is based on the postulate of diminishing marginal rate of substitution. Marginal utility (MU) of a commodity increasesas its quality decreases and vice- versa, and therefore, more and more units of other commodity are needed to keep the total utility constant.

III) INDIFFERENCE CURVE CAN NEITHER INTERSECT NOR TOUCH EACH OTHER:- If two indifference curve intersect or touch each other, it will reflect two impossible conclusions. (i) That two equal combinations of two goods yield two different level of satisfaction and (ii) That two different combination – one being larger than the other ‘yield same level of satisfaction’. Such conditions are impossible.




CONSUMER’S EQUILIBRIUM IN INDIFFERENCE CURVE:- As a consumer has a limited income, he aims to spend it in such a manner as to obtain maximum satisfaction. He will attain equilibrium when he gets maximum satisfaction from his expenditure on different goods. ASSUMPTION:-

a) The consumer has before him an indifference map for a pair of goods – say tea and biscuits. This map represents the preferences of for the two goods. It is assumed that his scale of preferences remain constant at a given time.

b) The consumer has a fixed amount of money two spend on two goods. It is assumed that he will spend the amount on both the goods and not save any part of it.

c) The prices of these goods are given in the market and are assumed to be constant.

d) The consumer is assumed to act rationally and maximize his satisfaction. A consumer’s indifference map for tea and biscuits represents three scales of preferences of a consumer for the goods. Indifferences curve to the right represent progressively highly satisfaction. The consumer would like to choose a combination of tea and biscuits, which will be on the highest indifference curve. But this will depend upon the income which the consumer has and the price of the two goods. BUDGET LINE OF THE CONSUMER:- Suppose that the consumer has Rs. 20 to spend on tea and biscuits, which cost 50 Paisa and 40 Paisa respectively. Three consumer has three alternative possibilities before him.

a) He may decide to buy tea only, in which case he can buy 40 cups of tea. b) He may decide to buy biscuits only in which case, he can buy 50

biscuits. c) He may decide to buy some quantities of both the goods

The line LM shows any combination between tea and biscuits. Point in represents maximum number of cup of tea, that can be bought with give income. Consumer can not choose any combination beyond this line because his income does not permit him. Nor would he like to choose a combination below this line, at it will not represent the maximum satisfaction. Line LM is called budget line, since it represents various amounts the consumer can buy with his income. Curve I3 is unsuitable to the consumer, since its fall outside the consumer’s price line LM. Indifference curve I1 can be realized with the money income of the consumer. But this curve represent lower satisfaction, it is possible for the consumer to achieve still higher satisfaction by moving to the higher indifference curve with the same amount of money.




Such a satisfaction is indicated by the point of C on indifference curve I3. The consumer get the maximum satisfaction from his income, when he buys combination X1 amount of tea and Y1 number of biscuits. Any other combination of the two goods will either yield less satisfaction or will be unobtainable at the present prices, with the given amount of income at the disposal of the consumers. THE LAW OF DEMAND:- The law of demand is one of the fundamental laws of economics. The law of demand states that the demand for a commodity increases, when its price decreases and fall when its price rises, other things remaining constant. This law is based on the observed facts and can be verified with new empirical data, hence is called the empirical law. According to the law, there is an inverse relationship between the price and quality demanded. This law holds under the condition that “Other things remain constant.” “Other things include the demand, wrt, consumers income, price of the substitutes and complements, tastes and preferences of the consumer etc. These factors remain constant only in the short run. In the long run they tend to change. The law of demand, holds only in the short run. Factors behind the law of demand:- Factors affecting the law of demand are as follows:- Substitution Effect:- When the price of a commodity falls, prices of its substitutes remaining constant, then the substitute become relatively costlier or the commodity whose price has fallen becomes relatively cheaper goods for costlier ones, demand for the cheaper commodity increases. The increases in demand on account of this factor is known as the substitution effect. Income Effect:- When the price of a commodity falls, other things remaining the same, then the real incomer of the consumer increases. Consequently, his purchasing power increases since he is required to pay less for a given quantity. The increase in real income encourages the consumer to demand more of goods and services. The increase in demand on account of an increase in real income is known as the effect. Expectations to the law of demand The law of demand does not apply to the following cases:-

(a) Expectation regarding further prices:- When consumers expect a continuous increase in the price of a double commodity, they buy more of it despite the increase in its price with a view to avoiding the pinch of a much higher price in future. For instance, in pre-budget months , prices generally tend to rise. Yet, people buy more storable goods in anticipation of further rise in prices due to new levies. Similarly, when consumers anticipate a further fall in future in the falling prices, they postpone their purchases rather than buying more when there is a fall in the price.

(b) Status Goods:- The law of demand, does not apply to the commodities which are used as a ‘status symbol’ for enhancing social prestige or for displaying wealth and riches e.g. gold, precious stones, rare paintings, antiques etc. Rich people buy such




goods mainly because their prices are high and buy more of them when their prices more up.

(c) Giffen Goods:- Another expectation to the law of demand is the classic case of Giffen goods. A giffen good may be any inferior commodity much cheaper than its superior substitutes, consumed by the poor households as an essential commodity. If the price of such goods increases its demand increases instead of decreasing because income effect of a price rise to greater than its substitution effect. The reason is, when price of an inferior good increases, income remaining the same, poor people cut the consumption of the superior substitute so that they may buy sufficient quantity of the inferior good to meet their basic need.

(d) Market Demand:- Market demand is the sum of individual demands for a product at a price per unit of time at a given price is known as ‘individual demand’ for that commodity. The aggregate of individual demands for a product is called market demand for the product.

