Self Learning Material Managerial Economics

Self Learning Material

Managerial Economics (MCOP-201)

Course: Masters of Commerce

Semester-II

Distance Education Programme

I.K. Gujral Punjab Technical University

Jalandhar

Syllabus

I.K. Gujral Punjab Technical University

MCOP-201 MANAGERIAL ECONOMICS

OBJECTIVE AND EXPECTED OUTCOME OF THE COURSE:

Aims to provide a broader understanding of Managerial Economics and its managerial

applications.

UNIT-I Introduction: Nature and scope of Managerial Economics, Role and Responsibility of Managerial economics in business. Fundamental business concepts – Incremental concept,

Opportunity cost concept, Time perspective, Discounting principle.

UNIT-II Demand analysis and Forecasting for consumer goods and capital goods - use of business indicators - type of elasticity. Demand Forecasting for new products. Test marketing, Opinion

pooling, Life cycle.

UNIT-III Concept and resources allocation - Cost Analysis - Short run and long run Cost functions - production functions - cost price - Output relations.Economics of size and capacity

Utilization - Input - Output analysis - Market Structure - Pricing and output general

equilibrium.

UNIT-IV Pricing Objectives - pricing methods and approaches - price discrimination, Product line pricing and Cost control. Theories of profit, Tools of profit planning. Business Cycles:

Meaning, Causes, Phases, Theories of Business cycles

SUGGESTED READINGS/ BOOKS:

1. Peterson, managerial economics, 4th edition - Pearson education - New Delhi.

2. Sampat Mokherjie, Business and Managerial Economics, New Central Book Agency,

Calcutta.

3. Spencer M.H.Managerial Economics Text, Problems and short cases, Richard D.Inwin

INC.

4. Sankaran.S, Managerial Economics Margham Publications, Chennai.

5. Dwivedi D.N , Managerial Economics, Vikas-New Delhi

6. Mankar & Denkar, Business Economics, Himalaya publishing House, Bombay

7. Joel Dean, Managerial Economics, Prentice Hall of India - New Delhi.

8. R.L. Varshney & K.L. Maheshwari, Managerial Economics-Sultan Chand & Sons, New

Delhi.

Table of Contents

Lesson No. Title Page No.

1 Managerial Economics: Meaning, Nature and Scope

1

2 Utility Analysis

17

3 Demand Analysis

39

4 Elasticity of Demand

58

5 Demand Forecasting

80

6 Theory of Production

96

7 Theory of Costs

117

8 Revenue and Revenue Curves

140

9 Market Structure and Pricing

158

10 Pricing Methods and Approaches

177

11 Profit

196

12 Business Cycles

207

Written by:

Ms.Deepali,

KMV College, Jalandhar

Reviwed by:

Dr.Mandeep Kaur,

IKGPTU, Jalandhar

© IK Gujral Punjab Technical University Jalandhar

All rights reserved with IK Gujral Punjab Technical University Jalandhar

LESSON – 1

Managerial Economics: Meaning, Nature and Scope

Structure

1.0 Objectives

1.1 Introduction

1.2 Definitions of Managerial Economics

1.3 Nature of Managerial Economics

1.4 Scope of Managerial Economics

1.5 Relationship of Managerial Economics with Other Disciplines

1.6 Role of Managerial Economics in Business Decision-Making

1.7 Summary

1.8 Glossary

1.9 Answer to Check Your Progress

1.10 References

1.11 Suggested Readings

1.12 Terminal and Model Questions

1.0 OBJECTIVES

After reading this lesson, you should be able:

To understand the basic theme of managerial economics.

To bring out the nature and scope of management.

To explain the role of managerial economics in decision-making.

1.1 INTRODUCTION

Business decision making has witnessed an increasing use of economic

concepts, theories and principles, which in turn has led to the development of

managerial economics or business economics as a separate branch of economics.

