Mangerial Economics

Kolhan University or Ranchi University

Managerial Economics Master of Business Administration

Sandeep Ghatuary

Semiester - 1

Managerial Economics 2

Economics Definition The branch of economics studies how the limited amount of resources is distributed amongst the population of

societies, cities, regions nations and the globe. From household goods, services provided in a market or stockroom, food

and clothing, vacation packages and luxuries, diamonds and gold, labor and employment and even the very action of

getting out of bed each morning, economics is the study of how these goods and services flow throughout markets.

A market is a place where these goods and services are exchanged. In early market places, bartering was the means of

exchange. This is where two individuals would trade goods or services directly. If a farmer needed a bag of hay he could

give another farmer a bag of horse shoes in exchange. While convenient for small exchanges, this method of exchange

proved cumbersome for larger exchanges.

What is Economics? As a substitute for bartering, money as a medium of exchange was established. Assigned set values, coins and bills were

easier to carry and transport, it could be exchanged for goods of equal value and they held their value making

transactions easier and cheaper. Regardless of how an exchange of goods and services is done, they only occur because

both individuals are getting something they desire at a lower cost than what they are giving up. A fundamental

assumption of economics is that all actions have benefits that outweigh their costs, or B > C. After all, why would a

person give $100 for a gumball if it only provides them with near $0.30 of value, or why would a salesman sell a car for

$5 when it cost them $10,000 to receive it into their inventory? Logically and in practice this does not happen. Even in

the event of sales, the idea is that the company will attract customers in which will lead to additional items being sold.

Therefore benefits are greater than the costs. Costs are not always monetary costs either. For example: If you have a

test in the morning, but a friend invites you out for a night of fun, there is more than the cost of spending money. If you

choose to go out, you give up the study time, the results of a higher grade and the pressure of having to do better on

your next test. if you choose to study instead, you give up the cost of what enjoyment you would have gained. These

costs are called opportunity costs, and must be considered in all economic decisions.

The two main branches of the study are macroeconomics and micro economics

� Definition and Meaning of Microeconomics - Microeconomics looks at the behavior of individual people and

companies within the economy. It is based on the idea of a market economy, in which consumer demand is the

driving force behind the prices and production levels of goods and services. Microeconomics is interested in how

specific parties choose to use the limited resources that are available to them. It focuses on what drives them to

make their decisions, as well as the ways in which their decisions affect the supply and demand of particular goods

and services. In turn, these choices influence the price levels of various commodities. Microeconomics also examines

how the decisions of individuals impact specific industries. For example, economists studying at the micro level

might be interested in discovering how current consumer demand is affecting the well-being of the oil industry.

Another basic principle of microeconomics is the "theory of the firm." This studies the actions of businesses as they

strive to increase their profits. It looks at which resources they choose to utilize as inputs, how much they produce,

and what they charge for their goods or services. In summary, microeconomics concerns itself with the human

beings whose purchasing and production-related decisions come together to form the backbone of a given

economy. Even when it involves companies, the focus of microeconomics is always at the personal level.

Microeconomics is the study of economics in a miniature scale. It breaks down the economy into attributes and

analyzes each specific component. Key features are to explore the possibilities of lowering production costs and

increasing income.

Definition and Meaning of Macroeconomics - The most concrete definition of macroeconomics is that it is a study

of "the big picture" in the economy. Instead of focusing on individual households and firms, it examines conditions

within the economy as a whole. This is the most vital difference of micro and macroeconomics. In more technical

terms, macroeconomics looks at the factors that influence aggregate supply and demand. Since it is associated with

the conditions of national economies, it deals with such statistics as unemployment rates, gross domestic product

(GDP), overall price levels, and inflation. Its general nature makes it closely associated with public policy. Most

nations around the world have their own central banks; in the United States, this is the Federal Reserve. In any class

about macroeconomics, the actions of a given country's central bank (known collectively as monetary policy) will be


a major topic of discussion. Those studying economics at the macro level will learn about the factors that drive a

central bank to manipulate the interest rates and money supply of its respective nation at any given time. They will

also learn about the ways in which the decisions of the national government can affect the overall economy. These

governmental actions are known collectively as fiscal policy. Although macroeconomics has a much broader focus

than microeconomics does, many macroeconomic factors are essential to making predictions and conclusions at the

microeconomic level. For instance, knowing what the unemployment rate is at the national level can help a micro

economist predict future layoffs in a specific industry. Macroeconomics is the study of the economy as a whole. The

economy’s actions are looked at together. It reflects on the governmental aspect of the economy, regarding tax and

regulation actions they address.

Differences between Macro and Microeconomics To an extent, both macro and microeconomics look at supply and demand, as well as price levels. However, each field

views these factors from a different standpoint. To better grasp the meaning of macroeconomics, it might be helpful to

think of it as a "top-down approach" toward understanding the economy. Macroeconomics paints a picture of the

economic conditions in a particular country as a whole; however, knowledge of macroeconomic principles can be used

to develop an understanding of conditions for the individual players in the economy. Likewise, microeconomics looks at

the economy from the bottom up, but the information it gathers about individual households and businesses is helpful

in gaining an understanding of general economic conditions. The difference of micro and macroeconomics may seem

well-defined on the surface, but these two categories of study can overlap in significant ways. In fact, no student of the

economy can truly comprehend the meaning of macroeconomics without comprehending the meaning of

microeconomics as well.

Managerial Economics: Definition, Nature, Scope Managerial economics is a discipline which deals with the application of economic theory to business management. It

deals with the use of economic concepts and principles of business decision making. Formerly it was known as “Business

Economics” but the term has now been discarded in favour of Managerial Economics.

Managerial Economics may be defined as the study of economic theories, logic and methodology which are generally

applied to seek solution to the practical problems of business. Managerial Economics is thus constituted of that part of

economic knowledge or economic theories which is used as a tool of analyzing business problems for rational business

decisions. Managerial Economics is often called as Business Economics or Economic for Firms.

Definition of Managerial Economics: 1. “Managerial Economics is economics applied in decision making. It is a special branch of economics bridging the

gap between abstract theory and managerial practice.” – Haynes, Mote and Paul.

2. “Business Economics consists of the use of economic modes of thought to analyze business situations.” - McNair

and Merriam

3. “Business Economics (Managerial Economics) is the integration of economic theory with business practice for

the purpose of facilitating decision making and forward planning by management.” - Spencer and Seegelman.

4. “Managerial economics is concerned with application of economic concepts and economic analysis to the

problems of formulating rational managerial decision.” – Mansfield

Nature of Managerial Economics: 1. The primary function of management executive in a business organisation is decision making and forward

planning.

2. Decision making and forward planning go hand in hand with each other. Decision making means the process of

selecting one action from two or more alternative courses of action. Forward planning means establishing plans

for the future to carry out the decision so taken.

3. The problem of choice arises because resources at the disposal of a business unit (land, labour, capital, and

managerial capacity) are limited and the firm has to make the most profitable use of these resources.


4. The decision making function is that of the business executive, he takes the decision which will ensure the most

efficient means of attaining a desired objective, say profit maximization. After taking the decision about the

particular output, pricing, capital, raw-materials and power etc., are prepared. Forward planning and decision-

making thus go on at the same time.

5. A business manager’s task is made difficult by the uncertainty which surrounds business decision-making.

Nobody can predict the future course of business conditions. He prepares the best possible plans for the future

depending on past experience and future outlook and yet he has to go on revising his plans in the light of new

experience to minimize the failure. Managers are thus engaged in a continuous process of decision-making

through an uncertain future and the overall problem confronting them is one of adjusting to uncertainty.

6. In fulfilling the function of decision-making in an uncertainty framework, economic theory can be, pressed into

service with considerable advantage as it deals with a number of concepts and principles which can be used to

solve or at least throw some light upon the problems of business management. E.g. are profit, demand, cost,

pricing, production, competition, business cycles, national income etc. The way economic analysis can be used

towards solving business problems, constitutes the subject-matter of Managerial Economics.

Thus in brief we can say that Managerial Economics is both a science and an art.

Scope of Managerial Economics: The scope of managerial economics is not yet clearly laid out because it is a

developing science. Even then the following fields may be said to generally fall under Managerial Economics:

1. Demand Analysis and Forecasting

2. Cost and Production Analysis

3. Pricing Decisions, Policies and Practices

4. Profit Management

5. Capital Management

These divisions of business economics constitute its subject matter. Recently, managerial economists have started

making increased use of Operation Research methods like Linear programming, inventory models, Games theory,

queuing up theory etc., have also come to be regarded as part of Managerial Economics.

1. Demand Analysis and Forecasting: A business firm is an economic organisation which is engaged in

transforming productive resources into goods that are to be sold in the market. A major part of managerial

decision making depends on accurate estimates of demand. A forecast of future sales serves as a guide to

management for preparing production schedules and employing resources. It will help management to maintain

or strengthen its market position and profit base. Demand analysis also identifies a number of other factors

influencing the demand for a product. Demand analysis and forecasting occupies a strategic place in Managerial

Economics.

2. Cost and production analysis: A firm’s profitability depends much on its cost of production. A wise manager

would prepare cost estimates of a range of output, identify the factors causing are cause variations in cost

estimates and choose the cost-minimizing output level, taking also into consideration the degree of uncertainty

in production and cost calculations. Production processes are under the charge of engineers but the business

manager is supposed to carry out the production function analysis in order to avoid wastages of materials and

time. Sound pricing practices depend much on cost control. The main topics discussed under cost and

production analysis are: Cost concepts, cost-output relationships, Economics and Diseconomies of scale and cost

control.

3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial Economics. In fact, price

is the genesis of the revenue of a firm ad as such the success of a business firm largely depends on the

correctness of the price decisions taken by it. The important aspects dealt with this area are: Price

determination in various market forms, pricing methods, differential pricing, product-line pricing and price

forecasting.

4. Profit management: Business firms are generally organized for earning profit and in the long period, it is profit

which provides the chief measure of success of a firm. Economics tells us that profits are the reward for

uncertainty bearing and risk taking. A successful business manager is one who can form more or less correct

estimates of costs and revenues likely to accrue to the firm at different levels of output. The more successful a


manager is in reducing uncertainty, the higher are the profits earned by him. In fact, profit-planning and profit

measurement constitute the most challenging area of Managerial Economics.

5. Capital management: The problems relating to firm’s capital investments are perhaps the most complex and

troublesome. Capital management implies planning and control of capital expenditure because it involves a

large sum and moreover the problems in disposing the capital assets off are so complex that they require

considerable time and labour. The main topics dealt with under capital management are cost of capital, rate of

return and selection of projects.

Conclusion: The various aspects outlined above represent the major uncertainties which a business firm has to reckon

with, viz., demand uncertainty, cost uncertainty, price uncertainty, profit uncertainty, and capital uncertainty. We can,

therefore, conclude that the subject-matter of Managerial Economics consists of applying economic principles and

concepts towards adjusting with various uncertainties faced by a business firm.

Techniques of Managerial Economics - Decision-making theory and game theory, which recognize the conditions of

uncertainty and imperfect knowledge under which business managers operate, have contributed to systematic methods

of assessing investment opportunities. Almost any business decision can be analyzed with managerial economics

techniques. However, the most frequent applications of these techniques are as follows:

1. Risk analysis: Various models are used to quantify risk and asymmetric information and to employ them in decision

rules to manage risk.

2. Production analysis: Microeconomic techniques are used to analyze production efficiency, optimum factor

allocation, costs and economies of scale. They are also utilised to estimate the firm's cost function.

3. Pricing analysis: Microeconomic techniques are employed to examine various pricing decisions. This involves

transfer pricing, joint product pricing, price discrimination, price elasticity estimations and choice of the optimal

pricing method.

4. Capital budgeting: Investment theory is used to scrutinize a firm's capital purchasing decisions.

CHARACTERISTICS OF MANAGERIAL ECONOMICS 1. Microeconomics: It studies the problems and principles of an individual business firm or an individual industry. It

aids the management in forecasting and evaluating the trends of the market.

2. Normative economics: It is concerned with varied corrective measures that a management undertakes under

various circumstances. It deals with goal determination, goal development and achievement of these goals. Future

planning, policy-making, decision-making and optimal utilization of available resources, come under the banner of

managerial economics.

3. Pragmatic: Managerial economics is pragmatic. In pure micro-economic theory, analysis is performed, based on

certain exceptions, which are far from reality. However, in managerial economics, managerial issues are resolved

daily and difficult issues of economic theory are kept at bay.

4. Uses theory of firm: Managerial economics employs economic concepts and principles, which are known as the

theory of Firm or 'Economics of the Firm'. Thus, its scope is narrower than that of pure economic theory.

5. Takes the help of macroeconomics: Managerial economics incorporates certain aspects of macroeconomic theory.

These are essential to comprehending the circumstances and environments that envelop the working conditions of

an individual firm or an industry. Knowledge of macroeconomic issues such as business cycles, taxation policies,

industrial Policy of the government, price and distribution policies, wage policies and antimonopoly policies and so

on, is integral to the successful functioning of a business enterprise.

6. Aims at helping the management: Managerial economics aims at supporting the management in taking corrective

decisions and charting plans and policies for future.

7. A scientific art: Science is a system of rules and principles engendered for attaining given ends. Scientific methods

have been credited as the optimal path to achieving one's goals. Managerial economics has been is also called a

scientific art because it helps the management in the best and efficient utilization of scarce economic resources. It

considers production costs, demand, price, profit, risk etc. It assists the management in singling out the most

feasible alternative. Managerial economics facilitates good and result oriented decisions under conditions of

uncertainty.


8. Prescriptive rather than descriptive: Managerial economics is a normative and applied discipline. It suggests the

application of economic principles with regard to policy formulation, decision-making and future planning. It not

only describes the goals of an organisation but also prescribes the means of achieving these goals.

How economics contributes to managerial functions Economics affords analytical tools and techniques that managers require to accomplish the goals of the organisation

they manage. Therefore, a working knowledge of economics, not necessarily a formal degree, is indispensable for

managers. Managers are fundamentally practicing economists. While executing his duties, a manager has to take several

decisions, which conform to the objectives of the firm. Many business decisions fall prey to conditions of uncertainty

and risk. Uncertainty and risk arise chiefly due to volatile market forces, changing business environment, emerging

competitors with highly competitive products, government policy, external influences on the domestic market and social

and political changes in the country. However, the degree of uncertainty and risk can be greatly condensed if market

conditions are calculated with a high degree of reliability. Envisaging a business environment in the future does not

suffice. Appropriate business decisions and formulation of a business strategy in conformity with the goals of the firm

hold similar importance. Pertinent business decisions require an unambiguous understanding of the technical and

environmental conditions under which business decisions are taken. Economic theories have many pronged applications

in the analysis of practical problems of business. Keeping in view the escalating complexity of business environment, the

efficacy of economic theory as a tool of analysis and its contribution to the process of decision-making has been widely

recognized.

According to Baumol, there are three main contributions of economic theory to business economics.

1. The practice of building analytical models, which assist in recognizing the structure of managerial problems and

eliminating minor details, which might obstruct decision making has been derived from economic theory.

Analytical models help in eradicating peripheral problems and help the management in retaining focus on core

issues.

2. Economic theory comprises a founding pillar of business analysis- ‘a set of analytical methods’, which may not

be applied directly to specific business problems, but they do enhance the analytical capabilities of the business

analyst.

3. Economic theories offer an unequivocal perspective on the various concepts used in business analysis, which

enables the manager to swerve from conceptual pitfalls.

Importance of managerial economics 1. Accommodating traditional theoretical concepts to the actual business behaviour and conditions: Managerial

economics amalgamates tools, techniques, models and theories of traditional economics with actual business

practices and with the environment in which a firm has to operate. According to Edwin Mansfield, “Managerial

Economics attempts to bridge the gap between purely analytical problems that intrigue many economic theories

and the problems of policies that management must face”.

2. Estimating economic relationships: Managerial economics estimates economic relationships between different

business factors such as income, elasticity of demand, cost volume, profit analysis etc.

3. Predicting relevant economic quantities: Managerial economics assists the management in predicting various

economic quantities such as cost, profit, demand, capital, production, price etc. As a business manager has to

function in an environment of uncertainty, it is imperative to anticipate the future working environment in

terms of the said quantities.

4. Understanding significant external forces: The management has to identify all the important factors that

influence a firm. These factors can broadly be divided into two categories. Managerial economics plays an

important role by assisting management in understanding these factors.

� External factors: A firm cannot exercise any control over these factors. The plans, policies and programmes

of the firm should be formulated in the light of these factors. Significant external factors impinging on the

decision-making process of a firm are economic system of the country, business cycles, fluctuations in

national income and national production, industrial policy of the government, trade and fiscal policy of the

government, taxation policy, licensing policy, trends in foreign trade of the country, general industrial

relation in the country and so on.


� Internal factors: These factors fall under the control of a firm. These factors are associated with business

operation. Knowledge of these factors aids the management in making sound business decisions.

5. Basis of business policies: Managerial economics is the founding principle of business policies. Business policies

are prepared based on studies and findings of managerial economics, which cautions the management against

potential upheavals in national as well as international economy.

Thus, managerial economics is helpful to the management in its decision-making process.