Or The total quantity that all the consumers/users of a commodity are willing

to buy per unit time at a given price, all other things remaining the same, is called ‘market demand’ for that product. Types of demand:- The demand of various goods is generally classified on the basis of the consumers of a product, supplies of the product, nature of goods, duration of consumption of a commodity, interdependence of demand, period of demand and nature of use of goods. Individual and Market demand:- The quality of a commodity which an individual is willing to buy at a particular price during a specific time period, given his money income, his tastes and prices of other commodities, is called ‘ individual’s demand for the commodity’. The total quality which all the consumers of a commodity are willing to buy at a given price per time unit, given their money income, taste and prices of other commodities is known as ‘market demand for the commodity’. Demands for film’s product and In-determined industry products:- The quality of the film’s product that can be disposed of it a given price over a time period connotes the demand for the film’s product. The aggregate of demand for the product of all the film’s of an industry is known as the market demand or demand for industry’s product. When market structure is oligopolistic, a distinction between the demand for a film’s product and for the industry’s product is useful from the managerial point of view. In such markets, products of each firm are so differentiated from the products of the rival firms that consumers treat each product as different from the other. In case of monopoly and perfect competition, the distinction between demand for a firm’s product that of the industry is not of much use from managerial point of view. In case of monopoly, the industry is a one-firm industry and the demand for the firm’s product is the same as that of the industry. In case of perfect competition, products of all firms of the industry are homogenous consumers do not distinguish between products of different firms; and price for each firm is




determined by the market forces. Firms have only little opportunity to maneuver the prices permissible under local conditions and advertisements by a firm becomes effective for the whole industry. Therefore, conceptual distinction between demand for a firm’s product and business decision-making. Autonomous and Derived demand:- An autonomous or direct demand for a commodity is one that arises on its own out of a natural desire to consume or possesses a commodity. For ex. Consider the demand for commodities which arises directly from the biological or physical needs of human beings. eg. Demand for those goods and the line is autonomous demand. Autonomous demand may also arise as a result of ‘demonstration effect’ of a rise in income, increase in population and advertisement of new products. The demand for a commodity that arises because of the demand for some other commodity, called ‘parent product’, is called derived demand. For instance, demand for land, fertilizers and agricultural tools and implements is a demand because these goods are demanded because food is demanded. Similarly, demand for steel, bricks, cement etc. is a derived demand derived from the demand for house and other kinds of buildings. The demand for producer goods or industrial inputs is a derived one. Also the demand for complementary goods or for supplementary goods is a derived demand. for ex – Petrol is complementary good for automobiles and chair is competent to a table. Butter is supplement to Demand for durable and non durable goods- Demand is also often classified under demand for durable and non-durable goods. Durable goods are those whose total utility or usefulness is not exhausted in a single or short run use. Such goods cab be used repeatedly or continuously over a period of time. Durable goods may be consumer goods as well as producer goods. Durable consumer goods include clothes, shoes, houses, furniture, utensils, refrigerator, scooters, cars etc. The durable producer goods include mainly the items under fixed assets, such as building, plant, machinery, office furniture and fixtures etc. Durable goods are further desired. Short term and Long term demand Short term demand refers to the demand for good that are demanded over a short period. In this category are found mostly the fashion consumer goods , goods of seasonal use, inferior substitutes during the scarcity period of superior goods etc. The long term demand refers to the demand which exists over a long period. The Cheque in long term demand is perceptible only after a long period. Most generic goods have long term demand. For example, demand fro consumer or producer goods, durable and non-durable goods is a long term demand through their different varieties or brands may only have a short term demand. Determinants of Market demand- 1. Price of the product 2. Price if related goods 3. Level of consumer income 4. Advertisement of the product




5. Consumers taste’s and preferences I) Price of the Product- The price of a product is one of the most important determinant of its demand in the long run and the only determinant in the short run the price of the product and its quality demanded are inversely related. The law of demand states that the demanded of a product which its consumer would like to buy per unit time, increases when its price falls and decreases when its price increases, other factors remaining constant. The assumptions ‘other factors remaining constant’ implies that income of consumers, price of substitutes and complementary goods, consumers taste and preferences and number of consumers remain constant. II) Price of related goods- Related goods may be substitutes or complementary goods.

Two commodities are deemed to be substitutes for one another if change in the price of one affects the demand for the other in the same direction. For example, commodities X and Y are considered as substitutes for one another if a rise in the price of X increases demand for Y and vice-versa. Tea relation between demand for a product and price of its substitutes is of positive nature.

A commodity is deemed to be complement for another when it complement the use of the other or when the use of two goods together so that their demand changes (increases or decreases) simultaneously.

For example, petrol is a complement to cars and scooters. In economic sense, two goods termed as complimentary be one another if an increase in the price of one causes a decrease in the demand for the other. By definition, there is an inverse relationship between the demand for a good and the price of its complement.

(a) Substitute (b) Complement Demand for substitutes and Complements III) Consumer Income- Income is the basic determinant of quality of a product demanded since it determines the purchasing power of the consumer. People with higher current disposable incomes spend a larger amount on consumer goods and services than those with lower income.

Demand curve for tea

Demand of tea Demand of car




For the purpose of income – demand analysis consumer goods and services may be grouped under four broad categories viz (a) essential goods (b) Inferior goods (c) Normal good (d) Prestige or luxury goods Quality Demanded (a) Essential Consumer Good (ECG)- The goods and services in this category are

called ‘basic needs’ and are consumed by all persons of the society, e.g. food grains, salt, vegetables etc. Quantity demanded of this category of goods increases with increase in consumer’s income but only up to a certain limit, even though the total expenditure may increase in accordance with quality of goods consumed, other factors remaining constant.

(b) Inferior Goods- Inferior and Superior goods are known to both sellers and consumers. For instance, every one knows that millet is inferior to wheat and rice Kerosene is Inferior to cooking gas etc. In an economic sense, a commodity is deemed to be inferior if its demand decreases with the increases consumers income beyond a certain level of income.

(c) Normal Goods- Normal are those which are demanded in increasing quantity as consumers’ income rises; clothing, household furniture and automobiles are some of the important examples of this category of goods. The demand for such goods increases with increase in income of the consumers, but at different rates at different levels of income. Demand for normal goods increases rapidly with the increase in the consumer’s income but slows down with further increase in income.