Managerial economics is an outcome of the close relationship between economics

and management. Management in business firms involves appropriate decision-

making which requires weighing different available alternatives and making the best

possible choice. This involves co-ordination among a group of individuals to help

them perform in an efficient and effective manner in order to attain common

objectives. On the other hand, economics involves the analysis of and solution to the

basic problem i.e. problem of choice. The universal problem of choice stems from

scarcity of resources available to satisfy unlimited human wants. This necessitates a

rational choice both at the individual level (individual as a producer and as a

consumer) as well as at the level of economy as a whole. Thus, economics helps to

study optimal allocation of scarce available resources to maximize gains both at the

micro level (individual) and the macro level (aggregate economy).

Such economic decision-making by firms and managers constitutes the core

of managerial economics. This appropriate decision making has become an

extremely complex task in the light of market imperfections, risk and uncertainties.

Managerial economics or business economics, thus, comes as a useful tool for the

business managers in the process of decision-making for the firms. Hence,

managerial economics is also sometimes referred to as „Economics for Managers‟.

Managerial economics makes use of both of the two very basic branches of

economics- microeconomics as well as macroeconomics. Managerial economics

may be considered as applied microeconomics to a large extent as it relies on the

tools and techniques provided by microeconomic theory to ease managerial

decision-making. However, it draws heavily from macroeconomic theory also as the

macroeconomic environment cannot be ignored in the rational decision-making

process for a firm. However, economic principles in general, make a significant

contribution in improving the performance of business managers. Managers with

some working knowledge of economics can perform their functions more effectively

and efficiently than those without such knowledge. Managerial economics, thus,

enables the managers to find the most efficient way to allocate scarce organizational

resources in order to achieve the given objectives of the firm.

1.2 Definitions of managerial economics

The meaning of managerial economics can be still better understood with the

help of its definition. A large number of eminent economists have defined managerial

economics in different ways. A few important ones are listed below:

“Managerial economics is concerned with the application of economic principles and

methodology to the decision-making process within the firm or organization. It seeks

to establish rules and principles to facilitate the attainment of the desired economic

goals.” -Douglas

“Managerial economics refers to the application of economic theory and the tools of

analysis of decision science to examine how an organization can achieve its

objectives most effectively.” -Salvatore

“Managerial economics applies economic theory and methods to business and

administrative decision-making.” -Pappas and Hirschey

“Managerial economics is concerned with the application of economic concepts and

economics to the problems of formulating rational decision-making.” -Mansfield

“Managerial economics is the study of allocation of limited resources available to a

firm or other unit of management among the various possible activities of that unit.”

-Henry and Haynes

Different definitions of managerial economics make it clear that managerial

economics is the application of economic theories, logic, concepts and tools of

economic analysis to the process of business decision-making in order to help the

business managers in taking best possible decisions. Although no single definition

can claim to be a perfect one, still a study of these different definitions of managerial

economics throw light on its basic nature and meaning.

1.3 Nature of Managerial Economics

The performance of business managers – their duties and responsibilities

relies heavily on a working knowledge of economics. The primary function of the

managers of a business firm is maximization of the given objective subject to the

constraint of limited availability of resources. It is quite obvious that there would not

have been any problem of decision making had there been an unlimited supply of

resources. As we are confronted with scarcity of resources- both natural and man-

made, so the problem of choice is the central problem of any economy or even of the

firm. The typical problems faced by managers in one way or the other can be

categorized as follows:

What to produce?

How to produce?

For whom to produce?

The first major economic decision to be taken for an economy is what to

produce? A choice has to be made between different alternative combinations of

goods and services that can be produced because the resources are limited. Such a

decision at firm level necessitates a review of market demand and the availability of

raw materials and technology. Hence, it leads to the problem of choice.

After this decision is made, the next question confronting the economy is how

to produce, as to what techniques of production should be used which would

maximize production or social benefit. This, again, leads to the problem of choice.

The next basic problem which any economy will face relates to the problem

of distribution of the total national output among the different economic agents.

There again lies a problem of choice as to which principle should be followed in

distribution.

If it were possible to specify the uses to which resources could be put,

perhaps the decision-making process in a situation with resource constraints could

be relatively easy. For instance if you have Rs. 1000 and you are told that out of Rs.

