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The Scope and

Method of Economics

1DR SALABH MEHROTRA (Economics forManager')


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The Study of Economics

Economics is the study of

how individuals and societies

choose to use the scarceresources that nature and

previous generations have

provided.

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Why Study Economics?

An important reason for

studying economics is to

learn a way of thinking.

Three fundamental concepts:

Opportunity cost

Marginalism, and

Efficient markets



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Opportunity Cost

Opportunity costis the best

alternative that we forgo, or

give up, when we make achoice or a decision.

Nearly all decisions involve

trade-offs.



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Marginalism

In weighing the costs andbenefits of a decision, it is

important to weigh only thecosts and benefits that arisefrom the decision.



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Marginalism

For example, when a firm decides

whether to produce additional

output, it considers only theadditional(or marginal cost), not

the sunk cost.

Sunk costs are costs that cannot be

avoided, regardless of what is done in

the future, because they have already

been incurred.



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Efficient Markets

An efficient marketis one in which

profit opportunities are eliminated

almost instantaneously. There is no free lunch! Profit

opportunities are rare because, at

any one time, there are manypeople searching for them.



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More Reasons to Study Economics

The study of economics is an

essential part of the study of

society. Economic decisions often have

enormous consequences.

During the Industrial Revolution, newmanufacturing technologies and

improved transportation gave rise to

the modern factory system.



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The Scope of Economics

Microeconomics is the

branch of economics that

examines the behavior ofindividual decision-making

unitsthat is, business firms

and households.



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Macroeconomics is the

branch of economics that

examines the behavior ofeconomicaggregates

income, output, employment,

and so onon a nationalscale.



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Examples of microeconomic and macroeconomic concerns

Production Prices Income Employment

Microeconomics Production/Output

in Individual

Industries and

Businesses

How much steel

How many offices

How many cars

Price of Individual

Goods and

Services

Price of medical

care

Price of gasoline

Food prices

Apartment rents

Distribution of

Income and Wealth

Wages in the auto

industry

Minimum wages

Executive salaries

Poverty

Employment by

Individual

Businesses &

Industries

Jobs in the steel

industry

Number of

employees in a firm

Macroeconomics National

Production/Output

Total Industrial

Output

Gross Domestic

Product

Growth of Output

Aggregate Price

Level

Consumer prices

Producer Prices

Rate of Inflation

National Income

Total wages andsalaries

Total corporate

profits

Employment and

Unemployment inthe Economy

Total number of

jobs

Unemployment

rate



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The Method of Economics

Positive economics studies

economic behavior without

making judgments. Itdescribes what exists and

how it works.



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The Method of Economics

Positive economics includes:

Descriptive economics, which

involves the compilation of data thatdescribe phenomena and facts.

Economic theory, which involves

building models of behavior.

An economictheoryis a generalstatement of cause and effect, action

and reaction.



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Managerial Economics Defined

The application of economic theoryand the tools of decision science toexamine how an organization can

achieve its aims or objectives mostefficiently.

A close interrelationship between

management and economics has ledto the development of managerialeconomics.



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What is Managerial Economics?

Howard Davies and Pun-Lee Lam -

It is the application of economic analysis tobusiness problems; it has its origin in theoretical

microeconomics.



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Cont.

The Law of Diminishing Marginal Utility

Marginal utility refers to the change in satisfaction which results when a little more or little

less of that good is consumed. For example, when a thirsty person takes five bottles of cold

drink continuously, the consumption of first bottle gives him utility, second bottle gives him

lesser utility than first but his total utility increases. Third bottle gives him still less utility

but increases total utility. The utility from fourth bottle may be zero as he is no more

thirsty. But the fifth bottle may cause uneasiness and thus give negative utility, i.e., the

total utility may now actually go down.

Bottle consumed Total Utility (Units) Marginal Utility (Units)

0 0

1 14 14

2 23 9

3 27 4

4 27 0

5 24 3

6 18 6



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Demand schedule & demand curve

Demand schedule: it refers to a table / tabular

statement which shows relationship b/w price

& demand. It is of two types: individual &

market.

Demand curve: it is a graphic representation

of demand schedule expressing the

relationship b/w price & demand . It is of twotypes: individual & market.



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Increase in Demand Decrease in Demand50DR SALABH MEHROTRA (Economics forManager')


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d) Individual's demand and market demand (firm should be

concern with market demand& consumer should be with

individual demand)

e) Firm and industry demand

f) Demand by market segments and by total market( if

market is large in terms of geog. Area, product use,

customer size distribution channel etc) then it is imp. todistinguish market by specific segments for a meaningful

analysis.

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Classification of Demand Curves


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Classification of Demand CurvesAccording to Their Elasticity

when price changes we can classify all demand curves

in the following five categories:

i. Perfectly inelastic demand curve (Ed=o) fig a

ii. Inelastic demand curve(Ed1) fig e

v. Perfectly elastic demand curve(Ed=) fig c


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Cont.

(b)(a)

(c)


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Ed1

fig e

10

5

50 70

5

10

50 150


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Income Elasticity

The income elasticity of demand is a numerical measure of the degree to which quantity

demanded responds to a change in income, other determinants of demand being kept

constant.