(d) Luxury and Prestige goods- All such goods that add to the pleasure and prestige of the consumer without enhancing his earning fall in the category of luxury goods. For example, Jewellery, accommodation in 5-star hotels etc can be treated as luxury goods. Demand for such goods arises beyond a certain level of consumer’s income, i.e. consumption enters the area of luxury goods. IV) Consumer taste and Preferences- Consumer’s taste and preferences play an important role in determining the demand for a product. Taste and preferences play an generally depend on lifestyle, social customs, religious values attached to the commodity, habit of the people, the general levels of living of the society and age sex of consumers change in these factors changes an account taste and preferences. As a result, consumer reduce or give up the consumption of same goods and add new one’s to their consumption pattern. For example, following the change in fashion, people switch their consumption pattern from cheaper, old-fashioned goods, so long as price differentials are commensurate with their preferences. Consumers are prepared to pay higher prices for ‘mod goods’ evil if their virtual utility is virtually the same as that if old fashioned goods.




V) Advertisement Expenditure- Advertisement costs are incurred with the objective of promoting sale of the product. Other factors remaining same, as the expenditure on advertisement increases, volume of sales increases to an extend. Advertisement Expenditure Assumptions-

Sales curve

a) Consumers are fairly sensitive and responsible to various modes of advertisement taste and preferences. As a result, consumer.

b) The rival firms do not react to the advertisement made by a firm. c) The level of demand has not reached the saturation point. Once the demand

reaches the saturation point, advertisement makes only a marginal impact on demand.

d) Advertisement cost added to the price does not make the price prohibitive for consumers, compared to the price of substitutes.

e) Other determinants of demand, e.g. income and tastes etc are not operating in reverse direction.

In the analysis of input-output relations and production function is expressed as Q= F (L, K) Where Q = the quantity of coal produced per uni time K= Capital; L = Labour The above equation implies that quantity produced depends on the quantity of capital K, and labour L, “employed to produce a commodity. Whether the firm can increase both K and L or only L depends on the time period it takes into account for increasing production, i.e. whether the firm considers ashort run or a long run. By defination, supply of capital in the elastic in the short run and elastic in the long run. In the short-run, therefore the firm can increase coal production by increasing labour only since the supply of capital in short run is fixed. In the long run, however, the firm can employ more of both capital becomes elastic over time; Accordingly, there are two kinds of production function.

i) Short run production function; and ii) Long run production function

The short run production function which is also called ‘single variable production function’ can be expressed Q = f (L) In the long run production function, both K and L are included and the production takes the form




Q = f (K, L) Assumptions A production function is based on the following assumptions:- i) Perfectly divisible inputs and output ii) There are only two factors of production – labour (L) and capital (K) iii) Limited substitution of one factor for the other iv) A given technology; and v) Inelastic supply of fixed factors in the short run.

In there is a change in these assumptions, the production function will have to be modified accordingly.

The Laws of Production In the short – run, input – output relations are studied with one variable input, other inputs held constant. The laws of production under these conditions are called “The Laws of variable Proportions” or “Laws of Return to a variable Input”. Input – output relations are studied assuming all the input to be variable. The long run input output relation are studied under ‘Laws of Return to scale.’ The Law of Returns to a variable Input: The Law of Diminishing Returns The Law of diminishing return states that when more and more units of variable input are applied to given quantity of fixed inputs, the total output may initially increase at an increasing rate, then at a constant rate but it will eventually increase at diminishing rate. That is, the marginal increase in total output eventually decreases when additional units of variable factors are applied to a given quantity of fixed factors. Assumptions- The law of diminishing return is based on the following assumptions i) The state of technology is given ii) Labour is homogenous iii) Input prices are given Suppose the labour-output relationship is given by a hypothetical production function of the following form Q = -L3 + 15 L2 + 10 L We may substitute different numerical value for L in the function and work out a series of quantity that can be produced with different number of workers. E.g. if L = 5, then by substitution Q = -53 + 15 x 52 + 10 x 5 = -125 + 375 +50 = 300 Marginal Product of Labour (MP) is defined as rate of change of output as labour is increased one unit. It can be obtained as MP = TPL – TPL-1Average Productivity of labour(APL) can be obtained by dividing the production function by L. Thus, AL = - L3 + 15L2 +10L L = - L2 =15L+10




Elasticity of production(Relationship between MP and AP) is defined as rate fractional change in total output ΔQ/Q relative to a slight change in variable factor ΔL/L. Thus e.g. ΔQ/Q = ΔQ . L ΔL/L ΔL Q = ΔQ ÷ Q => MP ΔL L AP No. of workers Causes of different stages of production A) Increase return – Economists emphasis two important reasons viz. advantages of indivisibilities and specialization. i) Indivisibility – In many lines of production, machinery and other factor units are so large that they can not be divided into smaller units since division division will result either in total useless in production or partial loss in efficiency. Such factors can produce smaller or larger quantities, almost with same amount of expenditure. E.g. Suppose that the smallest size of the automobile plant has the capacity to produce 1,00,000 cars in a year but suppose the actual demand is only for 20,000 cars

a) the plot of ten cars can be better acti and b) there can be greater specialization between the workers, such as some to

specialize in ploughing, some in sowing, some in weeing and so on. Thus, increasing marginal returns are due to better utilisation of the fixed factor and greater efficiency arising out of increasing specialization of the variable factor units.