1000, you should spend Rs. 500 on books, Rs. 200 on moves and the remaining on

food, the decision-making would have not been very complicated. However, in

practical reality, resources have alternative uses, Rs. 1000 could be used in

innumerable different ways. Hence, the decision making process becomes complex.

It is here that economic logic, tools and techniques come to the rescue. Hence,

optimization of use of scarce resources is the primary task of managers. Economics

helps the managers in this task of decision-making by providing models, tools and

techniques to achieve the goals of organizations; to reduce the degree of uncertainty

and risk arising due to uncertain market forces, dynamic business environment,

government policy, competitors, impact of international factors, social and political

factors and many others; and to predict future market conditions and business

prospects. Economic theories have, therefore, gained widespread application in

practical problems of business.

Thus, allocation of scarce resources among alternative uses to achieve the

desired objectives is the primary duty of a manager, which is done with the help of

economic tools, techniques and logic. This link between the responsibility of the

managers and economic logic, tools and techniques justifies the name managerial

economics. Highlighting the importance of managerial economics as a separate

discipline, different and distinct from economics in general, Prof. D .M .Mithani has

stated the following characteristics of managerial economics:

Managerial economics involves the application of the working knowledge

of economic theory, especially microeconomics, to solve practical

business problems.

Managerial economics is both a science as well as an art which facilitates

better and rational business decision making. As a science it is both a

positive science (it is a systematic knowledge and answers the question

„what is?‟) as well as a normative science (it involves value judgement

answers the question „what ought to be?‟)

Managerial economics is primarily concerned with optimum allocation of

scarce resources available to a firm which have alternative uses for any

business activity.

These features of managerial economics clearly throw light on its meaning and

nature and form a basis to study the scope of managerial economics or as it is

synonymously called business economics.

Activity A

Managerial economics is the discipline which deals with the application of ‘economic

theory to business management’. Comment.

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1.4 Scope of Managerial Economics

Managerial economics is the study of allocation of scarce resources available

to a firm (financial, human, machines, etc.) among alternative uses in order to realize

the objective of profit maximization or other specified objectives. Managerial

economics comprises of both microeconomic theories and macroeconomic theories

as both of these are applied to business decision-making and analysis in one way or

the other. The scope of managerial economics comprises all the areas of business

issues to which economic theories could be applied in one way or the other. The

important among these can be enlisted as follows.

Allocation of resources: As it has already been discussed earlier in the

context of problem of choice, a business manager has to decide how to

allocate the scarce available resources to their respective uses within the firm

in order to achieve the desired objectives.

Management of Inventory: Inventory problems relate to the issue of holding

an optimum stock of both finished goods and raw materials. Along with it

queuing problems also arise in which decisions have to be taken about

installing new machines or employing extra labour so as to balance the

business requirements.

Pricing and sales promotion: How to fix the prices for the products, how

to face price competition and how to promote sales are important business

decisions to be undertaken with regard to the pricing policy of the firm.

Investment Issues: Decisions regarding investment problems are

crucial to a firm- how to decide on investing in new plants, how much to

invest, how to manage capital and profits, etc.

The above mentioned problems appear in decision-making and forward

planning in any business firm. Micro economics as a part of managerial economics

deals with such operational or internal issues faced by managers of business firms.

The study of the following important microeconomic theories in this context is crucial

in order to make rational business decisions:

Demand Analysis: The theory of demand helps in making the choice of

products, determining their price and optimum level of production.

Product Analysis and cost analysis: The theory of production and

production decisions is very helpful in determining the size of the firm, its total

output & factors of production to be employed in order to attain the given

objectives of the firm.

Pricing Theory and policies: Analysis of market structure and pricing

theory helps in price determination under different market conditions. It also

aids in evaluating the possibility and feasibility of price discrimination and

advertisement for expansion of sales of a given commodity.

Profit Analysis: The theory of profit helps the firms to measure and

manage their profits keeping in view the uncertainties and the risk involved.