For example, let there be two goods, clothing and salt. Let the consumers income increase

by 5%. Then the percentage change (increase) in quantity demanded would be different for

clothing and different for salt (the percentage increase in quantity demanded for clothing islikely to be much higher than that for salt). Thus, clothing and salt are said to have a

different income elasticity of demand. Thus, for the same percentage increase in income

(i.e., 5%) the percentage increase in the quantity demanded for different goods is different.

Income elasticity of demand provides us with a numerical measure of this difference.

Thus, income elasticity of demand allows us to compare the sensitivity of the demand for

various goods for the same change in income. From the definition,

e1 =%change in quantity demanded

%change in income


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Importance of Elasticity of Demands


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Importance of Elasticity of Demands

The concept of elasticity of demand is quite

useful.

To business firms

In international trade

In fiscal policy


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Statistical Methods of Demand Forecasting

Statistical Methods

Trend Projection Methods Econometric Methods

Graphical

Methods

Least Squares

MethodsRegression

Method

Simultaneous

Equation Method

Barometric Methods

Types of Statistical Methods


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Leading Indicators are variables which moves up anddown ahead of other related variable like new ordersfor durable goods, enrolment in school etc.

Coincidental series are ones that moves up or down

along with level of general economic activities likenumber of employees in the non agricultural sectors,rate of unemployment

Lagging series consist of those indicators that follow a

change after some time/ are variables which fallbehind other related variables e.g. average durationof unemployment, labor cost per- unit of output

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Cont.

Regression Methods of Demand Forecasting

In regression techniques of demand forecasting, the analysts estimate the demand function

for a product. In the demand function, quantity to be forecast is a departmentvariable

and the variables that affect or determine the demand (the department variable) one

called as independent or explanatory variables.

The hypothetical data of consumption of sugar given in table.

Year Population Sugar Consumed(millions) (000) tones)

1995-96 10 40

1996-97 12 50

1997-98 15 60

1998-99 20 70

2000-2001 25 80

2001-2002 30 90

2002-2003 40 100

Consumption of Sugar

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The Production Process

Production is a process in which economic resources or inputs (composed of natural

resources like labour, land and capital equipment) are combined by entrepreneurs to create

economic goods and services (outputs or products).

Production Management

Pollution

Goods & Services

Labour

Natural

Resources, Land

Capital, Equipment

Machines

CONTROL

O

U

T

P

U

T

S

I

N

P

U

T

S

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Cont.

The Production Function

The task of a production unit is to organize a production process a process of combining

the different factors in some proportion so that those inputs can be efficiently transformedinto products or outputs. Various terms are used for inputs and outputs.

INPUTS OUTPUTS

Factors Quantity (Q)

Factors of production Total Product (P)

Resources Product

'A production function defines the relationship between inputs and the maximum amount

that can be produced within a given period of time with a given level oftechnology

Q=f(L,K,N,R,E)

Q= output N= Land input

L= Labour R= Raw material

k=capital E= efficiency parameter

Two special features of a production function are given below:

a. Labour and capital are inputs to produce any quantity of a good, and

b. Labour and capital are substitutes to each other in production. 83DR SALABH MEHROTRA (Economics for

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Types of production function

Short Run Production function or Law of

Variable Proportion or One variable input

Case long Run Production or Production with all

variable input

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Short Run Production function or Law


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Short Run Production function or aw

of Variable Proportion

It shows the maximum output a firm canproduce when only one of its inputs can be

changed ,while other inputs remaining fixed, it

can be , Q=f(L,K) Q= output, L= labour ,K= fixed amount of capital thus it is possible to substitute some capital by labour

As a result ratio b/w fixed & variable inputs also changes

This law states that beyond a certain a certain point further increase in

employment of variable factors will lead to smaller increase in total output

Therefore it is also called Diminishing Marginal Returns

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Cont.

Fixed inputs

grossly under

utilized,

specialization and

team work cause

APP to increase

when additional X

is used

Specialization

and teamwork

continue and

result in greater

output when

additional X is

used, fixed input

is being properly

utilized.

Fixed inputs

capacity is

reached,

additional X

causes output to

fall

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The Production Function with Two Variable Inputs

A firm may increase its output by using more of two variable inputs that are substitutes for

each other, e.g., labour and capital.

The technical possibilities of producing an output level by various combinations of the two

factors can be graphically represented in terms of an isoquant (also called iso-product

curve, equal-product curve or production indifference curve).

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Isoquants

Isoquants are a geometric representation of the production function. The same levelof output can be produced by various combinations of factor inputs. Assuming

continuous variation in the possible combination of labour and capital, we can draw

a curve by plotting all these alternative combinations for a given level of output. This

curve which is the locus of all possible combination is called the 'isoquant'.

OR

it is defined as the locus of various combinations of two inputs in the existing state

of technology to produce a given level of output.

OR

It is a curve that shows all possible combinations of inputs that gives same level of

output

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Cont.

Isocost Lines

If a firm uses only labour and capital, the total cost or expenditure of the firm can be

represented by

C = wL + rK

where C = total cost

w = wage rate of labour

L = quantity of labour used

r = rental price of capital

K = quantity of capital used

Isocost line

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Cont.