Causes of diminishing Returns- After the best proportion between the fixed and variable factor units have been achieved, the firm will start experiencing diminishing factors are increased. This tendency to eventually diminishing marginal returns is due to two reasons (a) the fixed factor has reached its maximum capacity;




and (b) the limit to maximum degree of specialisation has been reached as far as the variable factor units are concerned. Thus, increasing returns in the short period are due to greater efficiency, arising out of indivisibility of fixed factors and specialisation of the variable factor; diminishing marginal returns are due to increasing inefficiency in production after the maximum capacity of the indivisible factor has been reached and the limit to specilisation has been attained. Even to produce 20,000 cars, it is necessary to install the plant capacity of producing 1,00,000 cars. The entire cost of the plant will be spread over the actual production of 20,000 cars. But suppose the need of cars can be increased in the country. Then with the same plant, it is possible to increase the output upto 1,00,000 cars. Without additional expenditure on the plant. In other words, the entire cost on the plant can now be spread over a large voloume of goods which reduces the cost per unit. In the initial stages, the supply of the fixed factor is too large and indivisible, while the variable factor units are too few. Accordingly, the fixed indivisible factor is not full utilized. When the units of the variable factor are increased and combined with the fixed factor, the latter is utilized better and more fully. ii) Specialisation –When the units of the variable factors are increased and combined with the fixed factor, there is greater co-operation and a higher degree of specialisation between the different units of the variable factor units. The most important advantages of specialisation of labour include greater skill and dexterity, the avoidance of waste of time in shifting from one ask to another, the employment of persons best suited to particular types of work etc. e.g. If there is only one man working on a plot of ten acres, it may be difficult for him to utilize the plot in best possible manner. At the same time, the worker will have to undertake various activities such as ploughing, sowing weeds, irrigation etc. all by himself. On the other hand, if the number of workers is increased to two, three, four and so on, Theory of cost Inputs multiplied by their respective prices and added together give the money value of the inputs, i.e. the cost of production is an important factor in almost all business analysis and decisions, specially those pertaining in

a) locating the weak point in production management b) minimising the cost c) finding the optimum level of output d) determination of price and dealers mergin and e) estimating or projecting the cost of business opertions.

The cost concepts which are relevant to business operations and decisions can be grouped, on the basis of their nature and purpose, under two categories which are:-

i) Concepts used for accounting ii) Analytical cost concepts used in economic analysis of business

activities. Cost Concepts




1. Opportunity cost and actual cost- The opportunity will may be defined as the expected returns from the second best use of the resources which are foregone due to the scarcity of resources. The opportunity cost to be called alternative cost. For ex – Suppose that a firm has a sum of 100,000 for which it has only two alternative uses. It can buy other a printing machine or alternatively a lathe machine both having productive life of 10 years. From the printing machine, the firm expects an annual income of Rs. 20,000 and from the lathe, Rs, 15,000. A profit maximizing firm would invest its money in the printing machine and folego the expected income from the lathe ve. Rs 15,000. In assessing the alternative cost, both explicit & implicit costs are taken into account. Actual costs are those which are actually increased by the firm in payment for labour, material, plant, building, machinery, equipment, traveling and transport, advertisement etc. The total money expenses reached in the books of accounts are for practical purposes called the actual cost. 2. Business Costs and full costs- Business cost includes all the expenses which are incurred by the firm to carry out a business. It includes all the payments and contractual obligation made by the firm together with the book cost of depreciation on plant and equipment. These cost are used for calculating business profits and losses and for filling returns for income tax and also for other legal purposes. Full costs includes business costs, opportunity costs and normal profit. The opportunity cost includes the expected earning from the second test use of the resources or the market rate of interest on the total money capital & also the value of an entrepreneurs own services which are not charged for in the current business. Normal profit is a necessary minimum earning in addition to the opportunity cost, which a firm must receive to remain in its present occupation. 3. Explicit & Implicit Costs:- Explicit costs are those which fall under actual or business costs entered in the books of accounts. The payments for wages and salaries, materials, license fee, insurance pronouncing depreciation charges are the examples of explicit costs. These costs involve cash payment and are recorded in normal accounting practices. Implicit costs are not taken into account ‘while calculating the loss or gains of the business, but they form an important cone elevation in whether or not a factor would remain its present occupation. The explicit and implicit costs together make the economic cost. 4. Out of pocket and Book Costs- The items of expenditure cash payments or cash transfers, both recurring and non-recurring are known as out of pocket costs. All the explicit costs falls in this category. On the contrary, there are certain actual business costs which do not involve cash payments, but a provision to therefore made in the booksof account and they are taken into account while finalizing the profit & loss accounts, such expenses are known as book costs. In a way, these are payments made by a firm to itself. Depreciation allowances and unpaid interest on the owner’s own find are the example of book costs. Some analytical cost concepts 1. Fixed and variable cost- Fixed costs are those which are fixed in volume for a certain given output. Fixed cost does not vary with variations in the output between




zero and a certain given level of output. In other words, costs that do not costs. The fixed costs include (i) costs of managerial and administrative staff, (ii) depreciation of machinery building and other fixed assets, (iii) maintenance of land etc. The concept of fixed costs is associated with the short run. Variable costs are those which vary with the variations in the total output. Variable costs include cost of raw material, running cost of fixed assets such as fuel, repairs, direct labour charges associated with the level of output etc. 2. Total, Average and Marginal Costs- Total cost (TC) is the total expenditure incurred on the production of goods and services. It refers to the total outlays of money expenditure both explicit and implicit on the resources used to produce a given level of output. It includes both fixed and variable costs. The cost for a given by the cost function. Average cost(AC) is of stastical nature- it is not actual cost. It is obtained by dividing the total cost (TC) by the output(Q) i.e. AC = TC / Q Marginal Cost (MC) is the addition to the total cost on accoubt of producing one additional unit of the product or marginal cost is calculated as TCn – TCn-1, where n is the number of units produced. Alternately, given the cost function, MC can be defined as MC = ∆ TC ∆ Q Total, average and marginal cost concepts are used in the economic analysis fo firm’s production activities. 3. Short Run and Long Run Costs- Short run and long run cost concepts are related to variable and fixed costs. Short run costs are the costs which vary with the variations in output, the size of the firm remaining the same. Long run costs, on the other hand, are the costs which are increased on the fixed assets like plant, building, machinery etc. Short run costs are the same as variable costs. Long run costs are by implication the same as fixed costs. In the long run, however, even the fixed costs become variable costs as the size of the firm or scale of production. 4. Incremental costs and sunk costs- The concept of incremental cost is based on the fact that in real world, it is not practicable to employ factors for each unit of output separately. Besides, in the long run, when firms expand their production, they hire more expenditure of this nature are incremental costs. Incremental cost arise also owing to the change in production lines, additions or worn out plant and machinery, replacement of old technique of production with a new one etc. The sunk costs are those which can not be altered, increased or decreased by varying the rate of output. For example, once it is decided to make incremental investment expenditure and the funds are allocated and spent, all the preceding costs are considered to be the sunk cost, since they accord to the prior commitment and can not be revised or recovered when there is change in market conditions or change in business decisions.