Capital Budgeting: The theory of capital and investment decisions helps in

making investment decisions, choice of projects, capital budgeting for

investment decisions, etc for the business firm.

Besides the above mentioned issues, the scope of managerial economics

also includes the general business environment. This general business environment

of the economy relates to the economic, social and political set-up of the country.

These environmental factors include the type of economic system in the country-

socialist, capitalistic or mixed economy; general trends in national income,

employment, output, prices saving and investment etc.; trends in the working of the

financial institutions of the economy; the trends in foreign trade; the extent of

globalization of the economy; political factors, etc. These types of external issues

strongly influence the business and the functioning of the firms. Therefore, business

managers have to give due consideration to these external environmental factors

also in the process of decision making. These external environmental factors may

be broadly classified as follow:

Major Macroeconomic Parameters: Issues concerning the trends in

macroeconomic variables like national income, output, employment, prices,

investment etc. are extremely helpful in forward planning like setting up a new

plant or expanding the existing plant size for business expansion. The study

of these macro economic variables help the firms to make crucial decisions

regarding business expansion keeping in mind the external conditions

prevalent in the eonomy.

Foreign trade: Trade - internal and/or external is an important outcome

all business activity undertaken by the firms. Trade links with the rest of the

world influence the functioning of business firms directly or indirectly. Study of

monetary mechanism and international trade help the managers understand

international trade, prices, exchange rates, fluctuations in the foreign markets,

capital flows, etc.

Government policies: Regulatory government policies have a huge impact

on the working of business undertakings. Government tries to regulate and

control all types of business activities through its policy measures. Any

business activity which goes against the social well being or disturbs the

welfare of the society have to be and are checked by the government through

regulatory policies directed towards the concerned business activities. For

instance government policies to check environment pollution, traffic

congestion in cities etc. affect the concerned firms. Hence, the business

managers need to have complete information about government policies and

their repercussions on business. Their business decisions should be carefully

framed with an effort to not to violate any such government rules and

regulations. In this context the business managers also need to be aware and

sensitive towards the needs of the society so that no business action of theirs

reduces the welfare of the society as a whole or a section of the society.

Besides the above mentioned economic theories, the scope of managerial

economics may include any other issues influencing the working of managers in

business firms. However, these theories largely constitute the scope of

managerial economics with room for further additions.

Check Your Progress 1

1. State whether the following statements are True or False:

(i) Managerial economics is the application of economic tools to business.

(ii) Managerial economics is the study of micro economics only.

(iii) The basic problem of an economy is the problem of choice.

(iv) Managerial economics helps the managers to make efficient use of

scarceresources.

(v) The scope of managerial economics does not include the pricing policy.

1.5 Relationship of Managerial Economics with other disciplines

Essentially managerial economics involves the study of economic tools, logic

and analysis applied to the decision making process of business firms. However,

besides microeconomics and macroeconomics, managerial economics is also

associated with various other disciplines. These related fields of study include the

following:

Operations research: This field of study is an inter disciplinary solution

finding technique used to find an optimum solution to the managerial

problems subject to the given constraints. These problems are solved using

models built with the help of economics, mathematics and statistics. Linear

programming and goal programming are two important techniques studied

under operations research which are useful in business decision making.

Mathematical and Statistical Tools: Mathematical logic and tools are very

helpful in economic analysis as most of the concepts dealt by the managers of

business firms are quantitative in nature like cost, price, demand, profit,

interest, wages, stock etc. Advanced optimization techniques and

mathematical tools, thus, form an integral part of managerial economics.

Similarly statistical tools prove extremely helpful in collecting,

processing and analyzing data for business firms. Regression analysis

probability theory, forecasting techniques, etc. help in forecasting the future

values of economic variables and the probable outcome of the business

decisions undertaken.