CONSUMER’S EQUILIBRIUM–UTILITY MAXIMIZATION The theory of demand starts with the examination of the behaviour of the consumers. In our everyday life we behave in

different ways while buying and consuming a good or service. The simple calculations and human reasoning we

undertake while doing any transactions have been transformed into principles which guide us to attain satisfaction or

equilibrium in economic sense. When we go for shopping, we decide beforehand, what good to buy and how much to

spend. It makes sense as we try to get most of what we are spending. It is assumed that consumers are rational. Given

his money income and the prices of commodities, a consumer always tries to maximize his satisfaction. It is assumed

that the satisfaction a consumer gets by consuming a good is measurable (measured in terms of money), though in real

life it is not possible to measure satisfaction because it is psychological entity. We only feel the level of satisfaction and

express the same in different ways. We show our satisfaction by our behaviour like laughing, jumping in excitement or in

any other way. Thus, we cannot measure satisfaction in quantitative terms as we are capable of measuring time in

seconds, weight in kilograms or length in meters. How a consumer attains maximum satisfaction by spending his money

income on certain units of commodities, it is worthwhile to be familiar with certain important terms used in explaining

various concepts and theories of demand.

Utility - Utility is defined as the power of a commodity or service to satisfy a human want. Economists have leveled the

term satisfaction as utility. It is subjective concept and therefore varies from person to person. As already stated, it

resides in one’s mind and therefore cannot be measured in quantitative terms. Though utility and satisfaction are used

synonymously, we should note that utility is the expected satisfaction whereas satisfaction implies ‘realized satisfaction’.

Total Utility - It is the amount of utility (satisfaction); a consumer gets by consuming all the units of a commodity. If

there are n units of the commodity then the total utility is the sum of the utilities of all n units of the commodity. Thus, if

there are four units of a commodity, then total utility is, U = U1 (n1) + U2 (n2) + U3 (n3) + U4 (n4) Where U = total

utility; U1…….U4 are the utilities of n1…..n4 units of the commodity.

Thus, if by consuming first apple, a consumer gets 12 utils of satisfaction, 10 utils from the second apple, 9 utils from the

third and 7 utils from the fourth apple; then his total utility is, U = 12 + 10 + 9 + 7 = 38

Thus utilities of various goods are additive. This means that utilities of different commodities are independent of one

another. The utility derived from one commodity does not affect that of another.

Marginal Utility - Marginal utility is defined as the change in the total utility due to a unit change in the consumption of

a commodity per unit of time. It can also be defined as the addition made to the total utility by consuming an additional

unit of a commodity. For example, if total utility of 3 cups of tea is 18 utils and on consuming the 4th cup it rises to 20;

then marginal utility 20-18 = 2 utils. Thus, by consuming one more cup of tea, the additional utility, a consumer gets is 2

utils. Marginal utility can be expressed as, MU = ΔTU ÷ ΔQ

Where MU = marginal utility; ΔΤU = change in total utility; ΔQ = change in the quantity consumed. ‘Utils’ is the term

used by Marshall as a measuring unit of utility.

The following expression can also be used to find marginal utility: MU = TUn – TUn-1

Where, TUn is the total utility of nth unit of the commodity and TUn-1 utility from the n-1th commodity. Thus, if TU from

the second unit (nth unit) of apple is 13 and TU from the previous unit (n-1) is 7, then MU is 13 – 7 = 6.


The concept of total utility and marginal utility is shown in the utility schedule below

Units of commodity Total utility Marginal utility

1 7 7 – 0 = 7

2 13 13 – 7 = 6

3 18 18 – 13 = 5

4 22 22 – 18 = 4

5 25 25 – 22 = 3

6 27 27 – 25 = 2

7 28 28 – 27 = 1

8 28 28 – 28 = 0

LAW OF DIMINISHING MARGINAL UTILITY - One of the very important laws in regard to the satisfaction of human

wants is known as law of diminishing marginal utility. The law explains common feeling of every consumer. Suppose a

person starts consuming apples one after another. The first apple gives him the maximum satisfaction as he might be in

mood of taking some food at that time for meeting his appetite. As he takes the second apple, he gets less satisfaction

because by this time he has already met some level of appetite. The third and more apples yield him lesser satisfaction

or utility. It means that every time the consumer increases his consumption, he gets less and less satisfaction. The

satisfaction also tends to be zero when the consumer feels totally disgusted to take any more apples. If he takes more,

his satisfaction turns negative or utility now becomes disutility.

According to Marshall, “The additional benefit which a person derives from a given increase of his stock of a thing

diminishes with every increase in stock that he already has.”

Two important reasons for diminishing marginal utility are the following:

1. Each particular want is satiable (can be satisfied): Though there are unlimited wants, a single want can be

satisfied. Thus, when a consumer consumes more and more of a commodity, his want is satisfied and he does

not wish to have any further increase in the commodity. As such his marginal utility falls when consumption

increases.

2. Goods are imperfect substitutes for one another i.e., one good cannot be exactly used in place of another:

Satisfaction from any two goods is not same. Different goods satisfy different wants. If a good could be perfectly

substituted for another, it would have satisfied other wants. Hence, its marginal utility would not have fallen but

increased.


The law of diminishing MU has certain limitations. These are:

� If units of a commodity consumed are not of same size and shape, the law does not hold good. In the illustration

explained above, units of apples are assumed to be of same shape and size.

� The law does not hold good when there is enough time gap between consumption of two units. For instance, if

we take second apple after a long gap of time, we may feel hungry and hence satisfaction will increase instead

of falling.

� The taste of consumer should not change for the law to hold good. It means that the person should consume all

units of a good by same desire and pleasure.

� The law does not apply to money as it is said that more money a person has, the more he wants.

� Change in income of the consumer will falsify the law if money income of the consumer increases or decreases

during the time of consumption of a particular set of goods, the marginal utility will not fall as said above.

Demand Demand is an economic principle that describes a consumer's desire, willingness and ability to pay a price for a specific

good or service. Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity

demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and

quantity demanded is known as the demand relationship.

What is meant by demand? � Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a given

time period.

� Each of us has an individual demand for particular goods and services and our demand at each price reflects the

value that we place on a product, linked usually to the enjoyment or usefulness that we expect from consuming

it. Economists give this a term - utility

Definition –

1. The mathematical function explaining the quantity demanded in terms of its various determinants, including

income and price; thus the algebraic representation of the demand curve.

2. A theory relating to the relationship between consumer demand for goods and services and their prices Demand

theory forms the basis for the demand curve, which relates consumer desire to the amount of goods available.

As more of a good or service is available, demand drops and therefore so does the equilibrium price.

3. F. Benham, “The demand for anything at a given price is the amount of it which will be bought per unit of time

at that price.”

Effective demand - Demand is different to desire! Effective demand is when a desire to buy a product is backed up by

an ability to pay for it

Latent Demand - Latent demand exists when there is willingness to buy among people for a good or service, but where

consumers lack the purchasing power to be able to afford the product.

Derived Demand - The demand for a product X might be connected to the demand for a related product Y – giving rise

to the idea of a derived demand. For example, demand for steel is strongly linked to the demand for new vehicles and

other manufactured products, so that when an economy goes into a recession, so we expect the demand for steel to

decline likewise.


MARKET DEMAND - Market demand is the total sum of the demands of all individual consumers, who purchase the

Commodity in the market a market demand schedule is shown as under:

Price (per unit) A’s Demand B’s Demand C’s Demand Market Demand

(A+B+C)

1 8 9 10 27

2 7 6 9 22

4 6 4 8 18

6 5 3 7 15

8 4 2 6 12

10 3 1 5 9

DETERMINANTS OF DEMAND - Demand for a product depends upon a number of factors. The most important of

these are—the price of the product, income of the consumer, tastes and fashion and the prices of related goods. We can

put it in the functional form as: Dx = f (Px, I, Py, T, F…) Where Dx = demand of good x; Px, = price of good x; I = income

of the consumer; Py = prices of related goods; T = tastes and F = fashion.

Thus, demand for a commodity depends upon the following factors:

1. Price of the commodity: Price of a commodity is an important factor that determines demand for a commodity.

When price of a commodity rises, consumers buy less and when prices fall, demand increases. Here, we assume

other things (factors) to be remaining constant, i.e, ceteris paribus.

2. Income of the consumer: The demand for goods depends upon the incomes of the people. The greater the

income, the greater will be the demand for a good. More income means greater purchasing power. People can

afford to buy more when their incomes rise. On the other hand, if income falls, demand for a commodity also

decreases.

3. Prices of related goods: Related goods are of two types—substitute and complements. Substitute goods can be

interchangeably used. For example, tea and coffee are substitute goods. If tea is dearer, one can use coffee and

vice versa. Complementary goods are demanded together as bread and butter or car and petrol. When price of a

substitute for a good falls, the demand for that good declines and when price of substitute rises, the demand for

that good increases. In case of complementary goods, the change in the price of any of the two goods also

affects the demand of the other. For instance, if demand for two-wheelers fall, the demand for petrol also goes

down.

4. Taste and preferences of the consumer: These are important factors, which affects the demand for a product. If

tastes and preferences are favourable, the demand for a good will be large. On the other hand, when any good

goes out of fashion or people’s tastes and preferences no longer remain favourable, the demand decreases.

Demand Function - A demand function is the amount of a product demanded for each combination of price and

the other factors. Quantity Demanded = D (price, contributing factors)

Factors affecting demand function - innumerable factors and circumstances could affect a buyer's willingness or

ability to buy a good. Some of the more common factors are:

1. Good's own price: The basic demand relationship is between potential prices of a good and the quantities that

would be purchased at those prices. Generally the relationship is negative meaning that an increase in price will

induce a decrease in the quantity demanded. This negative relationship is embodied in the downward slope of

the consumer demand curve. The assumption of a negative relationship is reasonable and intuitive. If the price

of a new novel is high, a person might decide to borrow the book from the public library rather than buy it.

2. Price of related goods: The principal related goods are complements and substitutes. A complement is a good

that is used with the primary good. Examples include hotdogs and mustard, beer and pretzels, automobiles and

gasoline. (Perfect complements behave as a single good.) If the price of the complement goes up the quantity

demanded of the other good goes down. Mathematically, the variable representing the price of the

complementary good would have a negative coefficient in the demand function. For example, Qd = a - P - Pg

where Q is the quantity of automobiles demanded, P is the price of automobiles and Pg is the price of gasoline.

The other main category of related goods is substitutes. Substitutes are goods that can be used in place of the


primary good. The mathematical relationship between the price of the substitute and the demand for the good

in question is positive. If the price of the substitute goes down the demand for the good in question goes down.

3. Personal Disposable Income: In most cases, the more disposable income (income after tax and receipt of

benefits) a person has the more likely that person is to buy.

4. Tastes or preferences: The greater the desire to own a good the more likely one is to buy the good There is a

basic distinction between desire and demand. Desire is a measure of the willingness to buy a good based on its

intrinsic qualities. Demand is the willingness and ability to put one's desires into effect. It is assumed that tastes

and preferences are relatively constant.

5. Consumer expectations about future prices and income: If a consumer believes that the price of the good will

be higher in the future he is more likely to purchase the good now. If the consumer expects that his income will

be higher in the future the consumer may buy the good now.

6. Population: If the population grows this means that demand will also increase.

7. Nature of the good: If the good is a basic commodity, it will lead to a higher demand

This list is not exhaustive. All facts and circumstances that a buyer finds relevant to his willingness or ability to buy goods

can affect demand. For example, a person caught in an unexpected storm is more likely to buy an umbrella than if the

weather were bright and sunny.

Income and Substitution Effects- Changes in price can affect buyers' purchasing decisions; this effect is called

the income effect. Increases in price, while they don't affect the amount of your paycheck, make you feel poorer than

you were before, and so you buy less. Decreases in price make you feel richer, and so you may feel like buying more.

• What if we're looking at two goods at once? For instance, a fast food chain sells hamburgers and hot dogs. If

the price of hamburgers goes up, but the price of hot dogs stays the same, you might be more inclined to buy

hot dog. This tendency to change your purchase based on changes in relative price is called the substitution

effect. When the price of hamburgers goes up, it makes hamburgers relatively expensive and hot dogs relatively

cheap, which influences you to buy fewer hamburgers and more hot dogs than you usually would. Likewise, a

decrease in hamburger price would cause you to eat more hamburgers and fewer hot dogs, according to the

substitution effect. The income effect also affects buying decisions when there are two (or more) goods. When

the price of hamburgers goes up, it makes you feel relatively poorer, so your tendency might be to buy fewer of

both hamburgers and hot dogs. If you look at the combined results of the income effect and the substitution

effect, the total effect is a little unclear. According to the income effect, an increase in the price of hamburgers

decreases consumption of both hamburgers and hot dogs. According to the substitution effect, however,

hamburger consumption drops, but hot dog consumption rises. Thus, while it is clear what happens to

hamburger consumption, since both effects tend to cause a decrease, we cannot be sure what happens to hot

dog consumption, since there is both an increase (substitution effect) and a decrease (income effect).

• Table of Income and Substitution Effects- While we cannot be absolutely certain about the net result, in

general, the substitution effect is stronger than the income effect. That is, when the price of hamburgers goes

up, you will most likely eat fewer hamburgers and more hot dogs, since the change in relative prices

(substitution effect) affects you more than the perceived change in your income (income effect). Another factor


influencing demand is one which marketers and advertisers are always trying to understand and target: buyers'

preferences. What do people like? When and how do they like it? Still looking at soda, it makes sense that

people drink more soda when it's hot, or when they're eating a meal, or when they've been exercising. In these

cases, buyers' preferences have changed: they want the soda more, and are therefore willing to pay more for

the same good. Likewise, if it's snowing, fewer people will crave a cold soda, and the price they are willing to pay

for a cold soda is lower, although they may be willing to pay a little extra money for a hot coffee.

• Normal, Inferior, and Giffen Goods - Are all goods the same? Is more always better? Up to this point, we have

been assuming that when we have more money, or feel like we have more money, we will tend to buy more

goods. It makes sense: the more money we have, the more we buy. If we have less money, or if the price goes

up, however, we tend to buy less. Because this is usually the case, we call such goods normal goods. If you buy

more of a good when you have more money, that good is a normal good. If the price of a normal good increases,

you buy less. There are some exceptions, however: not all goods are normal goods. For instance, if an increase

in your income causes you to buy less of a good, that good is called an inferior good. For instance, "poor college

students" often satisfy themselves with generic soda and cheap ramen. When they get jobs and a steady

income, however, they might forego the cheap soda and ramen in favor of Coke and pasta. In this example, the

generic soda and cheap ramen are inferior goods. Income and substitution effects change demand differently

with different types of goods. For instance, we have been looking at income and substitution effects when a

buyer is faced with a choice between two normal goods. An increase in the price of good A will cause a decrease

in consumption of A, and an increase in consumption of good B (assuming that the substitution effect is stronger

than the income effect). If good A is a normal good, and good B is inferior, however, the results will be different.

Why is this true? Consider the case where the price of good A goes up.

• Income and Substitution Effects with Normal and Inferior Goods - The substitution effect makes B relatively

cheaper, so consumption of B will increase, and consumption of A will decrease. The income effect makes the

buyer feel poorer, and so consumption of A will decrease, but consumption of B will increase. Remember that

consumption of an inferior good varies inversely with income: when you are rich, you buy less, when you are

poor, you buy more. If the A is still normal and B is still inferior, and the price of A falls, then the substitution

effect will cause higher consumption of A and lower consumption of B, and the income effect will cause higher

consumption of A and lower consumption of B. Because the buyer now feels richer, they are less inclined to buy

the inferior good.


• Income and Substitution Effects with Normal and Inferior Goods - Another exception is the case where an

increase in price causes an increase in demand. This results in an upward-sloping demand curve, and the good is

called a Giffen good. Giffen goods are theoretically possible, but very improbable, since it is unlikely that an

increase in price causes increase in demand. One possible justification for a Giffen good is that people associate

higher prices with status, luxury, and quality, so that a higher price might increase the perceived value of a good.

In reality, however, this effect is outweighed by the overwhelming tendency to prefer lower prices: even if a few

people prefer the added cachet of a high-priced luxury good, the general public will prefer lower prices. Another

possible case that could because a Giffen good is the case in which a good is inferior and the income effect

outweighs the substitution effect. To illustrate, assume that ACME Cola is an inferior good. When it's price

increases, the income effect makes Calvin feel poorer. If the income effect is very strong, and the substitution

effect is very weak, then Calvin will buy more ACME Cola, because the consumption of inferior goods increases

with decreases in income. This, too, is unlikely, however, because the substitution effect is almost always

stronger than the income effect.

Demand Curve for a Giffen Good

LAW OF DEMAND The law of demand expresses the functional relationship between price and quantity demanded of a good. It is one of

the most important laws of economic theory. According to this law, other things remaining constant (ceteris paribus), if

the price of a commodity fall the quantity demanded of it will rise and if price of the good rises quantity demanded will

fall. Thus, there is inverse relationship between price and quantity demanded. Thus, we buy more units of apple when

its price comes down from Rs. 4 per unit to Rs. 2 per unit.

Assumptions of the law 1. Incomes of consumers do not change. If consumer’s income increases or decreases, the law will not hold well.

2. People’s tastes and preferences remain unchanged; and

3. Prices of substitutes and complements do not change.

The law of demand can be explained with the help of a demand schedule and through a demand curve. A demand

schedule is shown as under.

Price of apples per unit (in Rs.) Unit Quantity demanded (in nos.)