5. Historical and replacement costs- Historical costs refers to the cost of an asset acquired in the past whereas replacement cost refers to the outlay which has to be made for replacing an old asset. Historical costs of assets is used for accounting purposes in the assessment of the net worth of the firm. The replacement cost figures in business decisions regarding the renovation of the firm. 6. Private and Social Costs- There are certain costs which arise due to the

functioning of the firm but do not normally figure in the business decisions nor are such costs explicitly borne by the firm. The costs on this category are borne by the society. Thus, the total cost generated by a firm’s working may be divided into two categories (i) those paid out or provided for by the firms, and (ii) those not paid or borne by the firms including those of resources available plus the disutility created in the process of production. The costs of former category are known as external or social costs e.g. the discharging its wastage in the Yamuna river causes water pollution. Such cost is termed as external costs from the firm’s point of view and social costs from the society’s point of view.

(a)

Q1 Q2 Q3 (b) Q1 Q2 Q3

Long – run Total and Average cost curves By defination, long run is a period in which all the inputs become variable. The variability of inputs is based on the assumption that in the long run supply of all the inputs, including those hold constant in the short-run, become elastic. The firms are, therefore, in position to expand the scale of their production by hiring a




larger quantity of all the inputs. The long-run-cost output relations, therefore, imply the relationship between the changing scale of the firm and the total output, whereas in the short-run this relationship is essentially one between the total output and the variable cost (labour). Long run cost drive is composed of series of short run cost curves. Suppose that a firm having given by STC1 in panel (a). Suppose that the firm decides to ad two more plants to its size over time, one after the other. As a result two more short – run total cost curves are added to STC1 in form of STC2 and STC3. The LTC can now be drawn through the minimum points of STC1, STC2 and STC3 as shown by the LTC curve corresponding to each STC. Long Average cost curve (LAC) – The long run cost curve (LAC) is derived by combining the short-run average cost curves (SAC3). There is one SAC associated with each STC given STC1, STC2 , STC3 curve panel (a). There are three corresponding SAC curves as given by SAC1, SAC2 and SAC3 curves in panel (b). Thus, the firm has a series of SAC curves, each having a bottom point showing the minimum SAC. For instance C1Q1 is minimum AC when the firm has only one plant. The AC reduces to C2Q2 when the second plant is added and then rises to C3Q3 after the addition of the third plant. The LAC curve can be drawn through the SAC1, SAC2 and SAC3 (panel b). The LAC curve is also known as the ‘Envelop curve’ or ‘Planning curve’ as it serves as a guide to the entrepreneur in his plans to expand production. Long – run Marginal cost curve(LMC)- LMC is derived from the short – run marginal cost curves (SMCs). In derivation of LMC, SACs and LAC are the same as in long run total average cost curve and short run average cost curves. To derive the LMC, one has to consider the points of tangency between SACs and LAC, i.e. points A, B and C. In the long – run production planning these points determine the output levels at the different levels of production. For example, if one draws perpendiculars from points A, B an dC to the X – axis, the according output levels will be oQ1, OQ2 and OQ3. The perpendicular AQ1 intersects the SMC1 at point M. It means that at output OQ1, LMC is MQ1. If output increases to OQ2, LMC rises to BQ2. Similarly CQ3 measures the LMC at output OQ3. A curve drawn through points M, B and N represents the behaviour of the marginal cost in the long run. Q1 Q2 Q3

Derivation of LMC Economics and diseconomies of scale The economics of scale are classified as




a) Internal or Real economics and A) Internal Economics- Internal economics arise from the expansion of the plant size of the firm and are internalized. This means that internal economics are exclusively available to the expanding firm. Internal economics may be classified as

i) Economics of Production ii) Economics of Marketing iii) Managerial Economics iv) Economics in transport and storage

i) Economics in Production- These economics arise from the greater efficiency of larger capital equipment, which big firms can afford to have. A large firm will be able to install the right type of machinery or different types of specialized machinery. A high cost of such machinery may prohibit a small firm from installing them. A large firm, on the other hand, can afford to employ much costly machinery since the cost of machinery can be spread over a large volume of output. In spite of the high fixed costs of the plants used, the unit cost of the production will tend to be lower. Thus, the large scale firm enjoys the economy of superior technique. Another technical economy arises when a firm is able to carry through division of labour or specialisation to the maximum possible extend. Not only specialized machinery is utilized but the division of labour is carried to the most desirable extend. ii) Economics in Marketing- As the firm expands in size, it is able to buy raw materials and stores cheaply because it buys in large quantities and regularly. A large firm can secure special concessional rates from transport companies. It can also sell its finished product in a regular and smooth fashion, because it has established name and fame through regular propaganda and advertisement. The large firm can also have its sales equency. iii) Managerial Economics- Managerial economics arise from (a) specialisation in Management and (b) mechanization of managerial function. For a large size firm, it becomes possible to divide its management into specialized departments under specialized personnel. Such as production manager, personnel manager etc. This increases the efficiency of management at all levels of management because of decentralization of decision making. Large scale firms have the opportunity to use advanced techniques of communication, telephone and tele machines, computers and their own means of transport. All these lead to quick decision- making, thereby improve the managerial efficiency. For these reasons, managerial cost increases less than proportionally with the increase in production scale up to a certain level. iv) Economics in Transport and Storage- Economics in transportation and storage costs arise from fuller utilization of transport and storage facilities. The large size firms can acquire their own means of transport and they can, thereby, reduce the unit cost of transportation compared to the transport companies. Similarly, large scale firms can create their own go downs in the various center of product distribution and save in cost of storage. Diseconomies of Scale- Diseconomies of scale are disadvantages that arise due to the expansion of production scale and lead to rise in the cost of production. Managerial inefficiencies arise from the expansion of scale itself. Close control and supervision is replaced by remote control management. With the increase in managerial personnel, decision making becomes complex and delays become inevitable. Besides, with the expansion of the scale of production, management is professionlised beyond a point. As a




result, the owner’s objective function of profit maximization is generally replaced by manager’s utility function, like job security and high salary. All these lead to laxity in management and hence to a rise in the cost of production. Pricing under perfect competition A market for a result is said to be perfectly competitive when following features are present:-

a) Large number of buyers and sellers. It is difficult for any one producer or buyer to effect the price.