Management Theory and Accounting: These disciplines have a close link

with the study of managerial economics. Various management theories make

an attempt to study the behaviour of the business firms which in turn are

working to attain certain desired and pre stated objectives. Hence, a business

manager needs to have sufficient knowledge of management theory in order

to ascertain changes in the behaviour and objectives of the firms with change

in the conditions- internal and/or external. On the other hand accounting data

and statements help in reflecting the working the firm and evaluating its

performance.

Psychology and Organisation Behaviour: Managerial economics helps the

business managers to make rational business decisions by studying the

behaviour of individual buyers and sellers. This involves the study of the

psychological factors influencing the demand and supply patterns, needs,

expectations and aspirations of the market players- the buyers and sellers. In

fact, psychological economics has emerged as recent field of study for the

psychological analysis of the buying behaviour of the consumer. In addition to

the study of individual buyers, various behavioural models studying

organizational psychology have been developed of late to analyse the

economic behaviour of a firm.

Thus, the scope of managerial economics is immensely wide and beyond the

reach of this entire book. However, the above mentioned issues form the basic core

of managerial economics and its scope cannot be complete without the mention of

these issues.

1.6 Role of Managerial Economics in Business Decision-Making

The role of business managers in business decision making is to select

the best possible alternative out of the opportunities available to the business firm.

The process of business decision making primarily comprises of the following

stages:

Stage I : To determine and define the objective(s) to be achieved.

Stage II : To collect and analyse data and information regarding economic,

social, political, and technological environment.

Stage III : To invent, develop and analyse the possible alternatives to achieve

the desired objectives.

Stage IV : To rationally select the best possible alternative.

It is essential to take a note of the fact that stages II and III are very crucial in

order to make the right business decision and involve a need for in depth knowledge

of economic theories and tools, concepts and logic along with individual skills of the

business managers. For example, say a firm plans to launch a new product in the

market and many close substitutes of that product are already available in the

market. The foremost business decision to be taken would whether to launch the

product or not. In order to do so the business manager will have to carefully study

the market; the product and all issues relating to it; and issues relating to the sales.

Here comes the role of the different economic concepts, including demand, supply,

cost, price, etc., that can be and are used by the business managers in business

analysis. Various economic theories, tools, concepts and logic help in arriving at

appropriate and right conclusions as regards the business problem.

The primary responsibility of the manager of a business firm is the attainment

of the desired objectives. A managerial decision can be evaluated only in the context

of its objective. For this the objectives of the firm should be clearly stated which may

be various and conflicting. The conventional theory of firm takes profit maximization

as the primary objective of a business firm. This is defended on the basis of the

argument that making profit is indispensable for the survival of the firm in the long

run. Further, the achievement of alternative objectives of the firm like maximizing

long run growth, maximizing sales revenue, increasing market share and such like

are themselves dependent more or less on the profit objective, as profit is a relatively

more reliable measure of a firm‟s efficiency. Moreover, profit maximization

hypothesis is a time- tested one and is largely used to explain the price and output

decisions of the business firms.

However, whatever may be the objective of a firm, all the business decisions

taken by the managers aim at the attainment of pre determined objective(s).

Traditionally the process of business decision making relied on the rule of thumb

technique. Such a technique evolved out of traditional business practices, serves the

purpose where simple business decisions are involved. However, complex issues in

business decision-making involve the use of some basic economic concepts. A few

important economic concepts and their role in business decision-making are listed

below.:

1.6.1 Principle of opportunity cost

The business manager or as we may call the managerial economist needs to

sacrifice some alternatives against the selected ones in a rational manner in almost

all aspects of business -- the problem of choice. Since human wants are infinite and

means to satisfy them are scarce, it is impossible to satisfy all the wants. In order to

satisfy some wants, it becomes necessary to give up or postpone some other wants.

Similarly resources – natural and man-made are scarce in relation to their demand

but have alternative uses. This scarcity and possible alternative uses of the

resources leads to the concept of opportunity cost.

The opportunity cost or alternative cost is what has been sacrificed to have a

certain thing. It is the benefit foregone of the alternative that has not been chosen.