8 5

6 7

4 8

2 10

It is seen in the table that when the price of the commodity is Rs. 8/- per unit, consumers buy 5 units only and at Rs. 2/-

per unit, they buy 10 units of the commodity. Thus, as price goes down, consumers buy more of a commodity and vice

versa. Along x-axis, quantity is measured and along y-axis price of the commodity is measured. By joining various points


or combinations of price and quantity demanded, we get a curve ‘dd’ falling downwards from left to the right. This is

known as the demand curve. The demand curve clearly indicates that price is inversely related to quantity demanded. As

price falls, demand rises and it shrinks when price rises. It is to be noted here that we have assumed ‘other factors’ to be

constant. Thus, any changes in these factors such as tastes, fashion, income or prices of related goods etc, will falsify the

law of demand. For instance, if income of consumer rises at the time when price of goods have risen, demand will not go

down. Rather, it may increase. We do not bother of rise in price of goods when our income also increases.

Why does the Law of Demand Operate? A demand curve shows the relationship between the price of an item and the quantity demanded over a period of time.

Demand curve by and large slopes downward to the right. This is because of operation of the law of diminishing

marginal utility. When the price of a commodity decreases, new demand is created. Also that existing buyers buy more.

As the particular commodity has become cheaper, some people will purchase it in preference to other commodities. If

the law of diminishing marginal utility is true, the demand curve must slope downwards. This is because only a

downward sloping demand curve represents increase in demand due to fall in the prices of a commodity.

There are two reasons why more is demanded as price falls:

1. The Income Effect: There is an income effect when the price of a good falls because the consumer can maintain

the same consumption for less expenditure. Provided that the good is normal, some of the resulting increase in

real income is used to buy more of this product.

2. The Substitution Effect: There is a substitution effect when the price of a good falls because the product is now

relatively cheaper than an alternative item and some consumers switch their spending from the alternative good

or service.


� As price falls, a person switches away from rival products towards the product

� As price falls, a person’s willingness and ability to buy the product increases

� As price falls, a person’s opportunity cost of purchasing the product falls

Exceptions to the Law of Demand 1. There are certain goods called as Giffen goods. In case of such goods, the law of demand does not hold good. Sir

Francis Giffen observed that when Irish potato prices increased in bad years, people curtailed spending on other

commodities and increased their spending on potatoes because with high potato prices and no increase in their

money incomes, they were now too poor to afford meat and other foodstuffs. So they had to sustain themselves

by eating more potatoes. That is people demanded more potatoes when their prices increased and vice versa.

This is called Giffen Paradox.

2. In case of conspicuous consumption, as observed by Thorstein Veblen, the demand curve does not slope

downwards. Sometimes people buy some products to show their status in the society. The possession of such

commodities, they feel, may confer a higher level of social status on their holder. These goods are diamonds and

other precious stones etc. Rich class buys such goods at very high price to show that they belong to a prestigious

class.

3. The law of demand also not applies to a commodity whose quality is judged by its high price. At high prices,

some people buy more of such commodity than at lower price thinking that high priced are better than those

priced lower. This is out of sheer ignorance that people act in such a way.

4. Speculation (a guesswork or prediction of a future event and act accordingly) is another exception to the law of

demand. If the price of commodity is increasing and people expect a further rise in the price, they will tend to

buy more of the commodity at higher price than they did at the lower price. It is observed that when there is a

hike in edible oil prices recently, some people purchased more of it in the expectation that future prices will be

even more.


ELASTICITY OF DEMAND Elasticity, roughly, means responsiveness. What response demand of a commodity shows when there is either increase

or decrease in its price, is explained with the help of elasticity. Managers have great advantages by knowing elasticity of

the products he is selling. Greater response means greater elasticity and small response indicates less elasticity. A

manager is very interested in knowing whether sales will increase by 4 percent, 10 percent or more by cutting down

price by 8 percent. “The elasticity (or responsiveness) of demand in a market is great or small according as the amount

demanded increases much or little for a given fall in price and diminishes much or little for a given rise in price.”

Demand may be elastic or inelastic. When due to a small change in price, there is a great change in demand, it is said

that demand is elastic. If a 5 percent cut in prices of car results in an increase in 30 percent in sales, demand is said to be

highly elastic. On the other hand, if a great change in price is followed by a small change in demand, it is inelastic

demand. For example, the demand for salt is said to be inelastic because same quantity of it will be purchased even if

price rises or declines.

Ep = Percentage change in demand ÷ Percentage change in price

There are five cases/kinds of price elasticity of demand. 1. Perfectly Inelastic Demand: Demand for a commodity will be said to be perfectly inelastic, if the quantity demanded

does not change at all in response to a given change in price. If 10 percent change in price results in zero percent

change in demand, it is exactly inelastic demand. The demand curve, in this case, is vertical straight line

perpendicular to Y-axis.

2. Inelastic or less than Unit Elastic Demand: Demand for commodity will be said to be inelastic (or less than unit

elastic) if the percentage change in quantity demanded is less than the percentage change in price. If 10 percent

change in price results in 6 percent change in demand, it is inelastic demand.

3. Unitary Elastic Demand: Demand for a commodity will be said to be unit elastic if the percentage change in quantity

demanded equals the percentage change in price. If 10 percent change in price results in 10 percent change in

demand, it is unit elastic demand. The demand curve in such case is called rectangular hyperbola.


4. More than Unit Elastic: Demand for a commodity will be said to be more than unit elastic if a change in price results

in a significant change in demand for this commodity. If 10 percent change in price results in 14 percent change in

demand, it is elastic demand.

5. Perfectly Elastic Demand: Demand for a commodity is said to be perfectly elastic, when a small change in its price

results in an infinite change in its quantity demanded. If 10 percent change in price results in (α) percent change in

demand, it is exactly elastic demand. In this case, demand curve is horizontal straight line parallel to X-axis. The first

and the last cases are rare in real life.

Percentage in price Percentage in demand Types Coefficient of elasticity

10 0 Perfectly inelastic e = 0

10 6 Inelastic e < 1

10 10 Unit elastic e = 1

10 14 Elastic e > 1

10 α Perfectly elastic e = α

MEASUREMENT OF PRICE ELASTICITY OF DEMAND - It is very important to know to what extent demand is

responsive, that is elastic or inelastic. For this purpose measurement of elasticity is necessary.

The important methods to measure elasticity are the following:

1. Totals Outlay/Expenditure Method - Elasticity of demand for a commodity can be measured with the help of the

Total Outlay/ expenditure incurred by a household on the purchase of a commodity. Total outlay is (TQ = p × q)

where TQ stands for total outlay, p and q for price and quantity respectively. This method provides us with three

different measurements of the elasticity of demand, which are as follows:

� Less than Unit Elastic (e < 1)

Price (Rs. Per unit) Quantity (Q) Total Expenditure (TE)

5 10 50

2 25 50

� Unit Elastic (e = 1)


5 10 50

2 30 60


� More than Unit Elastic (e > 1)


5 10 50

2 15 30

2. Percentage Method - Price elasticity of demand can also be measured with the help of percentage method or

proportionate method. According to this method, percentage change in price is compared with the percentage

change in demand. Elasticity is the ratio of the percentage change in quantity demanded to the percentage change

in price.

� Ep = Percentage change in demand ÷Percentage change in price

Ep = (change in quantity demanded ÷quantity demanded) ÷ (change in price ÷ price)

= (Δq ÷ q) ÷ (Δp ÷ p)

Where, ep = price elasticity; Δq = change in quantity demanded; Δp = change in price; p = price; q = quantity.

3. Arc Method - In this method, we take the averages of original and new prices and quantities to measure elasticity.

This method is used when there is a big change in price so that an arc is formed on the demand curve.

= (Δq ÷ q' + q'') ÷ (Δp ÷ p' + p'')

= (Δq ÷ Δp ) * (q' + q'') ÷ (p' + p'')

Where, p' = original price; p'' = new price; q' = original quantity; q'' = new quantity.

4. Point/Geometrical Method - This method measures elasticity using demand curve. It is, therefore, also called as

geometrical method of measuring elasticity. The diagram below illustrates how to find different types of elasticity on

a demand curve. DD is the straight line demand curve (constant slope). Elasticity is measured as under,

E = Lower segment of the demand curve ÷ Upper segment of the demand curve

5. Revenue Method - Revenue is the amount that a firm earns by selling its products. It is measured by multiplying

price with total quantity/units of product sold. Thus, TR = Quantity × Price. Elasticity can be measured using the

concepts of average and marginal revenue. E = Average revenue ÷ (Average revenue − Marginal revenue)

� Income Elasticity of Demand - It is the ratio of the percentage change in the amount spent on the commodity to

a percentage change in the consumer’s income, price remaining constant. That is, Ie = Proportionate change in

demand ÷ Proportionate change in income.

� Cross Elasticity of Demand - The responsiveness of demand to a change in the prices of related commodities

(substitutes and complementary) is called cross elasticity of demand. It is responsiveness of demand for

commodity X to a change in price of commodity Y and is represented as follows: Cc = Proportionate change in

demand of X ÷ Proportionate change in price of good Y.


DETERMINANTS OF PRICE ELASTICITY OF DEMAND 1. Substitute goods: A commodity will have elastic demand if there are good substitutes for it. This is because

when price of a good rises, a consumer will not buy the good but purchase its substitute.

2. Nature of commodity: All necessities like salt, rice etc that have no substitutes/or less substitutes will have an

inelastic demand. People have to purchase such commodities for their sustenance. Therefore, there will be

some demand despite the changes in price. Demand for luxury goods, on the other hand, will be elastic. If prices

of such commodities rise even a little, consumers refrain to buy. At the same time a little lowering of price of

such commodities attract a large number of consumers.

3. Number of uses of commodity: The larger the number of uses to which a commodity can be put, the higher will

be its elasticity. Therefore the demand of such goods will have elastic demand. For example, milk can be used

for various purposes such as for making curd, cake, sweets etc. When its price goes down, demand increases but

a little rise in its price makes demand fall greatly.

4. Possibility of postponement of consumption: If there is a possibility of postponement of consumption of a

commodity then demand will be elastic otherwise inelastic. Demand for certain goods can be postponed for

sometime such as computers, printers, scanners etc. People may wait till they become cheaper. Therefore, their

demand is elastic. But the demand for food or electricity cannot be postponed. As such their demand is inelastic.

5. Percentage of income spent: The elasticity of demand is also influenced by the percentage of income spent on

the purchase of a commodity if the percentage is very less than the demand will be inelastic. For instance, we

spend a very less amount of our total money income on things like agarbatties (incense sticks), matches, pens,

pencils etc. If prices of such commodities rise also, our demand is not reduced. Thus, demand of such goods is

inelastic.

6. Fashion: Commodities, which are in fashion, will have inelastic demand. Fashion minded people do not

compromise with price. Even if price is high, some people will demand more just because goods are in fashion.

7. Change in taste: A habitual commodity or a commodity for which consumers have developed a taste will have

inelastic demand. A chain smoker always requires a cigarette, whatever the price may be. Likewise, a habitual

paan (betel nut) chewer cannot leave his habit, in spite of rise in price. In such cases, therefore, demand is

elastic.

8. Price of the commodity: Very high priced or very low priced goods have low elasticity whereas moderately

priced commodities are quite high-elastic. If a good is very expensive, demand will not increase much even if

there is little fall in its price. And demand will not increase even at very low prices, because people have already

purchased their requirement at low prices.


Cost The concept of cost is of great significance in the micro economic theory. It is the cost of production which determines

the production decision of an entrepreneur whose main aim is to maximize profit. Lower the cost of production, greater

is the profit margin.

Definition: An amount that has to be paid or given up in order to get something In business, cost is usually a monetary

valuation of (1) effort, (2) material, (3) resources, (4) time and utilities consumed, (5) risks incurred, and (6) opportunity

forgone in production and delivery of a good or service. All expenses are costs, but not all costs (such as those incurred

in acquisition of an income-generating asset) are expenses.

Definition of 'True Cost Economics' –

• If the prices of goods and services do not include the cost of negative externalities or the cost of harmful effects

they have on the environment, people might misuse them and use them in large quantities without thinking

about their ill effects on the environment. Therefore, environmentalists support true cost economics to counter

the impact of negative externalities.

• True cost economics is an economic model that includes the cost of negative externalities associated with goods

and services.

Types of Cost 1. COST OF PRODUCTION - The expenses incurred on all inputs of production–both factor inputs and non-factor

inputs are known as the cost of production. Land, labour, capital and organization are the factors of production

called factor inputs. Raw materials, fuel, equipments, tools etc are non factor inputs. Thus, cost is a function of

various factors. C = f (Q, T, Pf) Where C is the total cost of production, Q is output; T is technology, and Pf is the

prices of factors of production.

2. Real Cost and Nominal Cost –

� Real costs refer to those payments, which are made to factors of production for the toil and efforts in

rendering their services.

� Nominal cost is the money cost (expenses) of production incurred on various inputs of production.

3. Explicit and Implicit Costs –

� Explicit costs are the paid out costs. These are the payments made for productive resources purchased or

hired by the firm. These include wages paid to the laborers, rent paid for the premises, payments made for

the raw materials, payments into depreciation accounts, premium paid towards insurance against fire, theft,

etc.

� Implicit costs of production are the costs of self-owned and self-employed resources. These costs are

normally ignored while calculating the expenses of a producer. These include the rewards for the

entrepreneur’s self-owned land, labour and capital. These costs do not appear in the accounting records of

the firm.

4. Opportunity/Alternative/ Transfer Cost - the opportunity cost of using resources to produce a good is the value

of the best alternative or opportunity forgone. Opportunity costs include both explicit and implicit costs. For

example, if with a sum of Rs. 2000, a producer can produce a bicycle or a radio set and decides to produce a

radio set. In this case, opportunity cost of a radio set is equal to the cost of a bicycle that he has sacrificed. In this

case, opportunity cost of a radio set is equal to the cost of a bicycle that he has sacrificed.

5. Private, External and Social Costs - A cost that is not borne by the firm, but is incurred by others in society is

called an external cost. The true cost to the society must include all costs regardless of who bears them. Private

costs refer to the costs to a firm in producing a commodity. It is, in fact, the money costs of the firm. For

example, the purchase price of a car reflects the private cost experienced by the manufacturer. The air pollution

created in the production of the car however, is an external cost. Because the manufacturer does not pay for

these costs, and does not include them in the price of the car, they are said to be external to the market pricing

mechanism. The air pollution from driving the car is also an externality. The driver does not pay for the

environmental damage caused by using the car.

Social cost is the total of all the costs associated with an economic activity. It includes both costs borne by the

economic agent and also all costs borne by society at large. It includes the costs reflected in the organization’s

production function (called private costs) and the costs external to the firm’s private costs (called external


costs). Thus, it is the cost of producing a commodity to the society as a whole. Hence, the social cost is the sum

of private and external cost. That is, Social Cost = Private Cost + External Cost

6. Economic Costs - Economic costs are the payments which must be received by resource owners in order to

ensure that they will continue to supply them in the process of production. Economic cost includes normal

profit.

7. Short Run Costs and Long Run Costs - Short run is a period of time within which the firm can change its output

by changing only the amount of variable factors, such as labour and raw materials etc. In short period, fixed

factors such as land, machinery etc, cannot be changed. Costs of production incurred in the short run i.e., on

variable factors are called short run costs. The long run costs are the costs over a period in which all factors are

changeable. Thus, costs of production on all factors (in the long run all factors become variable) are long run

costs.

8. Total Fixed Cost (TFC) - Total fixed cost is the sum of expenses incurred on those inputs that remain same at

different Levels of output it is a straight line parallel to output or x-axis. TFC is the total fixed cost curve parallel

to x-axis indicating that it remains constant at all levels of output.

9. Total Variable Cost (TVC) - Total variable cost is the sum of expenses incurred on those factor inputs whose

quantity varies with a change in the level of output. It has inverse-S shape. Total variable costs increase as the

level of output increases.

10. Total Cost (TC) - Total cost to a producer for the various levels of output is the sum of total fixed costs and total

variable costs, i.e., TC = TFC+TVC

11. Average Fixed Cost (AFC) - Average fixed cost is total fixed cost divided by total output. It is per unit cost on

fixed factors. Symbolically, AFC = TFC ÷TQ Where, TQ is the total output. Average fixed cost is shown as under.

AFC curve is a rectangular hyperbola, indicating same magnitude at all points as TFC remains constant

throughout.


12. Average Variable Cost (AVC) - The average variable cost is found by dividing the total variable costs by the total

units of output, i.e., it is per unit cost of the variable inputs. Symbolically, AVC = TVC ÷ TQ Average variable cost

falls initially, reaches a minimum when the plant is operated optimally and rises after the point of normal

capacity has been reached.

13. Average Total Cost (ATC/AC) - ATC is per unit cost of both fixed and variable inputs. Average total cost of

production can be obtained by dividing total cost by the units of output,

AC = TC ÷ TQ

AC= (TFC + TVC) ÷ TQ

AC= AFC + AV

Average total cost or ATC curve has the similar shape as that of AVC, that is, U-shaped.

14. Marginal Cost - Marginal cost is the addition to the total cost as a result of a unit (one unit) increase in the

output. It is expressed as: MCN = TCN – TCN–1 Where, N is the number of units of output. Alternatively, marginal

cost can also be expressed as follows: MC = Δ TC ÷ Δ TQ Where, ΔTC stands for the change in total cost and ΔTQ

for total output. MC curve also has U-shaped. It first falls, goes to a minimum and then rises sharply.