b) Homogenous product:- The buyers regard the product of all the sellers as identical and have no preference for dealing with any particular seller. The goods are perfect substitute of each other.

c) Freedom to move in or out :- Firms and consumers have freedom to enter or leave the industry. Each firm is small in size and produces only a small portion of the total output. Hence firm entering or leaving the market won’t effect the size of the industry or price of the product.

d) Perfect Knowledge:- Perfect competition implies perfect knowledge on the part of buyers and seller regarding market conditions. No buyer will be prepared to pay a price higher than the ruling price. The seller perfect knowledge of potential sales at various levels and also perfect knowledge of cost behavior.

e) Absence of transportation cost:- This assumption is necessary so that there may be uniform price throughout the market. If transportation cost are present prices will differ in different sectors of the market.

Equilibrium of a Firm – A firm is said to be equilibrium when it produces that output and fixes that price at which it sources maximum profit. Assumptions- i) The firm has only one aim or goal i.e. to get maximum possible profit. ii) The firm has full knowledge of the position where profit is maximum.

If a firm goes in for maximum profit, it will not produce even in single unit of a product at a loss, the total profit will be reduced by the amount of loss. To maximize profits, a firm should produce and sell up to the point at which the revenue from the last unit (marginal revenue0 is equal to the cost of the last unit (marginal cost). Beyond this point of equality of MR and MC the firm will experience losses, because the additional loss will be more than the additional revenue. Thus there are two conditions for equilibrium of the firm:- 1) The first condition of equilibrium of a firm is the equality of MC and MR. The Equality of MC and MR is a necessary condition but not an adequate condition for equilibrium. Hence subsidiary condition is:- 2) The marginal cost curve should cut marginal revenue curve from below. After the point of equilibrium MC must exceed from MR.




N N1 Quantity

MC curve cuts the MR in two places, viz. at point as multiple equilibrium. However, point P1 can not be a determinate equilibrium point, since beyond this point the managerial cost is lower than marginal revenue and it is to the advantage of the firm if it produces more. By doing so, the firm can secure profits enclosed by the area P1 and P2. If the firm is assumed to go in for maximum profit then there is no reason why the firm should stop at ON even though marginal cost is equal to marginal revenue at the point. The determinate equilibrium point is in fact ON1 for, beyond that point, marginal cost is higher than marginal revenue. Relation between Market Price and equilibrium of the firm (Perfect Competition) The market price is common for all the sellers and buyers in the industry and it can not be changed by any one or group of persons. Every firm accepts the price as given O Q X O X Quantity (Thousand) Quantity (units) QP (= OA) is the equilibrium price for the industry. A horizontal Straight line drawn from the point P indicates that every firm accepts this price. Whether a firm will sell at the ruling market price and, if so, how much, will depend upon the relation between its reservation price and the market price. If the market price is higher or equal to its reservation price it will; if the market price is lower than its reservation price, it will not sell. During the market period the industry is in equilibrium when market demand and market supply are equal; the firm is in equilibrium when its minimum reservation price is equal to the market price. Equilibrium of the competitive Industry in the short run- Whether a competitive firm will produce or no in the short run will depend upon the relation between the price and the cost of production. In the short run, every firm has both fixed and variable costs corresponding to the fixed and variable factors. Normally, the price per unit should cover the average cost of production comprising both average fixed and average variable costs.


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MR2 MR1 MR O N X Quantity in units If price exceeds this cost, the firm enjoy excess profit. But in short run, every producer realizes that fixed cost will continue to exist even when the firm is closed down for the short period. On the other hand, the volume of output depends directly upon the variable costs and this cost should be covered by price if production has to take place at all. We can, therefore, state that minimum price which will induce a firm to produce in the short period is the one, which just equals average variable cost. Suppose that the short-period price is OP, the firm will decide do not to produce since the price does not cover even its AVC. Suppose that short-period price is OP1, this price is acceptable to the firm as it is equal to AVC at point A. The firm can produce output one. Obviously, even at the whole of the average cost AA’. The amount that a firm will produce will be determined by the equality of MR and MC. If the firm is prepared to produce at the price of P1, then it will readily do so short-period normal price happens to be higher, say P2. Group Equilibrium in the long run- The supernormal profit of short run brings about in the long run two important changes in a monopolistically competitive market. First, the supernormal profit attracts new firms to the industry. As a result, the existing firm loses a part of their market share to new firms. On the other hand, existences of lose in the short run and the anticipation of the same in the long run will induce existing firms to leave the industry. Second, the increasing number of firms intensifies the price competition between the firms. Price competition increases because losing firms try to regain or retain their market share by cutting down the prices of their product. And, new firms in order to penetrate the market set comparatively low prices for their product. The price competition increases the slope of the firms’ demand curve or, in the other words; it makes the demand curve more elastic. At the same time, there is a possibility that a long run average cost curve for every rises because of large number of sellers and the consequent increases in the demand for factors of production. These two tendencies which operator to rise-will eliminate excess profits; in the other words, profits will be competed away.