For example say a worker works in an ice factory and gets a wage of Rs. 4000 per

month. Alternatively if he gets employment in a shoe factory, he might be getting a

wage of Rs. 3000 per month. So the earning in the next best alternative (Rs. 3000) is

the opportunity cost or alternative cost of his services. Similarly a firm has limited

resources at its disposal which can be put to alternative uses. For example a firm

may have different options available to expand its output using a capital of say Rs.

10 million- setting up a new unit having expected annual return of Rs. 2.5 million or

expanding the existing unit having expected annual return of 1.8 million. A rational

business manager would definitely go in for the first alternative other things

remaining the same. This means that the manager will have to sacrifice Rs. 1.8

million- the annual return of second option which is not selected, in order to get an

annual return of Rs. 2.5 million (the selected alternative). Hence, the opportunity cost

of setting up a new unit in this example is the sacrifice involved is not expanding the

existing unit.

Thus, the opportunity cost is the cost of the next best alternative which is

foregone. This concept of alternative or opportunity cost is applicable to all types of

resources involved in business decision where alternative uses are possible.

1.6.2 Marginal Principle and Incremental concept

Marginal analysis is widely used in economic theory -marginal utility in utility

analysis; marginal cost in theory of production and marginal revenue in the theory of

pricing. As regards business decision making, marginal principle is applicable in the

cases where marginal revenue(MR) and marginal cost (MC) can be exactly

computed. According to marginal analysis, marginal cost is the change in total cost

(TC) due to a unit change in total output.

Or

Marginal cost of nth unit is the total cost of n units minus total of cost of n-1 units.

MCn = TCn –TC n-1

where n is the number of units of output.

MCChange in Total Cost

Change in Total Output

Similarly Marginal Revenue (MR) is the change in total revenue due to a unit change

in total output.

Change in Total RevenueMR=

Change in Total Output

Or

Marginal revenue of nth unit is the total revenue of n units minus total of revenue of

n-1 units.

Mrn = TRn – TRn-1

where n is the number of units of output.

The decision rule under the marginal principle for a profit maximizing firm is given as

MC = MR

In other words for a business firm the profit will be maximum when marginal

cost equals marginal revenue, that is the cost of producing an additional unit

becomes equal to the revenue earned by selling that additional unit.

However, a major drawback of this approach is that it is applicable only when

exact calculation of marginal cost and marginal revenue is possible and variable cost

can be subjected to a unit change. A relatively convenient concept which can instead

be used is the incremental principle. The incremental concept is of great use when

bulk production is involved and total cost and total revenue witness large changes.

The increase in revenue due to a given business decision would be called

incremental revenue. On the other hand similar increase in cost (due to say

expansion in the size of the firm) is called incremental cost. The business decision

rule in this context is that the given business decision taken to correct if it leads to a

higher incremental revenue as compared to incremental cost. If it is otherwise the

given business proposition is not accepted. Although marginal analysis is more

precise yet incremental concept finds more practical applicability.

1.6.3 Time perspective

The time element needs to be given due importance in the process of

business decision making. Every single business decision needs be undertaken with

a given time perspective. This means business managers should make decisions by

taking into account the time angle of business propositions well in advance. Relevant

past and foreseeable future have to be given due consideration while taking a

business decision. The time difference or duration between relevant past and

foreseeable future refers to the time perspective. Relevant past indicates the time

period of past experience and trends which are important for any business decision

in the present. Some of the business decisions involve short run outcome while

others may have long run pay-offs. A certain business decision may be more

profitable in the short-run than in the long-run and vice-versa. For instance say a

business firm decides to increase its expenses on medical facilities along with other

facilities to its workers. Such a decision may escalate costs in the short-run but in the

long run it may lead to increasing revenues by way of enhanced productivity of

workers. Therefore, time perspective is of utmost importance in business decision

making.