Unit of

outputs

TFC

(Total fixed

cost)

TVC

(Total variable

cost)

TC

(Total

cost)

AFC

(Average

fixed cost)

AVC

(Average

variable cost)

AC

(Average

cost)

MC

(Marginal

cost)

(1) (2) (3) (4) (5) (6) (7) (8)

0 10 0 10 - - - -

1 10 4 14 10 4 14 4

2 10 7 17 5 3.5 8.5 3

3 10 9 19 3.3 3 6.3 2

4 10 11 21 2.5 2.7 5.2 2

5 10 14 24 2 2.8 4.8 3

6 10 19 29 1.6 3.1 4.2 5

Calculation is done in the following manner:

Column (4) = (2) + (3); (5) = (2) ÷ (1); (6) = (3) ÷ (1); (7) = (5) + (6); (8) = Δ (4) ÷ Δ (1)

RELATIONSHIP BETWEEN AVERAGE COST AND MARGINAL COST Average cost is obtained by dividing total costs by the units of output. Marginal cost is the change in total costs resulting

from a unit increase in output. The relationships between the two are as follows:

1. When average cost falls with an increase in output, marginal cost is less than the average cost (before point P).

2. When average cost rises, marginal cost is greater than the average cost (after point P).

3. Marginal cost curve cuts the average cost curve at its minimum point (minimum point on the average cost curve

is also the point of optimum capacity) i.e., at the point of optimum capacity, MC = AC (at point P).

With increase in average cost, marginal cost rises at a faster rate. This relationship between AC and MC is illustrated in

the figure.

Break-Even Analysis Definition - An analysis to determine the point at which revenue received equals the costs associated with receiving the

revenue. Break-even analysis calculates what is known as a margin of safety, the amount that revenues exceed the

break-even point. This is the amount that revenues can fall while still staying above the break-even point.

Break-even analysis is a supply-side analysis; that is, it only analyzes the costs of the sales. It does not analyze how

demand may be affected at different price levels. For example, if it costs $50 to produce a widget, and there are fixed

costs of $1,000, the break-even point for selling the widgets would be:

If selling for $100: 20 Widgets (Calculated as 1000/ (100-50) =20)

If selling for $200: 7 Widgets (Calculated as 1000/ (200-50) =6.7)

In this example, if someone sells the product for a higher price, the break-even point will come faster. What the analysis

does not show is that it may be easier to sell 20 widgets at $100 each than 7 widgets at $200 each. A demand-side

analysis would give the seller that information.

The Break-Even Chart - In its simplest form, the break-even chart is a graphical representation of costs at various levels

of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The

point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below

by the intersection of the two lines:


In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output").

OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total

costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection,

P, costs are exactly equal to income, and hence neither profit nor loss is made.

1. Fixed Costs - Fixed costs are those business costs that are not directly related to the level of production or

output. In other words, even if the business has a zero output or high output, the level of fixed costs will remain

broadly the same. In the long term fixed costs can alter - perhaps as a result of investment in production

capacity (e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more

complex business. Examples of fixed costs: Rent and rates, Depreciation, Research and development, Marketing

costs (non- revenue related), Administration costs

2. Variable Costs - Variable costs are those costs which vary directly with the level of output. They represent

payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs such as

commission. A distinction is often made between "Direct" variable costs and "Indirect" variable costs.

� Direct variable costs are those which can be directly attributable to the production of a particular product or

service and allocated to a particular cost centre. Raw materials and the wages those working on the

production line are good examples.

� Indirect variable costs cannot be directly attributable to production but they do vary with output. These

include depreciation (where it is calculated related to output - e.g. machine hours), maintenance and certain

labour costs.

3. Semi-Variable Costs - Whilst the distinction between fixed and variable costs is a convenient way of categorising

business costs, in reality there are some costs which are fixed in nature but which increase when output reaches

certain levels. These are largely related to the overall "scale" and/or complexity of the business. For example,

when a business has relatively low levels of output or sales, it may not require costs associated with functions

such as human resource management or a fully-resourced finance department. However, as the scale of the

business grows (e.g. output, number people employed, number and complexity of transactions) then more

resources are required. If production rises suddenly then some short-term increase in warehousing and/or

transport may be required. In these circumstances, we say that part of the cost is variable and part fixed.

How to Use Breakeven Analysis in Managerial Economics A firm using breakeven analysis determines the smallest output level that leads to zero economic profit. Recall that zero

economic profit doesn’t mean that the firm’s owners receive nothing — it means that the firm’s owners are receiving a

normal rate of return. In other words, the firm’s owners are receiving exactly as much as they would in their next best

alternative. In breakeven pricing, your total revenue equals total cost — hence, zero profit. Because the focus is on the

point where you earn zero profit, it’s unlikely that breakeven analysis maximizes your profit. However, breakeven

analysis is a useful managerial tool. Managers use breakeven analysis to determine how a price change affects profit. If


you lower price, how many more units do you have to sell in order to achieve zero profit — or to break even? If your

firm has a large fixed cost, breakeven analysis enables you to determine the quantity of output you must sell in order to

avoid losses. In either of these situations, as a manager, you can then determine whether or not sales of that amount

are feasible. Your company has total fixed cost of $300,000, and its average variable cost (variable cost per unit of

output) is $2.00. In addition, you sell the good at a price of $5.00 per unit. The following steps are used to determine the

breakeven point:

1. Set total revenue equal to total cost. - Remember that total revenue equals price multiplied by the quantity sold,

and total cost equals total fixed cost plus total variable cost.

2. Substitute AVC ×q for TVC. - Recall that total variable cost equals average variable cost multiplied by the number of

units produced q.

3. Subtract AVC ×q from both sides of the equation in Step 2 and simplify.

4. Divide both sides of the equation by (P – AVC). - This step enables you to solve for the breakeven quantity, q.

5. Substitute the values for TFC, P, and AVC and solve for q.

Your breakeven quantity is 100,000 units.

Limitations � Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing about what sales are

actually likely to be for the product at these various prices.

� It assumes that fixed costs (FC) are constant. Although this is true in the short run, an increase in the scale of

production is likely to cause fixed costs to rise.

� It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of

sales. (i.e. linearity)

� It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in

the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in

inventory at the end of the period).

� In multi-product companies, it assumes that the relative proportions of each product sold and produced are

constant (i.e., the sales mix is constant).


Production

Production refers to the output of goods and services produced by businesses within a market. This production

creates the supply that allows our needs and wants to be satisfied. To simplify the idea of the production function,

economists create a number of time periods for analysis. Production is the act of creating output, a goods or service

which has value and contributes to the utility of individuals. The act may or may not include factors of production other

than labor. Any effort directed toward the realization of a desired product or service is a "productive" effort and the

performance of such act is production. The relation between the amount of inputs used in production and the resulting

amount of output is called the production function.

Production in economics generally refers to the transformation of inputs into outputs. Inputs are the raw materials or

other productive resources used to produce final products i.e., output. In technical terms, production means the

creation of utility or creation of want-satisfying goods and services. Any good become useful for us or satisfies our want

when it is worth consumption. Thus, a good can be made useful by adding utility. For instance, we cannot consume

wheat flour raw when we are hungry (want), unless it is turned into bread (output). This conversion of wheat flour into

bread is the process of creating utility. Utilities can be created in three ways. These are the following:

1. By changing form or shape and size of a good. The powdery wheat flour has been changed to slices of bread.

Thus form of the good has been changed. Likewise, a carpenter giving shape of a chair to a piece of wood or a

chef turning a lump of dough into delicious pizzas, are the examples of changing shape or size of a good/s and

thereby creating utility.

2. Using the scarce goods and services in proper time when they are most required. Government maintains a

buffer stock so that during the time of crisis, it releases food grains in the market to meet the demand.

3. By transferring a good from one place to another where its use is worthwhile. Sand transferred from river side

to construction site increases its utility.

Stages of production - Production can be distinguished into three stages:

1. Primary producers directly extract natural resources.

2. Secondary producers process resources to turn them into intermediate goods.

3. Tertiary producers provide final goods or services to the consumer.

Factors of Production Economic terms to describe the inputs that are used in the production of goods or services in the attempt to make an

economic profit. The factors of production include land, labor, capital and entrepreneurship. In essence, land, labor,

capital and entrepreneurship encompass all of the inputs needed to produce a good or service. Land represents all

natural resources, such as timber and gold, used in the production of a good. Labor is all of the work that laborers and

workers perform at all levels of an organization, except for the entrepreneur. The entrepreneur is the individual who

takes an idea and attempts to make an economic profit from it by combining all other factors of production. The

entrepreneur also takes on all of the risks and rewards of the business. The capital is all of the tools and machinery used

to produce a good or service. The production function relates the quantity of factor inputs used by a business to the

amount of output that result. We use three measures of production and productivity.

1. Total product (or total output). In manufacturing industries such as motor vehicles and DVD players, it is

straightforward to measure how much output is being produced. But in service or knowledge industries, where

output is less “tangible” it is harder to measure productivity.

2. Average product measures output per-worker-employed or output-per-unit of capital.

3. Marginal product is the change in output from increasing the number of workers used by one person, or by

adding one more machine to the production process in the short run.

According to Stigler, “the production function is name given to the relationship between the rates of input of productive

services and the rate of output of product. It is the economist’s summary of technological knowledge.”

Production function can be expressed as follows: Q = f (a, b, c, d…)

Where, Q stands for output, a, b, c, d…. are the productive resources or inputs that help producing Q output; f refers to

function. Thus Q is the function of a, b, c, d….., which means Q depends upon a, b, c, d…..


Short Run Production The short run is a period of time when there is at least one fixed factor input. This is usually the capital input such as

plant and machinery and the stock of buildings and technology. In the short run, the output of a business expands when

more variable factors of production (e.g. labour, raw materials and components) are employed.

1. The short run is a time period where at least one factor of production is in fixed supply. A business has chosen

it’s scale of production and must stick with this in the short run

2. We assume that the quantity of plant and machinery is fixed and that production can be altered by changing

variable inputs such as labour, raw materials and energy.

3. The time periods used differ from one industry to another; for example, the short-run in the electricity

generation industry differs from local sandwich bars. If you are starting out in business with a new venture

selling sandwiches and coffees to office workers, how long is your long run? It could be as short as a few days –

enough time to lease a new van and a sandwich-making machine!

Diminishing Returns - In the short run, the law of diminishing returns states that as we add more units of a

variable input to fixed amounts of land and capital, the change in total output will at first rise and then fall. Diminishing

returns to labour occurs when marginal product of labour starts to fall. This means that total output will be increasing at

a decreasing rate.

What might cause marginal product to fall?

One explanation is that, beyond a certain point, new workers will not have as much capital equipment to work with so it

becomes diluted among a larger workforce. In the following numerical example, we assume that there is a fixed supply

of capital (20 units) to which extra units of labour are added.

� Initially, marginal product is rising – e.g. the 4th worker adds 26 to output and the 5th worker adds 28 and the 6th

worker increases output by 29.

� Marginal product then starts to fall. The 7th worker supplies 26 units and the 8th worker just 20 added units. At this

point production demonstrates diminishing returns.

� Total output will continue to rise as long as marginal product is positive

� Average product will rise if marginal product > average product

The Law of Diminishing Returns

Capital

Input

Labour Input Total Output Marginal

Product

Average Product of

Labour

20 1 5 - 5

20 2 16 11 8

20 3 30 14 10

20 4 56 26 14

20 5 85 28 17

20 6 114 29 19

20 7 140 26 20

20 8 160 20 20

20 9 171 11 19

20 10 180 9 18


Average product rises as long as marginal product is greater than the average – e.g. when the seventh worker is added

the marginal gain in output is 26 and this drags the average up from 19 to 20 units. Once marginal product is below the

average as it is with the ninth worker employed then the average must decline.

Criticisms of the Law of Diminishing Returns � How realistic is this assumption of diminishing returns? Surely ambitious and successful businesses will do their

level best to avoid such a problem emerging?

� It is now widely recognised that the effects of globalisation and the ability of trans-national businesses to source

their inputs from more than one country and engage in transfers of business technology, makes diminishing

returns less relevant as a concept.

� Many businesses are multi-plant meaning that they operate factories in different locations – they can switch

output to meet changing demand.

Long run production In the long run, all of the factors of production can change giving a business the opportunity to increase the scale of its

operations. For example a business may grow by adding extra labour and capital to the production process and

introducing new technology into their operations.The length of time between the short and the long run will vary from

industry to industry. For example, how long would it take a newly created business delivering sandwiches around a local

town to move from the short to the long run? Let us assume that the business starts off with leased premises to make

the sandwiches; two leased vehicles for deliveries and five full-time and part-time staff. In the short run, they can

increase production by using more raw materials and by bringing in extra staff as required. But if demand grows, it wont

take the business long to perhaps lease another larger building, buy in some more capital equipment and also lease

some extra delivery vans – by the time it has done this, it has already moved into the long run.The point is that for some

businesses the long run can be a matter of weeks! Whereas for industries that requires very expensive capital

equipment which may take several months or perhaps years to become available, then the long run can be a sizeable

period of time. In the long run, all factors of production are variable. How the output of a business responds to a change

in factor inputs is called returns to scale.

Numerical example of long run returns to scale

Units of

Capital

Units of

Labour

Total Output % Change in Inputs % Change in

Output

Returns to

Scale

20 150 3000 - - -

40 300 7500 100 150 Increasing

60 450 12000 50 60 Increasing

80 600 16000 33 33 Constant

100 750 18000 25 13 Decreasing

� When we double the factor inputs from (150L + 20K) to (300L + 40K) then the percentage change in output is

150% - there are increasing returns to scale.

� When the scale of production is changed from (600L + 80K0 to (750L + 100K) then the percentage change in

output (13%) is less than the change in inputs (25%) implying a situation of decreasing returns to scale.

� Increasing returns to scale occur when the % change in output > % change in inputs

� Decreasing returns to scale occur when the % change in output < % change in inputs

� Constant returns to scale occur when the % change in output = % change in inputs

The nature of the returns to scale affects the shape of a business’s long run average cost curve.

Finding an optimal mix between labour and capital - In the long run businesses will be looking to find an output

that combines labour and capital in a way that maximises productivity and therefore reduces unit costs towards their

lowest level. This may involve a process of capital-labour substitution where capital machinery and new technology

replaces some of the labour input. In many industries over the years we have seen a rise in the capital intensity of

production - good examples include farming, banking and retailing.

Robotic technology is extensively used in many manufacturing / assembly industries such as cars and semi-conductors.

The image above is of a Ford car assembly factory in India.


Market structures

Market structure is defined by economists as the characteristics of the market. It can be organizational characteristics or

competitive characteristics or any other features that can best describe a goods and services market. The major

characteristics that economist have focused on in describing the market structures are the nature of competition and

the mode of pricing in that market. Market structures can also be described as the number of firms in the market that

produce identical goods and services. The market structure has great influence on the behavior of individuals firms in

the market. The market structure will affect how firm price their product in the industry.

Definition - The interconnected characteristics of a market, such as the number and relative strength of buyers and

sellers and degree of collusion among them, level and forms of competition, extent of product differentiation, and ease

of entry into and exit from the market

Four basic types of market structure are

1. Perfect competition: many buyers and sellers, none being able to influence prices.

2. Oligopoly: several large sellers who have some control over the prices.

3. Monopoly: single seller with considerable control over supply and prices.

4. Monopsony: single buyer with considerable control over demand and prices.

Perfect competition is a theoretical market structure. Perfect competition is sometimes referred to as "pure

competition". It is primarily used as a benchmark against which other, real-life market structures are compared. The

industry that most closely resembles perfect competition in real life is agriculture. Perfect competition is the opposite of

a monopoly, in which only a single firm supplies a particular goods or service, and that firm can charge whatever price it

wants because consumers have no alternatives and it is difficult for would-be competitors to enter the marketplace.

Under perfect competition, there are many buyers and sellers, and prices reflect supply and demand. Also, consumers

have many substitutes if the good or service they wish to buy becomes too expensive or its quality begins to fall short.

New firms can easily enter the market, generating additional competition. Companies earn just enough profit to stay in

business and no more, because if they were to earn excess profits, other companies would enter the market and drive

profits back down to the bare minimum. Real-world competition differs from the textbook model of perfect competition

in many ways. Real companies try to make their products different from those of their competitors. They advertise to try

to gain market share. They cut prices to try to take customers away from other firms. They raise prices in the hope of

increasing profits. And some firms are large enough to affect market prices. But the perfect competition model is not an

ideal that we should try to achieve in the real world. A situation where there are many firms competing in the market,

there is lot of competition and the firm producing the best quality goods and services at lowest price will be successful.

A market structure in which the following five criteria are met:

� All firms sell an identical product;

� All firms are price takers - they cannot control the market price of their product;

� All firms have a relatively small market share;

� Buyers have complete information about the product being sold and the prices charged by each firm; and

� Industry is characterized by freedom of entry and exit.

Assumptions behind a Perfectly Competitive Market 1. Many suppliers each with an insignificant share of the market – this means that each firm is too small relative to

the overall market to affect price via a change in its own supply – each individual firm is assumed to be a price

taker

2. An identical output produced by each firm – in other words, the market supplies homogeneous or standardised

products that are perfect substitutes for each other. Consumers perceive the products to be identical

3. Consumers have perfect information about the prices all sellers in the market charge – so if some firms decide to

charge a price higher than the ruling market price, there will be a large substitution effect away from this firm

4. All firms (industry participants and new entrants) are assumed to have equal access to resources (technology,

other factor inputs) and improvements in production technologies achieved by one firm can spill-over to all the

other suppliers in the market


5. There are assumed to be no barriers to entry & exit of firms in long run – which means that the market is open

to competition from new suppliers – this affects the long run profits made by each firm in the industry. The long

run equilibrium for a perfectly competitive market occurs when the marginal firm makes normal profit only in

the long term

6. No externalities in production and consumption so that there is no divergence between private and social costs

and benefits

Characteristics of Perfect Competition 1. Homogeneous products - All firms produce the identical products.