Returns to Scale

Returns to scale are classified as follows:

1. Increasing Returns to Scale (IRS)

2. Constant Returns to Scale (CRS)

3. Decreasing Returns to Scale (DRS)

Returns to scale

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Economies of Scale


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Economies of Scale

These occur when mass producing a good resultsin lower average cost.

Average costs fall per unit Average costs per unit

= total costs / quantity produced Economies of scale occur within an firm (internal) or

within an industry (external).

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Internal and External Economies


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Internal and External Economies

Internal Economies of Scale

As a business grows in scale, its costs will fall due to

internal economies of scale. An ability to produce units

of output more cheaply.

External Economies of Scale

Are those shared by a number of businesses in thesame industry in a particular area.

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These are advantages gained for the wholeindustry, not just for individual businesses.

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Examples of External Economies


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Examples of External Economies

As businesses grow within an area, specialist skillsbegin to develop.

Skilled labour in the area local colleges may begin

to run specialist courses. Being close to other similar businesses who can

work together with each other.

Having specialist supplies and support servicesnearby.

Reputation

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Diseconomies of Scale


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Types of diseconomy of

scale

Example

Communication When firms grow there can be problems with communication

As the number of people in the firm increases it is hard to get

the messages to the right people at the right time

In larger businesses it is often difficult for all staff to know

what is happening

Coordination and control

problems

As a business grows control of activities gets harder

As the firm gets bigger and new parts of the business are set

up it is increasingly likely people will be working in different

ways and this leads to problems with monitoring

Motivation As businesses grow it is harder to make everyone feel as

though they belongLess contact between senior managers and employees so

employees can feel less involved

Smaller businesses often have a better team environment

which is lost when they grow

Diseconomies of Scale

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Causes of operation of law of


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increasing returns

Division of labor or specialization Economics of management i.e. increases in

managerial efficiency

Capacity utilization with the increase in unitsof labor

Favorable factor ratio

Economics of buying and selling ( higherbarraging power, quick availability of freight,cheap credit facility etc.


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Limitation & Scope


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Limitation & Scope

This law applies only at initial stage becauseinitially increase in variable factors improves

productivity of labor & capital

It cannot continue indefinitely. This law applies all the field of production till

an optimum ratio is established


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Causes of operation of diminishing


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return

Fixity of one or more factors of production

Scarcity of productive resources

Going beyond the optimum combination of

factors of production

Factor of production are not perfect

substitutes for one another


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The Cobb-Douglas Production Function


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The Cobb Douglas Production Function

The Cobb-Douglas production model was identified by the economist & C.W. Cobb&Paul

Douglas This function is based on the empirical study of American manufacturing industries. It takes intoaccounts only two inputs labor and capital

The simplest production function is the Cobb-Douglas model. It has the following form:

Q=ALbCc

where Q stands for output, L for labor, and C for capital. The parameters a, b, and c (the latter twobeing the exponents) are estimated from empirical data.

The equation tells that output depends directly on L &C and that part of output which cannot beexplained by L & C is explained by A which is residual often called technical change

The production function proposed by Cobb Douglas has contribution to increase inmanufacturing industries and of labor

If b + c = 1, the Cobb-Douglas model shows constant returns to scale. If b + c > 1, it showsincreasing returns to scale, and if b + c < 1, diminishing returns to scale.


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Properties of Cobb-Douglas


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production function

There are constant return to scale Elasticity of substitution is equal to one

b and c represent the labor and capital shares of output respectively.

If one of the inputs is zero, output will also be zero

The marginal product of labor is equal to the increase in output when the

labor input is increased by one unit.

The average product of labor is equal to the ratio between output and

labor input


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Importance Of Cobb-DdouglasProduction Function


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Production Function

Convenient for international and inter industrycomparison.

Captures the non linear production process

Used to investigate the nature of long runproduction function

Simplest form of production function with 2

varriables


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Criticisms of function


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Criticisms of function

Based on assumption perfect competition Consider only two inputslabor & capital

Based on assumption of constant returns to scale

Assumes all units of inputs of production are identical in

nature

There is problem of measurement of capital which takes only

the quantity of capital available for production

It does not fit to all industries.

The parameters cannot give proper and correct economic

implication.


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Cont.

Concept of Supply

Supply is the willingness and ability of producers to make a specific quantity of output

available to consumers at a particular price over a given period of time.


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Cont.

Law of Supply

Supply refers to the various quantities offered for sale at various prices. According to the

Law of Supply, more of a good will be supplied the higher its price, other things constant or

less of a good will be supplied the lower its price, other things remaining constant.

The Supply Curve


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Cont.

Important shift factors of supply are:

Price of commodity

Natural factors

Changes in the prices of inputs used in production of a good

Changes in technology

Changes in suppliers expectations

Changes in taxes and subsidies


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Cont.

The major variables other than price are:

Movements along a supply curve

Movements along a supply curve


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Cont.

Shifts in Supply versus movement along a Supply Curve


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Cont.

ELASTICITY OF SUPPLY

The elasticity of supply, Es, is measured by using the formulae

or

Where P = original price, Q= original quantity supplied, dP = change in price, dQ = change in

quantity supplied.