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O N X Output Over a long period of time, there will definitely be no losses either, for any firm because if this were to be so, firms would leave the industry one after another; consequently, supply would diminish causing price of rise until it was high enough to cover the average cost of production of the firm. Hence, under monopolistic competitive condition, over a long period of time, every firm will tend to be no-profit, no-loss firm and will reap only normal profit. Pricing under Pure Monopoly Monopoly refers to a market situation where there is only one seller who has complete control over the supply of a commodity which has no close substitutes. The monopoly can adopt any price it takes; it can charge uniform price, or it can charge different prices from different customers. It is able to prevent others from entering the industry. The firm and industry refers to one and the same thing; a single firm constitutes the entire industry. Monopolies may be classified into two types, viz. private monopolies and public monopolies. A private monopoly is owned and operated by private individuals or companies for the purpose of securing profit-profit maximization is the primary objective. A public or govt. monopoly may be run not only for profit but also to increase economic welfare for the commodity. Some economists prefer to call it a welfare monopoly. Factors that lead to emergence of monopoly power in an industry include:- a) Control of a strategic raw material:- It may be possible a single firm to acquire control of all or most of the supply of a strategic raw material required for a particular business. Most diamond mines are located within a comparatively small area in South Africa and it was very easy for the De- Beers to get possession of these diamond mines and effect a monopoly of the world’s diamond supply. b) Fiscal monopolies- There are certain monopolies operated by the state itself. The most common example are the post office, the minting of coin, printing of currency, notes etc. These are services which are essential and which private companies may not be able to undertake or which can not be entrusted to private parties. c) Control of a secret process – A monopoly may arise simply because of the control of a secret process by a single company. An important product may be manufactured through a process known only to one firm. Price and output Determination in the Short Period






P1 P P2 AR = D MR O Q X As under perfect competition, pricing and output decisions under monopoly are based on revenue and cost conditions. Although cost conditions i.e. AC and MC curves, in a competitive and monopoly market are generally identical, revenue conditions differ. Revenue conditions, i.e. AR and MR curves are different under monopoly because, unlike a competitive firm, a monopoly firm faces a downward sloping demand curve. For, a monopolist can reduce the price and sell more and can raise the price and still retain some customers. A profit maximizing monopoly firm chooses a price-output combination at which MR = SMC. The equality of marginal cost and marginal revenue at point parallel to the Y-axis is drawn at point M connecting the X-axis at Q and demand curve at P. QP is the equilibrium price and OQ is equilibrium output. Profit per unit = Average revenue – Average cost Total Profit = PM x OQ (i.e. the number of units produced) = PMP1P2The total monopoly profit is the shaded area PMP1P2 Which is the largest amount of profit the firm can secure. At any other price and quantity, total profit will be less. Price and Output Determination in the Long Run- the monopoly price determination in the long run is similar to that under the short period. In the long run the monopoly firm adjusts its capacity to changes in long run demand. After these adjustments are complete, the monopoly firm will have a long period equilibrium, determined by the equality of long –period marginal cost and marginal revenue. The monopoly firm will fix a price PN in the long run. The total will be equal to the shaded area PP1RR. R P R1 P1 D / AR MR O N X Pricing Under Oligopoly Market




Oligopoly refers to a market situation with few sellers i.e. more than two sellers. Under oligopoly, industry is dominated by a few firms who are producing an identical or close substitute may emerge in an industry when:

a) Economics of scale or advantages of large-scale production exists- as a result, a few firms are able to supply all or much of the total industry output.

b) Superior entrepreneurs reduce the large number of firms into a few through mergers and holding companies.

c) The exclusive ownership of patents and other rights by a few firms or exploitation of the advantages of product differentiation creates oligopoly market.

d) The controlling power of a few firms over the available natural resources reduces competition only to a few firms.

e) The need for heavy investment of capital in some industries prevent the entry of a large number of firms.

Features of Oligopoly- First, every firm under digopoly has to be conscious of the reactions of its rivals. As the number of competitions is few, any change in price in price, output, product etc by one firm will have a direct effect on the others who naturally relatively by changing their own prices, output, products etc. Secondly, the oligopoly is characterized by indeterminateness. A firm does not know for certain whether its decisions regarding price and output will affect its competitors favourabely or adversely. Further, does not know whether competitors will approve or disapprove of its decision and in what way their rechons will be known. Thirdly, digoploly firms may show confliching attitudes to one another. On the one side, they may appear to realise the disadvantages of competition and rivalary and may work out some policy of collusion or they may continuously maximing its share of profits.

Fourthly, digopoly fimrs resort to various aggressive marketing methods to increase their share of the market or adopt defrnsive marketing methods to prevent a decline in their share of the market. They resort to extensive advertisement and sales promotion between them.

Finally, in digopoly seller has some monopoly power over the product it produces (brand name, patent etc) but it does not acquier monopoly control of the market.

There are various digopoly models:

1) Price leadership Model 2) Collusive model: The Cartel Arrangement. 3) Sweezy’s kinked demand cure Model. 4) Pricing under duopoly. Price Leadership A very important form of price Fixing under conditions of digopoly is the determination of price by a leading firm or doninant fims (known as price leader) and the adoption of the same with or without modification by others (known as price followers). The price leader my be a dominant firm producing a signigicant postion of the industry’s outpur or has a lower cost of production and almost the power of




monopolist. When the dominant firm is interested in eliminating the rivals in the market, It may trun into aggressive price leader

We assume the existence of two firms in the market 1 and 2 producing identical products, sharing market equally but having different cost of production . Each firms’s demand curve is given by D (which is half of the total demand) and each firm’s marginal revenue cure is given as Mr, AC1 and Mc1 and AC2 and Mc2 represent average and marginal Cost of firms 1 and 2 respectively. Under the conditions of independent pricing, each firm will fix a price at which MC=MR. These Price are represented by P1and P2, but under condition of digopoly, second firms cannot set p2 price, and attempt to maximize its profits rectangle (represented by dotted line). Its will have to set P1 proce which the lower cost firm has set, otherwise, it will not be lower cost firm has set, otherwise, it will not be able to0 sell its products and consumers will not pay a higher price for the same product. While the first firm will get maximum profits (as if it were a monopoly) the second will have to be satisfied with lower profits. The total output in the market willnot be ON1 +ON2 but twice ON1. The first firm-ie, the high cost firm –is the price follower. Pricing Under Collusion Collusion implies “to play together” when competing firms co-operate in pricing they are said to collude. Collusion may be various types. Open or explicit collusion is generally sanctioned by the government or tacit or implicit collusion is normally secret . Collusion may be based on agreements, either oral or written, collusion based on written agreements between rival producers or price, output, division or sales territories , etc creates what is known as cartels. The purpose of the cartel is to eliminate competition and fix such a price and produce such a quantity that will maximize industry profits. The total supply of the industry is given by the sum of MC1 and MC2 (ie/MC)