2. Many buyers in the market - Though there are many buyers in the market they cannot control the prices. They

are price takers. The prices are set through the price mechanism.

3. Many sellers in the market - There are many sellers in the market. There is no dominating firm. All firms are

usually small and are price takers.

4. Perfect information - All buyers and sellers have perfect knowledge about the prices in the market.

5. Freedom of entry and exit - There are no barriers to entry and exit for firms. Firms are free to enter or exit the

market at their discretion. If a firm is making profit other firms may enter the market tempted by the profits.

6. No preferential treatment - There is no preference given to any firm by government or anybody. All firms are

equally treated.

Merits of Perfect Competition � There is optimal allocation of resources in the long run.

� Maximum economic efficiency as no single firm can control prices. There is no wasteful excess capacity.

� Advertising and promotional expenses are eliminated because product is homogeneous and there is perfect

knowledge among the consumers.

Demerits of Perfect Competition � No Research and Development undertaken as the products are homogeneous.

� Prices in perfect competition are controlled by the price mechanism. It may lead to instable income and prices

due to frequent change in equilibrium prices.

Monopolistic competition - The concept of monopolistic competition is more realistic than perfect competition

and pure monopoly. According to Chamberlain in real economic situation both monopoly and competitive elements are

present. Chamberlain’s monopolistic competition is the blending of competition and monopoly. The most distinguishing

feature of monopolistic competition is that the products of various firms are not identical but different although they

are close substitutes for each other. Like perfect competition there are a large number of firms but unlike perfect

competition the firms produce differentiated products which are close substitutes of each other. Under monopolistic

competition there is freedom of entry and exit. Thus under monopolistic competition it is found that both the features

of competition and monopoly are present. In India, for example, we find the monopolistic competition. In India there are

a number of manufacturers producing different brands of tooth paste viz Colgate, Pepsodent, Promise, Close-up,

Prudent and Forhans etc. The manufacturer of Colgate has got the monopoly of producing it. Nobody can produce and

sell tooth paste with the name Colgate. But at the same time he faces competition from other manufactures of tooth

paste as their products are close substitutes of Colgate tooth paste. Thus we find that monopolistic competition is the

real market structure than either pure competition or monopoly. Definition of Monopolistic Competition - Monopolistic competition differs from perfect competition in that production

does not take place at the lowest possible cost. Because of this, firms are left with excess production capacity. This

market concept was developed by Chamberlin (USA) and Robinson (Great Britain).

A type of competition within an industry where:

1. All firms produce similar yet not perfectly substitutable products.

2. All firms are able to enter the industry if the profits are attractive.

3. All firms are profit maximizers.

4. All firms have some market power, which means none are price takers.


Important features of monopolistic competition 1. Existence of large number of firms: The first important feature of monopolistic competition is that there is a

large number of firms satisfying the market demand for the product. As there are a large number of firms under

monopolistic competition, there exists stiff competition between them. These firms do not produce perfect

substitutes. But the products are close substitute for each other.

2. Product differentiations: The various firms under monopolistic competition bring out differentiated products

which are relatively close substitutes for each other. So their prices cannot be very much different from each

other. Various firms under monopolistic competitors compete with each other as the products are similar and

close substitutes of each other. Differentiation of the product may be real or fancied. Real or physical

differentiation is done through differences in materials used, design, color etc. Further differentiation of a

particular product may be linked with the conditions of his sale, the location of his shop, courteous behaviour

and fair dealing etc.

3. Some influence over the price: As the products are close substitutes of others any reduction of price of a

commodity by a seller will attract some customers of other products. Thus with a fall in price quantity

demanded increases. It therefore, implies that the demand curve of a firm under monopolistic competition

slopes downward and marginal revenue curve lies below it. Thus under monopolistic competition a firm cannot

fix up price but has influence over price. A firm can sell a smaller quantity by increasing price and can sell more

by reducing price. Thus under monopolistic competition a firm has to choose a price-output combination that

will maximize price.

4. Absence of firm's interdependence: Under oligopoly, the firms are dependent upon each other and can't fix up

price independently. But under monopolistic competition the case is not so. Under monopolistic competition

each firm acts more or less independently. Each firm formulates its own price-output policy upon its own

demand cost.

5. Non-price competition: Firms under monopolistic competition incur a considerable expenditure on

advertisement and selling costs so as to win over customers. In order to promote sale firms follow definite -

methods of competing rivals other than price. Advertisement is a prominent example of non-price competition.

The advertisement and other selling costs by a firm change the demand for his product. The rival firms compete

with each other through advertisement by which they change the consumer's wants for their products and

attract more customers.

6. Freedom of entry and exit: In a monopolistic competition it is easy for new firms to enter into an existing firm or

to leave the industry. Lured by the profit of the existing firms new firms enter the industry which leads to the

expansion of output. But there exists a difference.

Under perfect competition the new firms produce identical products, but under monopolistic competition, the new

firms produce only new brands of product with certain product variation. In such a law the initial product faces

competition from the existing well- established brands of product.

Monopolistic Competitive Industries: � Shoes -Nike, Addidas, Reebok

� ice cream-Breyers, Tom & Jerry

� Mobile Phone- Nokia, Samsung, Sony Ericcson

Monopoly -

Monopoly, derived form the Greek words 'monos' or alone and 'polein' or sell, can be defined as "the exclusive

control or possession of supply or trade in a commodity or service". The term is extensively used in economics, referring

to controlled power over the market, by an individual or company. Let's brush up a bit more on this. Monopoly

symbolizes domination over a product to the extent that the enterprise or individual dictates the terms of access and

the markets for availability. The term is specific to a seller's market. A similar situation in the buyer's market is referred

to as monopsony. It first appeared as an economics-related term in 'Politics' by Aristotle. A natural monopoly is defined

in economics as an industry where the fixed cost of the capital goods is so high that it is not profitable for a second firm

to enter and compete. There is a "natural" reason for this industry being a monopoly. It is an extreme imperfect form of


market. In ancient times, common salt was responsible for natural monopolies, till the time people learned about

winning sea-salt. Regions facing scarcity of transport facilities and storage were most prone to notorious acceleration of

commodity prices and uneven distribution of daily-use products and services. The characteristics of monopoly are

solitary to the condition generated by intent. Definition - A situation in which a single company owns all or nearly all of the market for a given type of product or

service. This would happen in the case that there is a barrier to entry into the industry that allows tee single company to

operate without competition. For example vast economies of scale, barriers to entry, or governmental regulation. In

such an industry structure, the producer will often produce a volume that is less than the amount which would maximize

social welfare. A situation in which a single company or group owns all or nearly all of the market for a given type of

product or service. By definition, monopoly is characterized by an absence of competition, which often results in high

prices and inferior products. According to a strict academic definition, a monopoly is a market containing a single firm. In

such instances where a single firm holds monopoly power, the company will typically be forced to divest its assets.

Antimonopoly regulation protects free markets from being dominated by a single entity. Monopoly is the extreme case

in capitalism. Most believe that, with few exceptions, the system just doesn't work when there is only one provider of a

good or service because there is no incentive to improve it to meet the demands of consumers. Governments attempt

to prevent monopolies from arising through the use of antitrust laws. Of course, there are gray areas; take for example

the granting of patents on new inventions. These give, in effect, a monopoly on a product for a set period of time. The

reasoning behind patents is to give innovators some time to recoup what are often large research and development

costs. In theory, they are a way of using monopolies to promote innovation. Another example is public monopolies set

up by governments to provide essential services. Some believe that utilities should offer public goods and services such

as water and electricity at a price that is affordable to everyone.

The four key characteristics of monopoly are: 1. A single firm selling all output in a market,

2. A unique product,

3. Restrictions on entry into and exit out of the industry, and more often than not

4. Specialized information about production techniques unavailable to other potential producers.

Features of Monopoly 1. Single Seller - Under monopoly, there is a single producer of a particular commodity or service in the market

accruing to a rather large number of buyers. The mono manufacturer may be an individual, a group of partners

or a joint stock company or state, being the only source of supply for the goods or services with no close

substitute. In this market structure, the firm is the industry and, thus, the market is referred to as 'pure

monopoly', but, it is more of a theoretical concept. At times, close substitutes are produced by few

manufactures holding a substantial market share and this imperfect form of extreme market is termed as

monopolistic competition.

2. Restricted Entry - Free entry of new organizations in this market arrangement is prohibited, that is, other sellers

cannot enter the market of monopoly. Few of the primary barriers, constricting the entry of new sellers are:

� Government license or franchise

� Resource ownership

� Patents and copyrights

� High start-up cost

� Decreasing average total cost

3. Homogeneous Product - A monopoly firm manufactures a commodity that has no close substitute and is a

homogeneous product. With the absence of availability of a substitute, the buyer is bound to purchase what is

available at the tagged price. For instance: there is no substitute for railways as the 'bulk carrier'. Thus, to be the

sole seller, in the monopolistic setup, a unique product must be produced.

4. Full Control Over Price - In a monopoly market, restricted entry constricts competition and the monopolist

exhibits full control over the market conditions. The absence of competition spares the monopolizing company

from price pressure and grants him the opportunity to charge the product as per his advantage, targeting profit

maximizing via predetermined quantity choice. Thus, a monopolist is a 'price maker' and not a 'price taker',


wherein he decides the price and the buyers have to accept it. Nevertheless, to evade the entry from new

market participants, the company needs to regulate the set product or service price within the paradigms of the

Monopoly Theorem.

5. Price Discrimination - Price discrimination can be defined as the 'practice by a seller of charging different prices

from different buyers for the same good or service'. A monopolist has the leverage to carry out price

discrimination as he is the market and acts as per his suitability.

6. Increased Scope for Mergers - Scope for vertical and/or horizontal mergers increase in lieu of control exhibited

by a single entity under a monopoly. The mergers efficiently absorb competition and maintain the supply chain

management.

7. Price Elasticity - With regards to the demand of the product or service offered by the monopolizing company or

individual, the price elasticity to absolute value ratio is dictated by price increase and market demand. It is not

uncommon to see surplus and/or a loss categorized as 'deadweight' within a monopoly. The latter refers to gain

that evades both, the consumer and the monopolist.

8. Lack of Innovation - On account of solitary market domination, monopolies exhibit an inclination towards losing

efficiency over a period of time; new designing and marketing dexterity takes a back seat.

9. Lack of Competition - When the market is designed to serve a monopoly, the lack of business competition or the

absence of viable goods and products shrinks the scope for 'perfect competition'. Being the sole merchant of a

eccentric good with no close imitation, a monopoly has no opposition. The demand for turnout induced by a

monopoly is the market demand, adhering extensive market control. The incompetence resulting from market

dominance also makes monopoly a key type of market failure.

Oligopoly

An oligopoly maximizes profits by producing where marginal revenue equals marginal costs. Oligopolies are price

setters rather than price takers. Barriers to entry are high. The most important barriers are economies of scale, patents,

access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or

destroy nascent firms. There are so few firms that the actions of one firm can influence the actions of the other firms.

Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline firms from entering market to

capture excess profits. Product may be homogeneous (steel) or differentiated (automobiles).

Market situation between, and much more common than, perfect competition (having many suppliers) and monopoly

(having only one supplier) In oligopolistic markets, independent suppliers (few in numbers and not necessarily acting in

collusion) can effectively control the supply, and thus the price, thereby creating a seller's market. They offer largely

similar products, differentiated mainly by heavy advertising and promotional expenditure, and can anticipate the effect

of one another's marketing strategies. Examples include airline, automotive, banking, and petroleum markets. Mirror

image of Oligopsony

A situation in which a particular market is controlled by a small group of firms and oligopoly is much like a monopoly, in

which only one company exerts control over most of a market. In an oligopoly, there are at least two firms controlling

the market. The retail gas market is a good example of an oligopoly because a small number of firms control a large

majority of the market.

The main characteristics of oligopoly 1. Number of firms. Small number of firms. Oligopoly is a market structure characterized by a few firms. These handful

of firms dominate the industry to set prices.

2. Interdependence. All firms in an industry are mostly interdependent. Any action on the part of one firm with

respect to output, quality product differentiation can cause a reaction on the part of other firms.

3. Realization of profit. Oligopolists firms are often thought to realize economic profits. Whenever there are profits,

there is incentive for entry of new firms. The existing firms then try to obstruct entry of new firms into the industry.

4. Strategic game. In an oligopolistic market structure, the entrepreneurs of the firms are like generals in a war. They

attempt to predict the reactions of rival firms. It is a strategy game which they play.


Four characteristics of an oligopoly industry are 1. Few sellers. There are just several sellers who control all or most of the sales in the industry.

2. Barriers to entry. Oligopoly firms are large and benefit from economies of scale. It takes considerable know-how

and capital to compete in this industry.

3. Interdependence. Oligopoly firms are large relative to the market in which they operate. If one oligopoly firm

changes its price or its marketing strategy, it will significantly impact the rival firm(s). For instance, if Pepsi

lowers its price to 80 cents per can, Coke will be affected. If Coke does not respond, it will lose significant market

share. Therefore, Coke will most likely lower its price, too.

4. Prevalent advertising. Oligopoly firms frequently advertise on a national scale. Many Super Bowl, World Series,

Wimbledon finals, NBA finals, and NCAA March Madness commercials include advertising by oligopoly firms.

There are four major theories about oligopoly pricing: 1. Oligopoly firms collaborate to charge the monopoly price and get monopoly profits

2. Oligopoly firms compete on price so that price and profits will be the same as a competitive industry

3. Oligopoly price and profits will be between the monopoly and competitive ends of the scale

4. Oligopoly prices and profits are "indeterminate" because of the difficulties in modeling interdependent price

and output decisions.

Market Structure Seller Entry

Barriers Seller

Number Buyer Entry

Barriers Buyer

Number

Perfect Competition No Many No Many

Monopolistic

competition

No Many No Many

Oligopoly Yes Few No Many

Oligopsony No Many Yes Few

Monopoly Yes One No Many

Monopsony No Many Yes One

Characteristic Perfect

Competition

Oligopoly Monopoly Contestable Market

Number of firms Many Few dominant

firms

One with pure

monopoly Effective

duopoly in many cases

Many

Type of product Homogenous Differentiated Limited Differentiated

Barriers to entry None High High Low entry and exit costs

Supernormal short

run profit

ü ü ü Any profit possible

Supernormal long run

profit

û ü ü Supernormal invites hit

and run entry

Pricing power Price taker

(passive)

Price maker but

interdependent

behaviour

Price maker –

constrained by demand

curve and possible

regulation

Price maker – but

actual and potential

competition limits

pricing power

Non price

competition

û ü (important) ü ü (important)

Economic efficiency High Low allocative

but scale

economies and

innovation

Low allocative but

economies of scale and

reinvested profits

Risk of X-inefficiency

due to lack of

competition

High – depending on

strength of

contestability

Innovative behaviour Weak Very Strong Potentially strong Strong


Profit Maximization Economic theory is based on the reasonable notion that people attempt to do as well as they can for themselves, given

the constraints facing them. For example, consumers purchase things that they believe will make them feel more

satisfied, but their purchases are limited (at least in the long run) by the amount of income they earn. A consumer can

borrow to finance current purchases but must (if honest) repay the loans at a later date. Business owners also attempt

to manage their businesses so as to improve their well being. Since the real world is a complicated place, a business

owner may improve his well being in a number of ways. For example, if the business doesn't lack customers, the owner

could respond by reducing operating hours and enjoying more leisure. Or, the business owner may seek satisfaction by

earning as much profit as possible. This is the alternative we will focus on in class - for a very good reason. If a business

faces tough competition, the only way the business can survive is to pay attention to revenues and costs. In many

industries, profit maximization is not simply a potential goal; it's the only feasible goal, given the desire of other

businesspeople to drive their competitors out of business.

In economic terms, profit is the difference between a firm's total revenue and its total opportunity cost. Total revenue is

the amount of income earned by selling products. In our simplified examples, total revenue equals P x Q, the (single)

price of the product multiplied times the number of units sold. Total opportunity cost includes both the costs of all

inputs into the production process plus the value of the highest-valued alternatives to which owned resources could be

put. For example, a firm that has $100,000 in cash could invest in new, more efficient, machines to reduce its unit

production costs. But the firm could just as well use the $100,000 to purchase bonds paying a 7% rate of interest. If the

firm uses the money to buy new machinery, it must recognize that it is giving up $7000 per year in forgone interest

earnings. The $7000 represents the opportunity cost of using the funds to buy the machinery.

We will assume that the overriding goal of the managers of firms is to maximize profit: P = TR - TC. The managers do

this by increasing total revenue (TR) or reducing total opportunity cost (TC) so that the difference rises to a maximum.

Definition - A process that companies undergo to determine the best output and price levels in order to maximize its

return. The company will usually adjust influential factors such as production costs, sale prices, and output levels as a

way of reaching its profit goal. There are two main profit maximization methods used, and they are Marginal Cost-

Marginal Revenue Method and Total Cost-Total Revenue Method. Profit maximization is a good thing for a company, but

can be a bad thing for consumers if the company starts to use cheaper products or decides to raise prices.