EsPercentagechange inquantity supplied

Percentagechange inprice

EsP dQ

Q dP


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Factors influencing Elasticity of Supply


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1) Nature of product

2) Time factor

3) Ability to store the product

4) Barriers to entry

5) Future expectation6) nature of inputs


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Cont.

3. Perfectly Inelastic Supply 4. Perfectly Elastic Supply

Es = 0 Es =

Quantity supplied remains the Suppliers will produce an

same, whatever the price unlimited quantity at the existing price

5. Unit Supply Elasticity

Es = 1

Quantity supplied changes in

proportion to (by the same

percentage as) price.

(Price) Elasticity of Supply (Es)


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Costs


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Costs


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Costs

In buying factor inputs, the firmwill incur costs

Costs are classified as:

Fixed costs costs that are not related directly toproduction rent, rates, insurance costs, admin costs.They can change but not in relation to output

Variable Costs costs directly relatedto variations in output. Raw materials primarily


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Costs


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Costs

Total Cost - the sum of all costs incurred inproduction

TC = FC + VC

Average Cost the cost per unit

of output AC = TC/Output

Marginal Cost the cost of one more or one fewerunits of production

MC= TCn TCn-1 units


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Short run costs


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Short run costs

In the short run consider fixed and variable costs

Average total cost line is U-shaped as when

diminishing returns start to kick in the average total

cost per unit increases


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Cont.

Costs in the Short Run

The short run cost-output relationship needs to be

discussed in terms of:

Total cost and output

Average costs and output

Marginal cost and output


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Total cost

123

Total variablecost Total fixedcost


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Total cost: total cost is the sum of totalvariable cost and total fixed cost

TC = TVC+TFC

Total variable cost: total variable cost (TVC) atany output level consists of payments to the

variable factors used to produce that output.

TVC = TC-TFC


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Short Run Average Costs and Output


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Cont.

Short Run Average Costs and Output

Average Fixed Cost (AFC)

Average fixed cost is the total fixed cost divided by the number of units of output

produced. Therefore,

AFC=TFC

Q


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Average Variable Cost (AVC)


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Cont.

Average Variable Cost (AVC)

Average variable cost is the total variable cost divided by the number of units of output

produced. Therefore,

Thus, average variable cost is the variable cost per unit of output.

We know that the total variable cost (TVC) at any output level consists of payments to the

variable factors used to produce that output.

AVC =TVC

Q


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Average Total Cost (ATC)


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Cont.

Average Total Cost (ATC)

The average total cost or what is called simply average cost is the total cost divided by the

number of units of output produced. Therefore,

Since the total cost is the sum of total variable cost and total fixed cost, the average total

cost is also the sum of average variable cost and average fixed cost.

This can be proved as follows:

Since TC = TVC+TFC

Therefore,

= AVC + AFC

ATC =TC

Q

ATC =TC

Q

ATC=TVC+ TFC

Q

=TVC

Q

TFC

Q+


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Short Run Marginal Cost (MC) and Output


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Short Run Marginal Cost (MC) and Output

Marginal cost is the addition to the total cost caused by producing one more unit of output.

In other words, marginal cost is the addition to the total cost of producing n units insteadof n-1 units.

MCn = TCnTCn-1

In symbols, marginal cost is rate of change in total cost with respect to a unit change in

output, i.e.,

where d in the numerator and denominator indicates the change in TC and Q respectively.

Marginal cost is due to change in variable cost because it is only variable cost that change

in short run .The independence of the marginal cost from the fixed cost can be proved

algebraically as follows:

MCn = TCn TCn1= (TVCn + TFC) (TVCn1 + TFC)

= TVCn + TFC TVCn1 TFC

= TVCn TVCn1

MC =d(TC)

dQ


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Cont.

Unit of Total Cost TC Average Cost MC={(TCn)(TCn1)goods AC=TC/units

produced produced

1 2 3=2/1 4

10 5000 500

11 5300 481.82 300

12 5550 462.5 25013 5700 438.46 150

14 5950 425.0 250

15 6350 423.33 400

The Relationship between MC, AC and TC

Advantage of TC: break-even analysis profit of firm

Advantage of AC: calculating per unit profit of a firmAdvantage of MC: to decide whether a firm needs to expand or not


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AFC declines continuously AVC declines first, reaches aminimum point and rises thereafterward

ATC declines first reaches aminimum & rises thereafter

When ATC attains its minimumMC equals ATC

MC first declines reaches aminimum then rises.

MC equals AVC & ATC when thesecurves attain minimum levels

MC lies below both AVC & ATCwhen they are declining

MC lies above when AVC& ATCare rising.

0X

Y

MC

ATC

AFC

AVC

Q1

Q2

Q3

Average

Cost

Marginal

Cost

Quantity


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The Short Run Cost Function


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131

Mathematically,

AVC = TVC/Q

AFC = TFC/Q

ATC=TC/Q=(TFC+TVC)/Q=AFC+AVC


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The Short Run Cost Function


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132

Table illustrates how the short run costmeasures can be calculated.


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The LR Relationship Between

Production and Cost


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133

Production and Cost

In the long run, all inputs are variable. In the long run, there are no fixed costs

The long run cost structure of a firm isrelated to the firms long run productionprocess.

The firms long run production process isdescribed by the concept of returns to

scale.