. Cartel administration finds that the maximum profits is indicated where the aggregate MC and marginal revenue are equal (MR = Σ MC).The best output is OQ and best price is PQ. The two firms must fix the same price and produce ON and ON1 output respectively (ON + ON1 = OQ) Sweezy’s Kinked Model- This is the best known model explaining relatively more satisfactorily the behaviour of digopolistic firms. The kinked demand curveanalysis does not deal with price and output determination. Rather, it seeks to establish that once a price –quality combination is determined. An digopoly firm believes that if it reduces the price of its product, rival firms would follow and neutralize the expected gain from price reduction. But, if it raising firm stands to lose, at least a part of its market share. This behavioural assumption is made by all the firms with respect to others. The digopoly firms, therefore, find it more desirable to maintain their price and output at the existing level. There are possible ways in which rival firms may react to price change by one of the firms

1) the rival firms follow the price changes, but cut and hike. 2) The rival firms do not follow the price changes 3) Rival firms follow the price cuts but not the price hikes.

d

D P D’ d' O Q L X Output per unit time


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Suppose that the market demand curve for a product is given by dd’ curve and that initial price is fixed at PQ. Now let one of the firms change its price. If rival firms react in manner (i) i.e. they react with hike for hike and cut for cut, the price changing firm moves along the demand dd’. And if rival firms do not follow the price changes, the price changing firm will move along the demand curve DD’. The firm initiating the price change faces two different demand curves conforming to two different kinds of reactions (i) and (ii). The demand curve dd’ is based on reaction (i) and is less elastic that the demand curve DD’ which is based on reaction (ii) demand curve dd’ is less elastic because changes in demand in response to changes in price are restrained by the countermoves by the rivals. In case (iii), the rival firms follow the price cut but do not follow the price hike. This is asymmetrical behaviour of the rival firms, makes only a part of the two demand curves relevant and produces a kinked demand curve. If a firm increases its price and rivals do not follow, it loses a part of its market to the rivals. The demand for its product decreases considerably indicating a greater elasticity. The firm is, therefore, forced down from demand curve dP to DP.Thus, the relevant segment of demand curve for the price hiking firm in DP. Suppose, alternatively, that an digopoly firm decreases its prices. Then the rival firms, given their asymmetrical behaviour, cut down their prices. Otherwise, they would lose their customers. This counter price-move by the rivals prevents the oligopoly firm from taking full advantage of price-cuts along the demand curve PD’. Therefore, its demand curve below point P rotates down. Thus, the relevant segments of the demand curve for price cut is PD’. Thus, the two parts of the demand curve put together give relevant demand curve for the firm as DPd’ which has a kink at point P. The MR curve drawn, takes a shape as shown by a discontinuous curve DJKL. The DJ and KL segments of the MR curve correspond respectively, to the DP and Pd’ segments of the kinked demand curve, DPd’. Suppose that the original marginal cost curve resembles the curve MC, which intersects MR at point K. Since at output OQ,MR = MC1 the firm makes maximum profit. Now, even if the MC curve shifts upwards to MC2 or any level between points J and K, firms do not gain to increase the price though their profit would be affected. Therefore, the firm has no motivation for increasing or established. This is what the kinked demand curve analysis seeks to establish. Cournot’s Model of duopoly (Oligopoly) Augustine cournot, a French economist, has taken the example of two mineral water springs and made following assumptions:-

a) there are two firms, each owning an artesian mineral water weel. b) Both the firms operate their wells at zero marginal costs. c) Both of them face a demand curve with constant negative slope. d) Each seller acts on the assumptions that his competitor will not react to his decision

to change his output and price. This is Cournot’assumption. On the basis of this model, Cournot has concluded that each seller ultimately supplies one-third of the market and both the firms charge the same price. And, one third of the market remains unchanged. D






P2 P P1 R P’ O Q N M

MR Quantity Suppose there are only two two sellers A and B, nad that initially, A is the only seller of mineral water in the market. By assumption, his MC = 0. Following the profit maximizing rule, he sells quantity where his MC = 0 = MR, at price OP2. His total profit is OP2PQ. Now let B enter the market. The market open to him is Q1N, which is half of the total market. That is, he can sell his product in the remaining half of the market. B assumes that A will not change his price and output because he is making maximum profit, that is, B assumes that A will continue to sell OQ at price OP2. Thus, the market available to B is QM and the relevant part of the demand curve is PM. When he draws his MR curve, PN, it bisects QM at point N, where QN = NM. In order to maximize his revenue, B sells QN at price OP1. His total revenue is maximum at QRP’N which equals his total profit. B supplies only QN = 1/4 = (1/ 2) / 2 of the market. When the entry of B, price falls to OP1. Therefore, A’s expected profit falls to OP1RQ. Faced with this situation. A adjusts his price and output to the changed conditions. He assumes that B will not change his output QN and price OP1 as he is making maximum profit. Accordingly, A assumes that B will continue to supply 1/4 of the market. Thus, A, assumes that he has 3/ 4 (= 1 – 1/4) of the market available to him. To maximize his profit, A supplies 1/2 of 3/4 i.e. 3/8 of the market. It is noteworthy that A’s market share has fallen from 1/2 to

3/8. Now it is B’s turn to react. Following Cournot’s assumption, B assumes that A will continue to supply only 3/8 of the market and market open to him equals 1 - 3/8 = 5/8. To maximize his profit under the new conditions, B supplies 1/2 x 5/8 = 5/16 of the market. It is now for A to reappraise the situation and adjust his price and output accordingly. This process of action and reaction continuous in successive periods. In the process, A continuous to lose his market share and B continuous to gain. Eventually, a situation is reached when their market share equals 1/3 each. Any further attempt to adjust output produces the same result. The firms, therefore, reach their equilibrium position. Where each one supplies one-third of the market and both charge the same price.




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