1. Achieving Leadership - firms often like to become leaders in the respective line of business. they would rather

try to attain industrial leadership at the cost of profits. In those cases, the objective of profit maximization is

subordinated to the leadership goal in the field. Leadership may connote either maximum sales or manufacture

of maximum product lines.

2. For avoiding potential competition - firms may restrict the profit in order to discourage othe firms from

entering the field and competing with them. if the firm is maximizing profit, it will be an alluring proposition for

the new firms to enter the field of production. the new entrants may snatch away the market, make

infringement on patent rights on the existing firm and may adopt a policy of profit restriction, instead of profit

maximization. This is more so in the case of firms enjoying weeks or slender monopoly.

3. For preventing government's intervention - higher profits in business is considered as an index of monopoly

power. The government's attitude towards profit and the firm's attitude towards profit will be different.

Maximum profit may create an impression that the firm is exploiting the consumers and this may result in the

public in the public demand for nationalizing the firm or firms. The government may also probe into the financial

structure of the firm; make regulation of price, profits and dividends.

4. For maintaining customer’s goodwill - in modern business, customer goodwill is valued more than anything

else. In order to maintain that, the firms may adopt the policy of restricted profit and low price for the

commodity. even times of increased taxes and excise duties, these firms may not increase the price but reduce

the profit margin and thereby win the approbation of customers.

5. For restraining wages demands - higher is an indication of ability to pay higher wages by the firms. organized

trade union advance their arguments on the basis of higher profits earned by the firm for increasing the wages

of labours, bonus benefits e.tc but in India this point has no validity as wages of labour are fixed by the wages

boards and payment of minimum bonus is a statutory obligation.


6. For achieving financial soundness and liquidity - some firms may give greater importance to financial soundness

and liquidity rather than profit maximization. Consideration of maximum profit may result in huge investment in

fixed assets and consequently the liquidity of the firm will be reduced.

7. For avoiding risk - decision regarding profit maximization may involve risks. Many new projects have to be

worked through uncertainties. Generally, business managers will avoid taking risks which may result even in

losing their jobs or losing the image of the firm. Further, the rewards for business managers may not be directly

proportional to the profits earned.

Sales Maximization Sales maximization Definition: The notions that business firms (especially those operating in the real world) are

primarily motivated by the desire to achieve the greatest possible level of sales, rather than profit maximization. On a

day-to-day basis, most real world firms probably do try to maximize sales rather than profit. For firms operating in

relatively competitive markets, facing relative fixed prices, and relatively constant average cost, then increasing sales is

bound to increase profits, too. Moreover, according to the notion of natural selection, even firms that seek to maximize

sales, those that also maximize profit will remain in business. This is the highest level of sales a firm can achieve before

making success.

Sales Maximisation - Sales maximisation is another possible goal and occurs when the firm sells as much as possible

without making a loss. Not-for-profit organisations may choose to operate at this level of output, as may profit making

firms faced with certain situations, or employing certain strategies. An example of this would be predatory pricing

where, so long as costs are covered, a firm may reduce price to drive rivals out of the market. Sales maximisation means

achieving the highest possible sales volume, without making a loss. To the right of Q, the firm will make a loss, and to

the left of Q sales are not maximised where AC=AR. Managers are more interested in firm size than profits. Size leads to

greater monetary and non-monetary rewards. For example, managers usually have sales related bonuses. As well, the

size of the firm they are managing gives them a greater sense of worth; rather than just making their boss richer.


Firm is profitable between Q1 and Q2. At Q3 is the profit is at max point Managers take production right up to the point

where TC=TR; if they can Oligopolies can benefit most from going past the profit maximising output because it gives

them a market share advantage over their competition. The economic climate can affect managers' ability to deploy this

tactic. If a recession is on the cards then shareholders will be anxious and keeping them and profits high will be a priority

to which managers must abide to keep their position.

Why do firms sales maximize? 1. To survive

2. Create brand loyalty

3. Increase market share

4. Eradicate competition

Why AC=AR? 1. When AC=AR normal profit is achieved. The maximum output is achieved before losses are made because

AC>AR.

2. When AR>AC there is still profit to be made by increasing sales.

Give four reasons why firms may sales maximize? Answer - (i) to survive (ii) create brand loyalty (iii) increase market share (iv) eradicate competiton

At what point is does sales maximisation occur? Answer - AC=AR

What type of profit is achieved at sales maximisation point? Answer - Normal Profit

Why do firms make losses after the sales maximisation point? Answer - Because AC>AR

At what point in a firm’s life cycle do you think sales maximisation would be an objective? Answers - Early on


Baumol’s Model of Sales Revenue Maximisation Maximising sales revenue is an alternative to profit maximisation and occurs when the marginal revenue, MR, from

selling an extra unit is zero. Revenue maximisation graph (ref: The condition for revenue maximisation is, therefore, to

produce up to the point where MR = 0)

Difference between Sales Maximization & Profit Maximization Sales maximization and profit maximization are distinct business objectives. Sales maximization is an approach to

business where the company's primary objective is to generate as much revenue as possible. Profit maximization is an

objective where the company intends to generate the highest net income over time.

1. Revenue vs. Profits - The main difference between sales maximization and profit maximization is the financial

intention. Sales, or revenue, is the generation of cash flow through the sale of goods and services. A goal of

maximizing revenue does not necessarily produce profits, because companies often sell products at a loss to

generate revenue. Maximizing profits typically requires that you not only sell a significant volume, but that you

also maintain reasonable profit margins.

2. Timeliness - One of the more prominent differences between sales and profit maximization is time orientation.

Sales maximization objectives are typically intended to produce as much revenue as possible in a short time

frame. Companies often have this objective to build their customer base, to steal customers from competitors,

to drive quick cash flow and to sell excess inventory. Profit maximization is a longer-term objective where the

company intends to position itself for long-term viability and success.

3. Recurrence - Profit maximization theoretically remains the primary long-term objective of any for profit

business. However, sales maximization objectives can come and go. Companies use sales objectives for various

reasons and at different times. The launch of the business, near the end of a quarter or fiscal year, during

typically slow times, when the business is slumping and when excess inventory builds up are common points at

which a company may introduce sales maximization goals for a temporary period. Still, the long-term focus is

earning income.

4. Risks - Risks of profit maximization objectives are somewhat limited. The business does have to work diligently

to build the perception of value in the market. Sales maximization goals do pose significant risks to long-term

profit potential. Companies advertise to build the sense of worth customers have for their products. Constantly

cutting costs to drive revenue creates a price orientation in the market. If a business mismanages sales

objectives, it can restrict the success of long-term profit maximization.


ORGANIZATIONAL SLACK Slack is a pool of organizational resources in excess of the minimum necessary to produce a given level of organizational

output. Slack resources can provide a cushion that allows organizations to adjust successfully to internal pressures as

well as to initiate strategy with respect to the external environment . These excess resources may take the form of

redundant employees, excess capacity, or excess labor or capital. For example, employers may hire individuals with

seemingly underutilized skills as a form of organizational slack in order to expedite upgrades or respond to demand

surges when circumstances warrant. Payment to members of the internal competing coalition in excess of what is

required to maintain the organization is also a form of slack . Slack resources can be immediately available for use (e.g.,

underutilized employees), recoverable (e.g., overhead expenses), or potential (e.g., the ability to borrow funds for

development). The relationship between slack resources and performance has been much debated but not well studied,

especially in health care. There are basically two divergent views of their value. One approach sees slack resources as a

sign of inefficiency, that is, either too much money is spent to produce the output or the output exceeds what is needed

or desirable. The other view focuses on the potential of slack resources to permit managers to act strategically to exploit

opportunities, such as to expand hospital services or to increase demand by partnering with insurers. Some actions can

be intended to enhance standing or satisfy employees rather than increase profit, for example, by seeking prestigious

affiliations, offering better workplace conditions, or expanding community outreach. Other actions can be defensive, for

instance, countering competitor's threats or buffering against unexpected environmental changes such as a mandated

loss of revenue from third-party reimbursement payment rates.

DEFINITION OF ORGANIZATIONAL SLACK - Organizational slack is a concept that says there is time between the

demands and deadlines of the work to be done and the amount of time and capacity available. If there’s no time

available, there’s no slack—and you’re not going to get many new ideas because people will just be focused on the job

at hand. Too much time and people may not get anything done, and ideas that are generated may not have focus.

OPTIMIZING THE AMOUNT OF ORGANIZATIONAL SLACK If, as has been argued from a number of organizational perspectives, slack buffers organizations against environmental

turbulence, enhances performance, and resolves potentially destructive internal conflict, is it possible to have too little

slack? While the literature we have briefly reviewed suggests the answer may be yes, other evidence clearly supports

the view that there can be too much slack. As has been argued, the optimal amount of slack is determined by the rate of

change and source of change in the environment, the availability of resources in the environment, and the structure of

the market. When slack is present, organizations can absorb small to moderate changes fast, although large changes

may require more discretionary slack. While the debate over the existence of organizational slack has provided an

interesting theoretical challenge, maintaining an optimal level of slack is a significant managerial challenge. The purpose

of slack is to allow the organization to forego short-term gains for long-term outcomes. Rather than operating on a pure

cost-minimization model that eliminates short-term excess costs, in order to maximize performance, organizations must

balance the cost of slack and its protective abilities. Likewise, researchers and policy makers need to bear in mind that

their models and methods for evaluating efficiency should be cognizant of this larger literature. Indeed, while there is fat

to be trimmed from our health care system, slack resources can also provide muscle that is needed to maintain and

improve its quality and safety—so the value proposition needs to wisely seek the balance. Hussey and his colleagues

have helped us by reviewing the methods used and by exposing the need for better models and concepts about

efficiency as well.


Ownership and control � The owners of a private sector company normally elect a board of directors to control the business’s resources

for them.

� However, when the owner sells shares, or takes out a loan or bond to raise finance, they may sacrifice some of

their control. Other shareholders can exercise their voting rights, and providers of loans often have some control

(security) over the assets of the business

� This may lead to conflict between them as these different stakeholders may have different objectives. The flow

chart below attempts to show the divorce between ownership and control.

The Principal Agent Problem - How do the owners of a large business know that the managers they have employed

operate with the aim of maximizing shareholder value in both the short term and the long run? This lack of information

is known as the principal-agent problem or “agency problem”.

1. The principal agent problem revolves around a simple issue - how best to get your employees to act in your interests

rather than their own?

2. Shareholders tend to want good returns in the form of dividend payments and a rising share price.

3. Managers may have different objectives such as power, bonuses, large expense accounts, prestige and status. The

problem is the many shareholders - have no day-to-day control over managers. Pension fund managers cannot

dictate what CEOs and CFOs of businesses decide to do and senior executives may have little knowledge of what

their managers are doing.

4. Many investors in a business are 'passive'. The biggest investors in UK listed companies tend to be large institutional

shareholders such as pension funds and insurance companies.

Examples of the principal-agent problem that have hit the headlines recently in the UK include the mis-management of

financial assets on behalf of investors (e.g. Equitable Life.) The classic case in the United States was the Enron fraud and

debacle. The credit crunch focused attention on the failure of shareholders in the major banks to understand the

complex and risky behaviour that was being undertaken by bank employees involved in the sub-prime mortgage boom

and the growth of securitised lending.

In the banking crisis it became clear that senior management at many of the world's biggest banks simply did not

understand the complexity of what their traders were doing. Traders stood to earn huge bonuses if their risky loans

worked, but faced little sanction or loss if they went bad. This skewed their incentives and created a problem of moral

hazard. This term originated in insurance, recognising the idea that people with insurance may be careless – for

example, paying for secure off-street parking looks less attractive if your car is insured.


A separation of ownership and control in banks and insurance companies contributed to the sub-prime crisis and the

result has been a collapse in shareholder value as the stock market prices of banks and insurance companies has fallen

sharply.

Employee Share Ownership Schemes - There are various strategies available for coping with the principle- agent

problem. One is the expansion of employee share-ownership schemes. But the use and occasional misuse of share

options schemes has been controversial for several years. A recent example involved the US computer giant Apple.

The growth of "shareholder activism" 1. Increasingly we are seeing shareholders who are more proactive in putting executive management under

pressure - these are known as activist shareholders. In 2012 some commentators pointed to the emergence of a

“shareholder spring” prompted by investor anger over huge remuneration packages alongside poor financial

performance

2. At the forefront of this change has been the expansion of hedge funds and a number of wealthy private

investors. Latterly, the sovereign wealth funds have appeared on the scene.

3. An activist shareholder uses an equity stake in a corporation to put pressure on its existing management.

4. The goals of activist shareholders range from financial (e.g. increase of shareholder value through changes in

dividend decisions, plans for cost cutting or investment projects etc.) to non-financial (e.g. dis-investment from

particular countries with a poor human rights record, or pressuring a business to speed up the adoption of

environmentally friendly policies and build a better reputation for ethical behaviour, etc.).

5. Activist shareholders do not have to hold large stakes in a business to make an impact. Even those with

relatively small stakes or 3 or 4 per cent can launch publicity campaigns and make direct contact with the senior

management. Private equity / hedge funds have been among those most involved in the rise of shareholder

activism. They tend to focus on under-performing businesses

Is this new breed of shareholder activists an important voice and counter-balance to the power of entrenched

management and willing to stand up to corporate corruption and highlight poor management?

Can they help to overcome the principle-agent problem? Or are they aggressive corporate raiders seeking short-term

corporate change merely for their own personal gain?

Environmental groups such as Friends of the Earth have also latched onto the potential for shareholder activism to

impact on businesses especially in the areas of the environmental impact of their business activities.

It remains the case that ownership and control within British industry is dispersed. Typically the largest shareholder in

any large business listed on the stock market is likely to own a minority of the shares. Majority ownership by a single

shareholder is unusual.

Corporate Social Responsibility (CRS) and Business Ethics 1. Business ethics is concerned with the social responsibility of management towards the firm’s stakeholders, the

environment and society in general.

2. There is a growing belief that ethical and ‘green’ business are linked to improved business performance because

of increased public concern for human rights and the environment.

3. For example, many businesses are now trumpeting their progress in making their activities carbon neutral by

offsetting the impact of their production activities on their environment through offset activities. Businesses

such as Carbon Clear provide a means by which organisations can find ways to offset their carbon emissions.

4. Business ethics extends to treating stakeholders ‘fairly’; hence the growing emphasis on health and safety

issues, good working practices and the like in business decision-making.

5. According to the Ethical Investment Research Service (EIRIS) £6.7 billion is invested in ethical and environmental

investment funds in the UK (and rising)

For more reading on this try this link to the Institute for Business Ethics. The Times 100 Case Studies includes one on

Cadbury’s and corporate social responsibility. Click here for BBC news articles on carbon neutrality.


Examples of private benefits from corporate social responsibility projects 1. Marks & Spencer Plan A to cut carbon emissions: Estimate of £50m extra profit (20% cut in packaging costs; 19%

increase in energy efficiency) – their aim is to be the world’s most sustainable retailer

2. GE (Ecomagination): $70bn of extra revenue in first 5 years (new products for the green economy)

3. Unilever (Project Shakti): $100m extra sales by selling to rural Indian communities – their Sustainable Living Plan

aims to double sales & halve environmental impact of its products by 2020. 15 years of sustainability projects = CO2

from energy down 41%; water use down 65%; total waste down 73%

4. British Telecom: BT’s commitment to its sustainability agenda has helped it win £2.2bn worth of business in the

financial year 2007-2008, up from £1.8bn the year before.

5. Sony: A vision of being a zero carbon emission firm by 2050 with staged targets along the way

6. Dow Jones: A.T. Kearney looked at 99 companies who have a strong commitment to sustainability (as defined by the

Dow Jones Sustainability Index) and compared their performance with industry averages. They found that In 16 out

of the 18 industries studied, companies committed to sustainability outperformed industry averages by 15%

Gross National Product (GNP) Definition of 'Gross National Product - GNP' –

• An economic statistic that includes GDP, plus any income earned by residents from overseas investments, minus

income earned within the domestic economy by overseas residents.GNP is a measure of a country's economic

performance, or what its citizens produced (i.e. goods and services) and whether they produced these items

within its borders. GNP is the total value of all final goods and services produced within a nation in a particular

year, plus income earned by its citizens (including income of those located abroad), minus income of non-

residents located in that country.

• Gross National Product (GNP) can be defined as an economic statistic which includes Gross Domestic Product,

plus any income earned by the residents from investments made overseas. Also, the income earned within the

domestic economy by overseas residents. Gross National Product (GNP) refers to a quantification of economic

performance of a country. Also, it measures whatever goods and services are generated by the citizens and

whether these are produced within the borders of the country. However, GNP does not discern between

qualitative improvements in the state of technical arts, like increasing computer processing speeds, and

quantitative increases in goods, like number of computers produced, and considers both as types of “economic

growth.”

Formula for Gross National Product - The general formula used for Gross National Product is:

GNP = GDP + Net factor income from abroad Where,

� GDP = Gross Domestic Product

� Net factor income from abroad = income earned in foreign countries by the residents of a country – income

earned by non-residents in that country

Why is GNP required? The Gross National Product is helpful in measuring the contribution of a country’s residents to the flow of goods and

services inside and outside the national territory. Therefore, Gross National Product is the basic concept of national

income accounting.