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Production and Cost


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134

Production and Cost

Economists hypothesize that a firms long-runproduction function may exhibit at first

increasing returns, then constant returns, and

finally decreasing returns to scale.

When a firm experiences increasing returns to

scale

A proportional increase in all inputs increases

output by a greater percentage than costs.

Costs increase at a decreasing rate


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Production and Cost


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135

Production and Cost

When a firm experiences constant returns toscale

A proportional increase in all inputs increasesoutput by the same percentage as costs.

Costs increase at a constant rate When a firm experiences decreasing returns to

scale

A proportional increase in all inputs increasesoutput by a smaller percentage than costs.

Costs increase at an increasing rate


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The Long-Run Cost Function


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136

Long run marginal cost (LRMC) measures thechange in long run costs associated with achange in output.

Long run average cost (LRAC) measures theaverage per-unit cost of production when allinputs are variable.

In general, the LRAC is u-shaped.


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137

When LRAC is declining we say that the firm isexperiencing economies of scale.

Economies of scale implies that per-unit costs

are falling. When LRAC is increasing we say that the firm

is experiencing diseconomies of scale.

Diseconomies of scale implies that per-unitcosts are rising.


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138

The figureillustrates the

general shape

of the LRAC.


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139

Reasons for Economies of Scale Increasing returns to scale

Specialization in the use of labor and capital

Indivisible nature of many types of capital

equipment Productive capacity of capital equipment rises

faster than purchase price

Discounts from bulk purchases

Lower cost of raising capital funds Spreading promotional and R&D cost

Management efficiencies


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140

Reasons for Diseconomies of Scale

Decreasing returns to scale

Disproportionate rise in transportation costs

Input market imperfections

Management coordination and control

problems

Disproportionate rise in staff and indirectlabor


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The Long Run Average

Cost Curve is Derived from

Sh t R C t C

Cost

Per

Unit


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Short Run Cost Curves

Suppose there are three plants

operate with average costsSAC1,SAC2 & SAC3

If firm plans to produce Q1 output it

will choose smallest plant

It will choose medium plant size if it

plans to produce Q2

Larger plant if it produce Q3 outputIf the firm starts with smallest plant

and faces increase in demand it will

increase its output

It will continue producing with small

plant(have lowest cost level ) beyond

Q1 as average cost is still lower incompare to medium plant

It is only when demand for its

product reaches the level Q2 the firm

has to choose b/w plant A OR B

Process go on & on for further plant

0

Output (Q)

Q1

Q2

Q3

Q4

Unit

C1

C2

SAC1

SAC2

SAC4

SAC3


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Explanation of the U-shape of the Long Run Average Cost Curve


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p p g g

0

Output (Q)X*

Cost

PerUnit

SAC1

SAC2

SAC3

SAC4

SM

LMC LAC

SAC5

SAC6

Short Run and Long Run Cost Curves


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144

In the long run the firm is able to adjust itsplant size.

LRAC tells us the lowest possible per-unit cost

when all inputs are variable. What is the LRAC in the graph?


Manager')



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145

In the long run the firm is able to adjust itsplant size.

LRAC tells us the lowest possible per-unit cost

when all inputs are variable. What is the LRAC in the graph?


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Learning curves


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Learning by doing in economics refers to process by whichproducers learn from experience

Production technique available to real world are regularlychanging because of learning by doing

Technological change on the other hand is an increase in therange of production techniques

The concept of learning curve represent the extent to whichaverage cost declines in relation to increase in output

This concept is based on the assumption that individuals whoperform anything over number of times will get better

Learning curve initially has a steeper slope, then it becomes

flatter indicating that it would be very hard to realize costadvantage as most of the learning opportunities are alreadyexploited.


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The Learning Curve


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The Learning Curve

A downward slope

in the learning curve

indicates the presence

of the learning curve

effect. It shows

workers improve theirproductivity with

practice

The learning curve

effect acts to shift theSRAC downward.


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Economies of Scope


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The reduction of a firms unit cost by

producing two or more goods or services

jointly rather than separately.


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Opportunity costs


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A benefit, profit, or value of something that must be given up toacquire or achieve something else. Since

every resource (land, money, time, etc.) can be put to

alternative uses, every action, choice, or decision has

an associated opportunity cost.

Opportunity costs are fundamental costs in economics, and are

used in computing cost benefit analysis of a project. Such costs,

however, are not recorded in the account books but are

recognized in decision making by computing

the cash outlays and their resulting profit or loss.


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Accounting Cost Monetary value of economic resources used in performingan activity.

Economic Cost, The sacrifice involved in performing an activity, or followinga decision or course of action. It may be expressed as the total of opportunitycost (cost of employing resources in one activity than the other) and accountingcosts (the cash outlays)

Real Cost When cost is expressed in terms of physical or mental efforts put in by aperson in the making of a product, it is called as real cost

ORThe overall actual expense involved in creating a good or service forsale to consumers. The real cost of production for a business typically includesthe value of all tangible resources such as raw materials and labor that are used inthe production process.

Money Cost When cost is expressed in terms of money, it is called as money cost.

It relates to money outlays by a firm on various factor inputs to produce acommodity.