Measurement of GNP - The GNP is measured at:

� Current market prices (Nominal GNP) - This method of estimating the GNP involves measuring the GNP at the

prices of goods and services being measured at the prices existing in the market in current year.

� Constant prices (Real GNP) - Through this method, Gross National Product is estimated at a fixed price of a

specific base year.


Calculating GNP - The main steps involved in calculation of GNP are as follows:

� Sum up the total consumer spending, government spending and private investing by the citizens of a given

country.

� Calculate the net exports by deducting the exports made by a country’s citizensfrom the total amount of a

country’s imports.

Add up the net exports for the citizens of a country to the expenditure by its citizens worldwide thus reaching the GNP.

Gross Domestic Product - GDP Definition of 'Gross Domestic Product - GDP'- GDP is commonly used as an indicator of the economic health of a

country, as well as to gauge a country's standard of living. Critics of using GDP as an economic measure say the statistic

does not take into account the underground economy - transactions that, for whatever reason, are not reported to the

government. Others say that GDP is not intended to gauge material well-being, but serves as a measure of a nation's

productivity, which is unrelated. The total market value of all final goods and services produced in a country in a given

year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of

imports.

The monetary value of all the finished goods and services produced within a country's borders in a specific time period,

though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government

outlays, investments and exports less imports that occur within a defined territory.

GDP = C + G + I + NX Where:

� "C" is equal to all private consumption, or consumer spending, in a nation's economy

� "G" is the sum of government spending

� "I" is the sum of all the country's businesses spending on capital

� "NX" is the nation's total net exports, calculated as total exports minus total imports. (NX = Exports - Imports)

GDP Reporting - The GDP report is released at 8:30 am EST on the last day of each quarter and reflects the previous

quarter. Growth in GDP is what matters, and the U.S. GDP growth has historically averaged about 2.5-3% per year but

with substantial deviations. Each initial GDP report will be revised twice before the final figure is settled upon: the

"advance report" is followed by the "preliminary report" about a month later and a final report a month after that.

Significant revisions to the advance number can cause additional ripples through the markets.

The GDP numbers are reported in two forms: current dollar and constant dollar.

� Current dollar GDP is calculated using today's dollars and makes comparisons between time periods difficult

because of the effects of inflation.

� Constant dollar GDP solves this problem by converting the current information into some standard era dollar,

such as 1997 dollars. This process factors out the effects of inflation and allows easy comparisons between

periods.


GDP GNP

Stands for: Gross Domestic Product Gross National Product

Definition: An estimated value of the total worth of a

country’s production and services, within its

boundary, by its nationals and foreigners,

calculated over the course on one year.

An estimated value of the total worth of

production and services, by citizens of a

country, on its land or on foreign land,

calculated over the course on one year.

Formula for

Calculation:

GDP = consumption + investment + (government

spending) + (exports − imports).

GNP = GDP + NR (Net income inflow from

assets abroad or Net Income Receipts) - NP

(Net payment outflow to foreign assets).

Uses: Business, Economic Forecasting. Business, Economic Forecasting.

Application (Context in

which these terms are

used):

To see the strength of a country’s local economy. To see how the nationals of a country are

doing economically.

Layman Usage: Total value of products & Services produced

within the territorial boundary of a country.

Total value of Goods and Services produced

by all nationals of a country (whether within

or outside the country).

Country with Highest

Per Capita (US$):

Luxembourg ($87,400). Luxembourg ($45,360).

Country with Lowest

Per Capita (US$):

Liberia ($16). Mozambique ($80).

Country with Highest

(Cumulative):

USA ($13.06 Trillion in 2006). USA (~ $11.5 Trillion in 2005).

Consumption Consumption is a major concept in economics and is also studied by many other social sciences. Economists are

particularly interested in the relationship between consumption and income, and therefore in economics the

consumption function plays a major role.

Consumption theory - The Keynesian Theory of consumption is that current real disposable income is the most

important determinant of consumption in the short run. Real Income is money income adjusted for inflation. It is a

measure of the quantity of goods and services that consumers have buy with their income (or budget). For example, a

10% rise in money income may be matched by a 10% rise in inflation. This means that real income (the quantity or

volume of goods and services that can be bought) has remained constant.


The chart above shows how real disposable incomes and consumer spending have grown in recent years. This increase

in real incomes has been a factor behind the yearly growth of consumer demand in each of the last nine years.

The Keynesian Consumption Function

Disposable Income (Yd) = Gross Income - (Deductions from Direct Taxation + Benefits)

The standard Keynesian consumption function is as follows:

C = a + c Yd

Where,

C= Consumer expenditure

a = autonomous consumption.

This is the level of consumption that would take place even if income was zero. If an individual's income fell to zero

some of his existing spending could be sustained by using savings. This is known as dis-saving.

c = marginal propensity to consume (mpc). This is the change in consumption divided by the change in income. Simply, it

is the percentage of each additional pound earned that will be spent.

There is a positive relationship between disposable income (Yd) and consumer spending (Ct). The gradient of the

consumption curve gives the marginal propensity to consume. As income rises, so does total consumer demand.

A change in the marginal propensity to consume causes a pivotal change in the consumption function. In this case the

marginal propensity to consume has fallen leading to a fall in consumption at each level of income. This is shown below:

Key Consumption Definitions

• Average propensity to consume = Total consumption divided by total income

• Average propensity to Save = Total savings divided by total income (also known as the Saving Ratio

A Shift in the Consumption Function


The consumption - income relationship changes when other factors than income change - for example a rise in interest

rates or a fall in consumer confidence might lead to a fall in consumption spending at each level of income.

A rise in household wealth or a rise in consumer's expectations might lead to an increased level of consumer demand at

each income level (an upward shift in the consumption curve).

Capital Formation Definition of 'Capital Formation ' - A term used to describe net capital accumulation during an accounting period.

Capital formation refers to net additions of capital stock such as equipment, buildings and other intermediate goods. A

nation uses capital stock in combination with labour to provide services and produce goods; an increase in this capital

stock is known as capital formation. Generally, the higher the capital formation of an economy, the faster an economy

can grow its aggregate income. Increasing an economy's capital stock also increases its capacity for production, which

means an economy can produce more. Producing more goods and services can lead to an increase in national income

levels.

Gross domestic capital formation: What are its components? Capital is the produced means of production or it is called produced wealth by which more wealth is possible in the

economy directly and indirectly. Capital formation means creation of physical assets and non- physical capital consisting

of public health efficiency, visible and no visible capital.

According Harbigh - human capital formation is the process of increasing knowledge, skill and the capacities of all

people of the country.

Gross domestic capital formation is the addition to the capital stock within the domestic territory of a country during a

year. The surplus of production over consumption during a year adds to the capital stock of a country Gross capital

formation which includes two components such as (a) Gross domestic fixed capital formation (b) change in stock.

Gross domestic capital formation includes all expenses made by household, business people and Govt, adding new

durable goods to the fixed capital stock of a country. These assets are in the form of infrastructure such as buildings,

roads canals, bridges, means of transport, machinery and other equipments. The value of the new fixed assets is equal

to the expenditure made on new capital assets bought.

The difference between sale and purchase of second hand physical assets from abroad is known as the net purchase of

second hand goods from foreign countries. It is also added with the fixed capital formation. If a country's purchase of

second hand assets is more than its sales of such assets, net purchase will be positive. But if the sale is more than the

purchase the net purchase is negative. A negative purchase of second hand assets will reduce the gross domestic capital

formation.

The change in stock means the change in stocks or inventories. The change in stock is the difference between market

prices of the stock held by the Govt at the beginning and end of the period.

The change in stock is a flow concept. It keeps on changing. The change in stock means the stock of raw-materials, semi-

finished and finished goods with the producer households, corporate and semi-corporate enterprises. Charge in stock

consists of inventories with firms, charge in stock with the Govt and non-Govt. departmental undertaking, charge in live

stock. There is a difference between change in stocks and fixed capital formation. Change in stocks is determined by

short term demand but fixed capital asset is determined by long term demand.


Wholesale Price Index - WPI The Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods. Some countries (like India

and The Philippines) use WPI changes as a central measure of inflation. However, United States now report a producer

price index instead. The Wholesale Price Index or WPI is "the price of a representative basket of wholesale goods".

Some countries use the changes in this index to measure inflation in their economies, in particular India – The Indian

WPI figure was earlier released weekly on every Thursday and influenced stock and fixed price markets. The Indian WPI

is now updated on a monthly basis. The Wholesale Price Index focuses on the price of goods traded between

corporations, rather than goods bought by consumers, which is measured by the Consumer Price Index. The purpose of

the WPI is to monitor price movements that reflect supply and demand in industry, manufacturing and construction.

This helps in analyzing both macroeconomic and microeconomic conditions. Inflation is based on Wholesale Price Index.

Definition of 'Wholesale Price Index - WPI' - An index that measures and tracks the changes in price of goods in the

stages before the retail level. Wholesale price indexes (WPIs) report monthly to show the average price changes of

goods sold in bulk, and they are a group of the indicators that follow growth in the economy. Although some countries

still use the WPIs as a measure of inflation, many countries, including the United States, use the producer price index

(PPI) instead. The wholesale price indexes used in Indonesia were originally set up in 1996; the base year was reset in

April of 2006 with a WPI value of 2000. Index values in Indonesia are commonly expressed as 2000=100. As an example,

the Indonesian Agriculture WPI in February of 2008 was 5140, but was expressed in the recent tables released by

Statistics Indonesia as 257 (calculated as 5140/[2000/100]=257).

Calculation - The wholesale price index (WPI) is based on the wholesale price of a few relevant commodities of over

240 commodities available. The commodities chosen for the calculation are based on their importance in the region and

the point of time the WPI is employed. For example in India about 435 items were used for calculating the WPI in base

year 1993-94 while the advanced base year 2004-05 and which has now been changed to 2010-2011; uses 676 items.

The indicator tracks the price movement of each commodity individually. Based on this individual movement, the WPI is

determined through the averaging principle. The following methods are used to compute the WPI:

• Laspeyres Formula - It is the weighted arithmetic mean based on the fixed value-based weights for the base

period.

• Ten-Day Price Index - Under this method, “sample prices” with high intra-month fluctuations are selected and

surveyed every ten days through phone. Utilizing the data retrieved by this procedure and with the assumption

that other non-surveyed “sample prices” remain unchanged, a “ten-day price index” is compiled and released.

Calculation Method - Monthly price indexes are compiled by calculating the simple arithmetic mean of three ten- day

“sample prices” in the month.

Ten-Day Price Index - Under this method, “sample prices” with high intra-month fluctuations are selected and

surveyed every ten days through phone. Utilizing the data retrieved by this procedure and with the assumption that

other non-surveyed “sample prices” remain unchanged, a “ten-day price index” is compiled and released. Calculation

Method Monthly price indexes are compiled by calculating the simple arithmetic mean of three ten-day “sample prices”

in the month.

Consumer price index A consumer price index (CPI) measures changes in the price level of a

purchased by households. The CPI in the United States is defined by the

average change over time in the prices paid by urban consumers for a

The CPI is a statistical estimate constructed using the prices of a sample of

collected periodically. Sub-indexes and sub

goods and services, being combined to produce the overall index with weights reflecting their shares i

consumer expenditures covered by the index. It is one of several

agencies. The annual percentage change in a CP

for the effect of inflation) the real value of wages, salaries,

magnitudes to show changes in real values. In most countries, the CPI is, along with the population

National Income and Product Accounts, one of the most closely watched national economic statistics.

Definition of 'Consumer Price Index consumer goods and services, such as transportat

changes for each item in the predetermined basket of goods

their importance. Changes in CPI are used to assess price changes associated with the cost of living. The U.S. Bureau of

Labor Statistics measures two kinds of CPI statistics: CPI for urban wage earne

chained CPI for all urban consumers (C

general public, because it accounts for about 87% of the population. CPI is one of the most frequ

identifying periods of inflation or deflation. This is because large rises in CPI during a short period of time typically

denote periods of inflation and large drops in CPI during a short period of time usually mark periods of def

Calculating the CPI for a single item Current item price ($) = (base year price) * (Current CPI) / (Base year CPI)

Where 1 is usually the comparison year and CPI

Alternatively, the CPI can be performed as =

The "updated cost" (i.e. the price of an item at a given year, e.g.: the price of bread in 2010) is divided by the initial ye

(the price of bread in 1970), then multiplied by one hundred.

Calculating the CPI for multiple itemsto 1 or 100.

Example: The prices of 95,000 items from 22,000 stores, and 35,000 rental units are added together and averaged. T

are weighted this way: Housing: 41.4%, Food and Beverage: 17.4%, Transport: 17.0%, Medical Care: 6.9%, Other: 6.9%,

Apparel: 6.0%, Entertainment: 4.4%. Taxes (43%) are not included in CPI computation.

Where the s sum to 1 or 100

Managerial Economics

) measures changes in the price level of a market basket of

purchased by households. The CPI in the United States is defined by the Bureau of Labor Statistics

over time in the prices paid by urban consumers for a market basket of consumer goods and services."

The CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are

indexes and sub-sub-indexes are computed for different categories and sub

goods and services, being combined to produce the overall index with weights reflecting their shares i

consumer expenditures covered by the index. It is one of several price indices calculated by most national statistical

agencies. The annual percentage change in a CPI is used as a measure of inflation. A CPI can be used to index (i.e., adjust

for the effect of inflation) the real value of wages, salaries, pensions, for regulating prices and for deflating monetary

magnitudes to show changes in real values. In most countries, the CPI is, along with the population

, one of the most closely watched national economic statistics.

ndex - CPI' - A measure that examines the weighted average of prices of a basket of

consumer goods and services, such as transportation, food and medical care The CPI is calculated by taking price

changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to


Labor Statistics measures two kinds of CPI statistics: CPI for urban wage earners and clerical workers (CPI

chained CPI for all urban consumers (C-CPI-U). Of the two types of CPI, the C-CPI-U is a better representation of the

general public, because it accounts for about 87% of the population. CPI is one of the most frequ


denote periods of inflation and large drops in CPI during a short period of time usually mark periods of def

–

Current item price ($) = (base year price) * (Current CPI) / (Base year CPI) or

Where 1 is usually the comparison year and CPI1 is usually an index of 100.

Alternatively, the CPI can be performed as =

The "updated cost" (i.e. the price of an item at a given year, e.g.: the price of bread in 2010) is divided by the initial ye

(the price of bread in 1970), then multiplied by one hundred.

Calculating the CPI for multiple items - Many but not all price indices are weighted averages using weights that sum

Example: The prices of 95,000 items from 22,000 stores, and 35,000 rental units are added together and averaged. T


Apparel: 6.0%, Entertainment: 4.4%. Taxes (43%) are not included in CPI computation.

s sum to 1 or 100


of consumer goods and services

Bureau of Labor Statistics as "a measure of the

of consumer goods and services."

representative items whose prices are

indexes are computed for different categories and sub-categories of

goods and services, being combined to produce the overall index with weights reflecting their shares in the total of the

calculated by most national statistical

. A CPI can be used to index (i.e., adjust

, for regulating prices and for deflating monetary

magnitudes to show changes in real values. In most countries, the CPI is, along with the population census and the USA

, one of the most closely watched national economic statistics.

A measure that examines the weighted average of prices of a basket of

The CPI is calculated by taking price

and averaging them; the goods are weighted according to


rs and clerical workers (CPI-W), and the

U is a better representation of the

general public, because it accounts for about 87% of the population. CPI is one of the most frequently used statistics for


denote periods of inflation and large drops in CPI during a short period of time usually mark periods of deflation.

.

The "updated cost" (i.e. the price of an item at a given year, e.g.: the price of bread in 2010) is divided by the initial year

are weighted averages using weights that sum

Example: The prices of 95,000 items from 22,000 stores, and 35,000 rental units are added together and averaged. They



Inflation Definition of 'Inflation' - The rate at which the general level of prices for goods and services is rising, and,

subsequently, purchasing power is falling Central banks attempt to stop severe inflation, along with severe deflation, in

an attempt to keep the excessive growth of prices to a minimum. As inflation rises, every dollar will buy a smaller

percentage of a good. For example, if the inflation rate is 2%, then a $1 pack of gum will cost $1.02 in a year. Most

countries' central banks will try to sustain an inflation rate of 2-3%.

What Is an Inflation Index? An inflation index is a tool used to measure the rate of inflation in an economy. There are several different ways to

measure inflation, leading to more than one inflation index with different economists and investors preferring one

method to another, sometimes strongly. This brief overview should help you understand how an inflation index works,

some of the more popular models, and perhaps even help you decide for yourself the one you think represents the

"true" inflation rate. Before we can begin, you need to understand the definition of an "index". Basically, an index is just

a collection of data that serves as a baseline for future reference. We use the index model in all areas of life, from the

stock market (the most famous of which is probably the Dow Jones Industrial Index), to inflation. We index wage levels,

corporate profits as a percentage of GDP, and almost anything else that can be measured. We do this to compare where

we are now to where we have been in the past.

Some Popular Inflation Index Reports - There are several popular inflation index reports that investors and

economists follow:

� Consumer Price Index (CPI): This inflation index measures the change in prices regular consumers pay to live

their day-to-day lives. We'll talk about it more in depth in a moment.

� Producer Price Index (PPI): This inflation index measures the change in prices manufacturers and producers

experience on materials necessary for conducting their business. The price of steel and aluminum for

automobile manufacturers would be tracked by the PPI.

� Employment Cost Index (ECI): This inflation index measures the rising cost of hiring employees in various fields.

� Gross Domestic Product Deflator (GDP Deflator): This inflation index measures the rise in cost experienced by

end consumers as well as the government or institution providing goods and services to those consumers.

The Consumer Price Index, or CPI, Is the Most Popular Inflation Index in the United States - The CPI, or

Consumer Price Index, is without a doubt the most popular inflation index in the United States. There are several

different version of the CPI but they all are built upon the idea of tracking prices for a basket of goods and comparing

them to a baseline year.

According to the government, The Consumer Price Index covers different categories and items including:

� Food and Beverages: Milk, coffee, wine, snacks, chicken, breakfast cereal, etc.

� Housing: Rent, heating oil, bedroom furniture

� Apparel: Shirts, sweaters, jewelry

� Transportation: New vehicles, airline fares, car insurance, gasoline

� Medical Care: Prescription drugs, medical supplies, doctor visits, eyeglasses, hospital bills

� Recreation and Entertainment: Televisions, toys, pet products, sports equiment, admissions

� Education and Communication: College tuition, postage, telephone service, computer software

� Other Goods and Services: Tobacco, haircuts, funeral expenses, etc.

How the Government Updates the Inflation Index - Every month, employees of the Bureau of Labor Statistics visit

thousands of retail stores, restaurants, service establishments, apartment buildings, and medical facilities throughout

the country and research prices. It is estimated that they sample approximately 80,000 items per month, which is used

as the raw data to perform the Consumer Price Index calculations that get reported to the press. The government even

reports the inflation index for major metropolitan areas so that you can tell if prices are rising more rapidly in, say,

Atlanta than they are Denver.


Inflation Index Controversy - It has been estimated that up to 30% of the United States Federal Budget is based upon

changes in the Consumer Price Index. During the 1990's, when Bill Clinton served as President, the CPI was changed to

reflect "buying habits" rather than serving as a true inflation index. This involved rule changes that accounted for

substitution. That is, if the price of beef skyrockets, families will switch to chicken. Therefore, the price of chicken is used

instead of beef. Likewise, if a product improves and remains the same price, the index is lowered to reflect the fact

consumers are getting more value for their money. Some economists believe this drastically understates the real rate of

inflation. Others think it is more accurate because it reflects what real families do when confronted with higher prices of

a specific commodity.

Types of Inflation � Creeping inflation (Low to Moderate Inflation) - Most stable nations in the world have to deal with inflation at

some level and try to maintain a target inflation rate of around 1-2% but depending on the state of the country’s

economy it can reach up to 6%. You could consider this a natural rate of inflation that is almost impossible to

eliminate.

� Chronic Inflation (High Inflation) - For some industrialized nations and developing nations inflation is high and

can continue to increase each year possibly reaching annual rates of 10% to 35% and possibly greater in some

places. It is defined as chronic because the high inflation rate persists over time without any downward

movement, possibly leading to hyperinflation rate.

� Hyperinflation - The most popular period for Hyper inflation was after World Wars I and II. During these harsh

economic times many countries saw extremely high price increases ranging from 15 to 80% year over year. With

inflation rates this high prices become ‘out of control’ as the purchasing power of money quickly dwindles. The

most outrageous example of Hyperinflation was in Germany during 1923 when the rate of inflation was so high

that prices were doubling every 50 hours. The classic story (which is true) during this time was that people were

burning money for heat as it was cheaper (and would burn longer) than the wood they would have to purchase.

Concepts of National Income

There are various concepts of National Income. The main concepts of NI are: GDP, GNP, NNP, NI, PI, DI, and PCI. These

different concepts explain about the phenomenon of economic activities of the various sectors of the various sectors of

the economy.

Gross Domestic Product (GDP) - The most important concept of national income is Gross Domestic Product. Gross

domestic product is the money value of all final goods and services produced within the domestic territory of a country

during a year. Algebraic expression under product method is, GDP=(P*Q)

where,

GDP=Gross Domestic Product

P=Price of goods and service

Q=Quantity of goods and service

denotes the summation of all values.

According to expenditure approach, GDP is the sum of consumption, investment, government expenditure, net foreign

exports of a country during a year. Algebraic expression under expenditure approach is, GDP=C+I+G+(X-M)

Where,

C=Consumption

I=Investment

G=Government expenditure

(X-M)=Export minus import

GDP includes the following types of final goods and services. They are:

1. Consumer goods and services.

2. Gross private domestic investment in capital goods.

3. Government expenditure.

4. Exports and imports.


Gross National Product (GNP) - Gross National Product is the total market value of all final goods and services

produced annually in a country plus net factor income from abroad. Thus, GNP is the total measure of the flow of goods

and services at market value resulting from current production during a year in a country including net factor income

from abroad. The GNP can be expressed as the following equation: GNP=GDP+NFIA (Net Factor Income from Abroad)

or, GNP=C+I+G+(X-M)+NFIA

Hence, GNP includes the following:

1. Consumer goods and services.

2. Gross private domestic investment in capital goods.

3. Government expenditure.

4. Net exports (exports-imports).

5. Net factor income from abroad.

Net National Product (NNP) - Net National Product is the market value of all final goods and services after allowing

for depreciation. It is also called National Income at market price. When charges for depreciation are deducted from the

gross national product, we get it. Thus,

� NNP=GNP-Depreciation or,

� NNP=C+I+G+(X-M)+NFIA-Depreciation

National Income (NI) - National Income is also known as National Income at factor cost. National income at factor cost

means the sum of all incomes earned by resources suppliers for their contribution of land, labor, capital and

organizational ability which go into the year’s net production. Hence, the sum of the income received by factors of

production in the form of rent, wages, interest and profit is called National Income. Symbolically,

� NI=NNP+Subsidies-Interest Taxes or,

� GNP-Depreciation +Subsidies-Indirect Taxes or,

� NI=C+G+I+(X-M)+NFIA-Depreciation-Indirect Taxes+ Subsidies

Personal Income (PI) - Personal Income i s the total money income received by individuals and households of a

country from all possible sources before direct taxes. Therefore, personal income can be expressed as follows:

� PI=NI-Corporate Income Taxes-Undistributed Corporate Profits-Social Security Contribution+ Transfer Payments

Disposable Income (DI) - The income left after the payment of direct taxes from personal income is called Disposable

Income. Disposable income means actual income which can be spent on consumption by individuals and families. Thus,

it can be expressed as:

� DI=PI-Direct Taxes

From consumption approach,

� DI=Consumption Expenditure + Savings

Per Capital Income (PCI) - Per Capita Income of a country is derived by dividing the national income of the country by

the total population of a country. Thus,

� PCI=Total National Income/Total National Population

What are the three methods of measuring national income? Primarily there are three methods of measuring national income. Which method is to be employed depends on the

availability of data and purpose. The methods are product method, income method and expenditure method. Product

method is given by Dr. Alfred Marshall, income method by A.C. Pigou and expenditure method by Dr. Iriving Fisher.

� According to product method, the total value of final goods and services produced in a country during a year is

calculated at market prices. According to this method only the final goods and services are included and the

intermediary goods and services are not taken into account.


� According to income method, the net income payments received by all citizens of a country in a particular year

are added up. The net incomes earned by the factors of production in the form of rent, wage, interest and profit

aggregated but incomes in the form of transfer payments are not included in the national income.

� According to the expenditure method, the total expenditure incurred by the society in a particular year is added

together. There expenditures include personal consumption expenditure, net domestic investment, Govt,

expenditure on goods and-services, and net foreign investments, Govt, expenditure and net foreign investment.

According to these methods total expenditure equals the national income.

The above three methods, it applied give identical results. It is wise to use any method in measuring national income.

The use of the above three methods depends on the level at which the national income is calculated. The product

method is used at the product level. Income method is used at income level and expenditure method is used at

expenditure level. As all the three methods are used to measure the lame physical output at three phases, namely

production, distributions and expenditure, they will provide the same national income. Below is given a chart showing

the reconciliation of the three methods of calculating GDP at market price. The choice of above three methods depends

on the level at which the national income is calculated. The product method is the principal method used in

underdeveloped economies, whereas income method is generally used in developed economics for the estimation of

national income.

Importance of Calculating National Income - Today, not well informed observer would neglect a country’s national

income reports. Following are the some of the important uses of national income estimates.

1. Level of Economic Welfare: National Income estimates reveal production performance of the economy per

capital income. Which is found by dividing the total national income by the populations given us an idea about

the average standard of living of the people which determines the economic welfare enjoyed by them.

2. Rate of Economic Growth: We can judge the rate of economic growth or development of a country by

measuring the rate of increase in national income. By comparing national income estimates over a period of

time, we can know whether the economy is growing stagnant of declining.

3. Inter Sectoral Comparison: In an economy, inter sectoral comparison can be made with the help or national

income statics. They show the contributions made by various sectors of the economy and also highlight the

sectors which reflects abnormal performance and need to be boosted up.

4. Distribution of Wealth: National income estimates highlight on the distribution of nation’s income among

different categories of income such as wages, profits, rents and interest. This distribution is of special

significance. Since inequality in personal; income depends to a large extent on the share of working classes

(wages) and the shares of property owner’s gains profits and interest.

5. Evaluate The Planning: National Income estimates over period of years enable us to evaluate the planning. They

provides us important data regarding consumptions, investments and savings which is indispensable for an

economic study since it is the rate of saving and investments in the economy that determines the rate economic

growth.

6. Comparison between the Economies of the World: With the help of national income estimates of various

countries of the world we can compare the standard of living and the levels of economic welfare of he people in

those countries. Moreover developed and under developed countries are usually classified on the basis of per

capital income.

7. Formation of Budget: National income estimate are also important in the formation of the budget by the

finance minister of the country. The amount of taxation and the money which can be got from the public is to be

determined keeping in view the national income figures.

8. Guide to Economic Policy: No development planning possible without national income estimates. By looking at

the national income statistics, the government can decide if the economy or its various sectors need any

simulated or regulation. Those estimates prove very useful for formulating planning and findings targets of

productions. Later, the government can assess or evaluate the achievements or otherwise of the development

targets laid down in the plans from the changes in the national income and its various components.

9. Role of Public and Private Sector in the Economy: Study of national income helps us to know the relative roles

of public and private sector in the economy.


10. Problems of Inflation and Deflation Can Be Controlled: National income estimate help the economists and

government a lot in controlling inflation or deflation on the basis of these figures of consumption, savings and

investments in the country.

11. Information about Balance of Payment: The national income shows us the import and export condition of the

country.

12. Importance of Entrepreneurs: Entrepreneurs always explore profitable opportunities in any sector of the

economy for making investment. National Income statistics help them in this direction.

13. Importance for Political Parties: Political parties analyze national income thoroughly to identify economic

problems of the people. Thereafter they make commitments to solve the economic problems like poverty,

unemployment, inflation, unequal distribution of wealth etc. in their election manifestos.

DETERMINATION OF EQUILIBRIUM NATIONAL INCOME IN A TWO SECTOR ECONOMY J.M. Keynes in his famous book, “General theory”, has used two methods for the determination of national income at a

particular time, (1) Saving investment Method and (2) Aggregate Demand and Aggregate Supply Method. Both .these

approaches lead us to the determination of the same level of national income.

It may here be mentioned that Keynes model of income determination is relevant in the context of short run only.

Keynes assumes that in the short run,

1. The stock of capital, technique of production, forms of business organizations, does not change.

2. He also assumes a fair degree of competition in the market (

3. There is also absence of government role either as a taxer or as a spender

4. Keynes further assumes that the economy under analysis is a closed one. There is no influence of exports and

imports on the economy.

Determination of National Income by the Equality of Saying and Investment - This approach is based on the

Keynesian definitions of saving and investment. According to Keynes, the .level of national income, in the short run, is

determined at a point where planned or intended saving is equal to planned or intended investment. Saving as defined

by Keynes is that part of income which is not spent on consumption (S=Y-C). On the other hand, investment is the

expenditure on goods and services not meant for consumption. (1=Y-C). .

According to Keynes, if at any time, the intended saving is less than intended investment, it implies that people are

spending more on consumption. The rise, in consumption will reduce the stock of goods in the market. This will give

incentive to entrepreneurs to increase output. Likewise, if at any time intended saving is greater than intended

investment, this would mean that people are spending lesser volume of money on consumption. As a result of this, the

inventories of goods will pile up. This will induce entrepreneurs to reduce output. The result of this will be that national

income would decrease. The national income will be in equilibrium only when intended saving is equal to intended

investment.

Illustration. The determination of national income is now explained with the help of saving and investment curve below.

In figure (31.2), income is measured on OX axis and saving and investment on OY axis, SS is the saving curve which shows

intended saying at different levels of income.

The investment curve is drawn parallel to the X axis which shows that investment does not change. The entrepreneurs

intend to invest Rs. 50 crore only irrespective of the amount of income. Saving (SS) and investment curves (II’) intersect

each other at point M. If the conditions stated above remain the same, the size of equilibrium level of income is Rs.250

crore.


Income saving and investment or disequilibrium, the forces will operate in the economy and restore the equilibrium

position. Let us suppose that the income has increased from the equilibrium level OL to ON (Rs. 300 crore). At this level

of income, desired saving is greater than the desired investment. When intended saving exceeds planned or intended

investment, the businessmen will not be able to dispose of all their current output. They will slow down their productive

activities. This will result in reducing -the number of workers employed in factories and a decrease in the income. This

process will go on until due to a decrease in income, people’s saving is reduced to the level of investment (Rs.50 crore).

The equilibrium income is Rs. 250 crore. In the same way, income cannot remain below this equilibrium level of Rs. 250

crore. If at any time, income falls below the equilibrium level, then it means that people are investing more than they

are willing to save 1 > S. They will increase productive activities as they are making high profits. The number of workers

employed in the factories will increase. This will result in an increase in income and higher saving. This rise in national

income will go on up to a point where saving and investment are just in balance and that will be the equilibrium level. At

this point, income will have the tendency of neither to rise nor to fall. It will be in a state of rest. It is, thus, clear that

national income is determined at a point where the intended investment is equal to intended saving.

Determination of Equilibrium level of National Income according to Aggregate Demand and Aggregate

Supply Approach - While determining the level of national income in a two sector economy, it is assumed that it is an

economy where there is no role of the government and of foreign trade. In other words, it is a closed economy with no

government intervention. The two sector economy comprises of households and firms. According to J. M. Keynes, the equilibrium level of national income is that situation in which aggregate demand (0+1) is

equal to aggregate supply (C+S). The aggregate demand (0+1) refers to the total spending in the economy. In a two

sector economy, the aggregate demand is the sum of demands for the consumer goods (c) and investment goods by

households and firms respectively. The aggregate demand curve is positively sloped. It indicates that as the level of

national income rises, the aggregate demand (or aggregate spending) in the economy also rises.

Aggregate supply (C+S) is the flow of goods and services in the economy. In other words, the value of aggregate supply

is equal to the value of net national product (national income). The aggregate supply curve (C+S) is a positively sloped

450 helping line. It signifies that as the level of national income rises, the aggregate supply also rises by the same

proportion.

Equilibrium level of income - According to Keynesian model the equilibrium level of national income is determined at a

point where the aggregate demand curve intersects the aggregate supply curve. The 450 helping line represents

aggregate supply. By definition, output equals income on each point of aggregate supply curve. The determination of

the level of aggregate income is explained below.


In the figure 31.3, income is measured along OX axis and expenditure on OY axis. The aggregate demand curve (0+1)

intersects the aggregate supply curve (45° line) at point K point. K, here, is the only point where the economy is willing

to spend exactly the amount which is necessary to dispose off the •entire output. The equilibrium level of income is Rs.

250 billion. It may, however, be noted that this equilibrium output does not mean in any way the full employment

output.

Departure from Equilibrium Level of Income: Now a question arises that if at any time there is a departure from the

equilibrium income of Rs. 250 billion, how will the economy move towards an equilibrium level? To answer this

question, we examine two possible levels of income other than the equilibrium level. Let us suppose first that the actual

income is Rs. 300 billion rather than • Rs. 250 billion. According to aggregate demand, schedule 0+1, the actual

consumption + investment expenditure at an income of Rs. 300 billion falls short by Rs. 30 billion (shown by bracket).

This means that the goods worth Rs. 30 billion are not sold. When the inventories pile up with the business, they would

curtail this production and provide fewer jobs. There will thus be a decline in total income which will continue till the

income falls to the equilibrium level of Rs. 250 billion. Now let us suppose that the level of income falls to Rs. 100 billion.

According to aggregate demand schedule represented by 0+1 curve, the expenditure at this level exceeds income by Rs.

50 billion {shown by bracket). The increase in demand of consumer and investment goods will induce the businesses to

increase their output. The higher rate of production will provide more jobs to the workers. The level of income would

rise and the upward drive continues till the income reaches the equilibrium, level of Rs. 250 billion. We, thus, conclude

by saying that an economy sustains only that level of income where the total quantity supplied and the aggregate

quantity demanded are equal. At this equilibrium national income of Rs. 250 billion, the firms have neither the tendency

to increase output nor the tendency to decrease output. Hence, Rs. 250 billion , is the equilibrium level of national

income. The equilibrium output, in this simple Keynesian analysis, does not mean full employment.

Mangerial Economics

Documents

exchange of goods

household goods

goods of equal value

services flow

micro economics definition

demand of particular

monetary costs

opportunity costs