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Perfect competition


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Generally, a perfectly competitive market exists when every participant is a "pricetaker", and no participant influences the price of the product it buys or sells.Specific characteristics may include:

Large number of buyers and sellersInfinite consumers with the willingness andability to buy the product at a certain price, and infinite producers with thewillingness and ability to supply the product at a certain price.

Free entry and exit barriersIt is relatively easy for a business to enter or exit ina perfectly competitive market.

Perfect factor mobility - In the long run factors of production are perfectly mobileallowing free long term adjustments to changing market conditions.

Perfect information - Prices and quality of products are assumed to be known toall consumers and producers.

Zero transaction costs - Buyers and sellers incur no costs in making an exchange(perfect mobility).

Profit maximization - Firms aim to sell where marginal costs meet marginalrevenue, where they generate the most profit.

Homogeneous productsThe characteristics of any given market good or servicedo not vary across suppliers.

Uniform price


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Monopolistic competition


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Large number of buyers and sellers but less thanperfect.

product differentiation

many firms

free entry and exit in long run Independent decision making

Market Power

Buyers and Sellers have im-perfect information

Downward slopping demand curve but more elasticity. Examples restaurants, professions solicitors, etc., building firmsplasterers, plumbers, etc.


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Monopoly


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Single seller: In a monopoly there is one seller of the good who producesall the output.[ Therefore, the whole market is being served by a single firm,

and for practical purposes, the firm is the same as the industry.

Market power: Market power is the ability to affect the terms and conditions

of exchange so that the price of the product is set by the firm (price is not

imposed by the market as in perfect competition).Although a monopoly's

market power is high it is still limited by the demand side of the market. Amonopoly faces a negatively sloped demand curve not a perfectly inelastic

curve. Consequently, any price increase will result in the loss of some

customers.

Firm and industry: In a monopoly, market, a firm is itself an industry.

Therefore, there is no distinction between a firm and an industry in such a

market.

Price Discrimination: A monopolist can change the price and quality of the

product. He sells more quantities charging less price against the product in

a highly elastic market and sells less quantities charging high price in a less

elastic market.154


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What is an oligopoly? An oligopoly is an economic condition in which there are so few


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independent suppliers of a particular product

.Oligopoly is a form of market where there is domination of a limitednumber of suppliers and sellers called Oligopolists.In an oligopoly,

there are at least two firms controlling the market.

An oligopoly is a market dominated by a few large suppliers. The

degree of market concentration is very high. Firms within an

oligopoly produce branded products and there are also barriers to

entry.

Another important characteristic of an oligopoly is interdependence

between firms. This means that each firm must take into account the

likely reactions of other firms in the market when making pricing and

investment decisions.

The retail gas market is a good example of an oligopoly because a

small number of firms control a large majority of the market.


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What is an Oligopoly?


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Oligopoly is best defined by the market conduct(behaviour) of firms

A market dominated by a few large firms I.e.

Competition amongst the few

High level ofmarket concentration

Concentration ratio is the market share of the

leading firms

Each firm tends to produce branded / differentiatedproducts


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What is an Oligopoly?


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Entry barriers long run supernormal profits

Mutual interdependence between competing firms(important)

Intensive non-price competition is common

Periodic aggressive price wars

Strong tendency for many market structures to tendtowards oligopoly in the long run

Market consolidation

Exploitation of economies of scale Interdependence - either firm will not take an action unless

it considers the reaction from the other firms


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Market Structure


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Examples of oligopolistic structures: Supermarkets

Banking industry

Chemicals

Oil

Medicinal drugs

Broadcasting


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Pricing and Output in

Monopolistic Competition


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p p

The demand curve of a monopolisticallycompetitive firm is highly, but not perfectly,elastic.

The price elasticity of demand for a monopolistic

competitor depends on the number of rivals andthe degree of product differentiation.

The larger the number of rival firms and theweaker the product differentiation, the greater

the price elasticity of each firms demand.

.


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The Short Run: Profit or Loss


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The monopolistically competitive firmmaximizes profit or minimizes loss in the short

run. It produces a quantity Q at which MR =

MC and charges a price P based on its demandcurve.

When P > ATC, the firm earns an economic profit.

When P < ATC, the firm incurs a loss.


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The Long Run:

Only a Normal Profit


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In the long-run, firms will enter a profitablemonopolistically competitive industry and

leave an unprofitable one.

A monopolistic competitor will earn only anormal profit and price just equals average

total cost at the MR = MC output.


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The Long Run:



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Because entry to the industry is relativelyeasy, economic profits attract new rivals.

As new firms enter, the demand curve faced bythe typical firm shifts to the left, reducing its

economic profit. When entry of new firms has reduced demand to

the extent that the demand curve is tangent tothe ATC curve at the profit-maximizing output, the

firm is just making a normal profit, leaving noincentive for new firms to enter.


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The Long Run:



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When the industry suffers short-run losses,some firms will exit in the long run.

As firms exit, the demand curve of surviving firms

begins to shift to the right, reducing losses until

the firms are just making normal profit.


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Price determination in perfect market


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165

In the short-run, it is

possible for an

individual firm to make

aneconomic profit.This situation is shown

in this diagram,

as the price or average

revenue, denoted byP,is above the averagecost denoted byC.


Manager')

in the long period, economicprofit cannot be sustained. The

arrival of new firms or expansion

of existing firms (if returns to
http://en.wikipedia.org/wiki/File:Economics_Perfect_competition.svghttp://en.wikipedia.org/wiki/File:Perfect_competition_in_the_short_run.svg


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scale are constant) in the market

causes the (horizontal) demandcurve of each individual firm to

shift downward, bringing down at

the same time the price, the

average revenue and marginal

revenue curve. The finaloutcome is that, in the long run,

the firm will make only normal

profit (zero economic profit). Its

horizontal demand curve will

touch its average total cost

curve at its lowest point.


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Price and Output Determination in

monopoly
http://en.wikipedia.org/wiki/File:Perfect_competition_in_the_short_run.svghttp://en.wikipedia.org/wiki/File:Perfect_competition_in_the_short_run.svg


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Objective of monopolies Maximize profits First determine profit-maximizing output

Then determine price required to sell output

Alternatively, they can first determine profit-maximizing price

Then from market demand curve determine level of output that can besold at this price

Resulting profit-maximizing price/output combination will be the same

Regardless of which method is employed

Both are based on a monopolys determining its equilibrium price and outputgiven market demand curve

Market demand curve is downward sloping If a monopoly reduces output, price it receives for this output will

increase


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The Profit-Maximizing Output Level


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168

To maximize profit, the firm should producelevel of output where MC = MR and

MC curve crosses MR curve from below

For a monopoly, price and output are notindependent decisions

But different ways of expressing the same decision


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Profit And Loss


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170

A monopoly earns a profit whenever P > ATC Its total profit at best output level equals area of a

rectangle

Height equal to distance between P and ATC

Width equal to level of output A monopoly suffers a loss whenever P < ATC

Its total loss at best output level equals area of a rectangle

Height equal to distance between ATC and P

Width equal to level of output


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Monopoly Profit and Loss


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171

E

MR10,000

$40

MC

32

TotalProfit

ATC

D

E

Total Loss

AVC

ATC

MR10,000

40

MC

D

$50

Dollars

(a)

Number ofSubscribers

Dollars

(b)

Number ofSubscribers


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Kinked Demand CurvePrice


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179

Kinked Demand Curve

P1

Starting price

179

DMR

MR Gap

QuantityQ1

E


Manager')


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Above the kink, demand is relatively elasticbecause all other firms' prices remain

unchanged. Below the kink, demand is

relatively inelastic because all other firms will

introduce a similar price cut, eventually

leading to a price war. Therefore, the best

option for the oligopolist is to produce at

point E which is the equilibrium point and thekink point.


Manager')

Graph explanation: Let P1 and Q1 be the
http://en.wikipedia.org/wiki/Price_warhttp://en.wikipedia.org/wiki/Price_war


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existing price and quantity for this

oligopoly firm: due to the assumptions

of this model, the demand curve has a

kink in it at this price and output.Because of the strange shape of the

demand curve, the MR curve is

discontinuous, or has a gap in it.


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What does the kinked demand


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182

curve illustrate? There is a great deal of price stability and

nonprice competition is important


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Inflation


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Inflation is an increase in the overall price

level.

Sustained inflation occurs when the overallprice level continues to rise over some fairly

long period of time.


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Monetary Policy


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The instrument of monetary policy (methods of credit control) may be

broadly divided into the following parts:

Quantitative methods;

a. Open Market Operations

b. Bank Rate

c. Cash Reserve Ratio (CRR)d. Statutory Liquidity Ratio (SLR)

e. Repo (Repurchase) rate& Reverse Repo rate(Liquidity Adjustment facility)

Qualitative methods

a. Selective Credit Controls (SCC)

b. Moral Suasionc. margin requirement


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CRR means Cash Reserve Ratio. Banks in India are requiredto hold a certain proportion of their deposits in the form

of cash. However, actually Banks dont hold these as cash with

themselves, but deposit such case with Reserve Bank of India

(RBI) / currency chests, which is considered as equivalent to

holding cash with themselves..This minimum ratio (that is thepart of the total deposits to be held as cash) is stipulated by the

RBI and is known as the CRR or Cash Reserve Ratio. .

Therefore, higher the ratio (i.e. CRR), the lower is the amount

that banks will be able to use for lending and investment. Thus, it is a tool used by RBI to control liquidity in the banking

system.


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( h ) h h h h l d h


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Repo (Repurchase) rate is the rate at which the RBI lends shot-term

money to the banks. When the repo rate increases borrowing fromRBI becomes more expensive. Therefore, we can say that incase, RBI wants to make it more expensive for the banks to borrowmoney, it increases the repo rate; similarly, if it wants to make itcheaper for banks to borrow money, it reduces the repo rate

Reverse Repo rate is the rate at which banks park their short-termexcess liquidity with the RBI. The RBI uses this tool when it feelsthere is too much money floating in the banking system. Anincrease in the reverse repo rate means that the RBI will borrowmoney from the banks at a higher rate of interest. As a result, bankswould prefer to keep their money with the RBI


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Qualitative methods


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margin requirement ,it is gap between value of security andamount of loan if RBI wants to reduce money supply it will increase the gapbetween the two.

Selective credit control; any step in this will affect onlyselective sector not the entire economy.

Moral Suggestion; it includes moral suggestion by government/RBI


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PRODUCT MARKET

CIRCULAR FLOW OF INCOMEThe Circular Flow of Income 2 Sector Model


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Goods & Services

Payment for Goods & Services

Payment of factor income

Factor Services

FACTOR MARKET


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Two Sector Model with Financial Sector

PRODUCT MARKET


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Savings : Residual income that households do not use to purchase goods and services

FINANCIAL

SECTOR

Savings

(Leakage)

Investment

(Injection)

Investment : Expenditure on capital goods

Goods and Services

Factor Services

Payment for goods & services


FACTOR MARKET


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Three Sector Model

Goods and Services

PRODUCT MARKET


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Financial SectorSavings

(Leakage)

Investment

(Injection)

Factor Services



FACTOR MARKET

Equilibrium is achieved when leakages = injections

Savings + Taxes = Investment + Govt. Purchase + Payments

GOVERNMENT

(Leakage) (Leakage)

Taxes

Factor payments &

Transfer payments

Government purchases &

subsidies(Injection) (Injection)

Taxes


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Four Sector Model

Rest of theWorld

Payment for Imports

(Leakage)

Payment for Imports

(Leakage)


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Financial

Sector

Savings

(Leakage)

Investment

(Injection)

Goods and Services

Factor Services



PRODUCT MARKET

FACTOR MARKET

Government

(Leakage) (Leakage)

Taxes

Factor payments &

Transfer payments

Government purchases &

subsidies(Injection) (Injection)

Taxes

In Equilibrium : Leakages = Injections

Savings + Taxes + Imports = Investment + Govt. Expenditure & Transfers + Exports

World

Factor Income

(Injection)

Export Receipts

(Injection)


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Domestic Product vs National product

National income is the income earned by residents of an

economy


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economy

Domestic income = income of residents in the domestic

territory

+ income of non-residents in the

domestic territory

National income = income of residents in the domestic

territory

+ income of residents from abroad

National income = Domestic income

+ net factor income from abroad


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Definitions

NDPFC or Domestic Income Value of factor incomes received by factors of production in a given time period


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Takes place within the domestic territory Excludes net indirect taxes

Excludes depreciation

NNPFC or National Income Value of factor incomes received by residents of a country in a given time period

Includes net factor income from abroad

Does not include net indirect taxes

Does not include depreciation


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Value Added Method Concepts

When D in stock > 0Current output = Sales + Change in stock


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(100kg) (80kg) (20kg)

When D in stock < 0

(100kg) (120kg) (20kg)

*Current years output not sold+

*Previous years output sold

in the current year]

Current output = Sales - Change in stock

=

=

+

-


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Value Added Method Concepts


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Sum of value added is equal to value of final good

Farmer

Wheat

Rs. 20

Miller

Flour

Rs. 30

Baker

Bread

Rs. 40

Customer

Bread

Rs. 40

Value of

output

Intermediate

consumption

Value Added

20 30 40

- 0 - 20 - 30

20 10 10

Value of final good

Rs 40

Value Added in Production Process

20 + 10 + 10 = Rs 40


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Value Added Method Steps

Identification and classification of production units Primary Sector


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Secondary Sector Tertiary Sector

Calculation of NVAFC for each production unit

Calculation of NDPFC [ NVAFC]

Add Net Factor Income from Abroad (NFIFA) to estimateNational Income


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Compensation of Employees : (COE) remuneration paid to employees in return for work undertaken in the

Income Method Concepts


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production process

Wages & Salaries

in cash

Wages & Salaries

in kind

Employers contribution

to Social Security

Basic Salary

Dearness Allowance

Travel Allowance

House

Car

Free education

Provident Fund

Pension Fund

Compensation of Employees


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Private final consumption expenditure Expenditure incurred by households on the purchase of goods and services

Expenditure Method Concepts


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Includes purchases made by non-profit institutions

Includes purchases made by households abroad


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Expenditure Method Concepts

Net Exports : Exports (X) minus Imports (M)


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Reflects the demand from the

rest of the world for domestic

product

X > M ROW is demanding

more than domestic demand

X < M ROW is demandingless than domestic demand

Purchase of goods from

abroad (imports)

Sale of goods abroad

(Export)


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Expenditure Method Steps

Identification and classification of sectors

Estimation of final expenditure


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Calculation of domestic income

GDPMP = C + I + G + X M

NDPMP = GDPMP Consumption of Capital

NDPFC = NDPMP Net Indirect Taxes

Estimation of National Income by adding Net Factor Incomefrom Abroad to domestic Income


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Full Cost Pricing

Full cost plus pricing seeks to set a price that takes into account all relevant costs of

d i Thi ld b l l d f ll


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production. This could be calculated as follows: Total budgeted factory cost + selling / distribution costs + other overheads + MARK UP ON

COST

Factory Costs

The first factor that the full cost plus strategy takes into account is the factory costs of making

the item per unit. This does not mean that the business actually creates the product.Manufacturers create products and may consider factory costs associated with buying supplies

and operating equipment. Distributors, on the other hand, consider factory costs as the prices

at which they must buy items from the manufacturer. These prices are lower than consumer

costs, but still represent a significant investment of business funds and make a necessary

starting place.


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