1.6.4 Production Possibility Curve

Production Possibility Curve (PPC) is a curve which indicates different

combinations of two commodities that can be produced in an economy at any point

of time with the help of given techniques and resources. Production Possibility Curve

(PPC) is also called Production Possibility Frontier or Transformation Curve. For an

individual consumer, a PPC shows the different combinations of the two

commodities which a consumer can buy given his income and prices of the two

commodities. However, for the economy as a whole, it depicts the opportunity cost or

alternative cost of producing one good in terms of the amount of the other good

sacrificed subject to the limited availability of resources. This concept is also very

important for the business managers for decision making.

Activity B

How does the study of managerial economics help a business manager in decision making?

Illustrate your answer with examples from production and pricing issues.

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Fill up the blanks with correct words

(i) Managerial economics is a ………………to an end for managers in any business.

(ii) Marginal concept is applied when …………….calculation of MC and MR is

possible.

(iii) The opportunity cost is the cost of the benefit …………..

(iv) A rational decision involves ……………… incremental revenue as compared to

incremental cost.

1.7 Summary

Managerial economics has emerged as a separated branch of economics due

to increased applicability of economics in business decision-making process by the

managers. Managerial economics helps the business managers in choosing the

most efficient allocation of scarce resources to achieve the given objects. It is micro

as well as macro in nature. Its scope is immensely vast comprising economic

theories and concepts used to analyse business issues and to find practical solutions

to business problems. Managerial economics can thus be referred to as working

knowledge of economics applied to business decision making. It is also linked to

other fields of study, including mathematical tools, statistics, operation management

theory. The role of managerial economics in business decision making is extremely

important for the overall development of business activity. Important decision making

concepts include the principle of opportunity cost, marginal and incremental

principle, time perspective and production possibility curve.

1.8 Glossary

Managerial Economics: The study of economic theories, logic and tools of

economic analysis used in the process of business decision making.

Microeconomics: It attempts to study the economic behaviour of particular small

units of the entire economic system such as a consumer, a producer, a firm, a

worker, price of a particular commodity, etc.

Microeconomics: It attempts to study the economic problems concerning

aggregates in the economic system such as aggregate demand, aggregate supply,

general price level, gross national expenditure, growth rate of the economy, etc.

Opportunity cost: It is cost of the next best alternative which is not selected or

foregone.

Production Possibility Curve: It is a graph showing different combination of two

commodities which can be produced in an economy, given the scarce availability of

resources.

1.9 ANSWERS TO CHECK YOUR PROGRESS


1) (i) true

(ii) false

(iii) true

(iv) true

(v) false


1) (i) means

(ii) precise

(iii) foregone/not selected

(iv) higher

1.10 References

1. Spencer, M.H, and Seigelman, L., Managerial Economics, Irwin Illinois

2. Douglas, Evan J., Managerial Economics: Analysis and Strategy, Prentice-

Hall, N.J

3. Baye, Micheal R., Managerial Economics and Business Strategy, McGraw

Hill, Toronto.

4. Mithani D.M. : Managerial Economics, Himalaya Publishing House, Mumbai

5. Dwivedi, D.N. : Managerial Economics, Vikas Publishing House Pvt. Ltd, New

Delhi


1. Dean, Joel, Managerial Economics, Prentice Hall of India, New Delhi.

2. Solvatore, D., Managerial Economics, Mc Graw Hill, New York.

3. Davis, R and S. Chang, Principles of Managerial Economics, Prentice Hall,NJ

1.12 Terminal Questions

1) What do you understand by managerial economics? Explain its nature and

characteristics.

2) Discuss in detail the scope of managerial economics in modern business

environment.

3) Managerial economics is applied economics Discuss

4) Mention the important features of managerial economics.

5) Discuss the link of managerial economics with other disciplines. How do they

contribute to managerial economics?

6) The study of managerial economics helps a business manager in decision

making. Do you agree?

7) What is opportunity cost principle as applied to decision making?

8) How is time perspective important in business decision making?

LESSON – 2

Utility Analysis

Structure

2.0 Objectives

2.1 Introduction

2.2 Utility: Meaning and Features

2.3 Measurement of Utility

2.3.1 Cardinal Utility Analysis

2.3.1.1Assumptions of Cardinal Utility Analysis

2.3.1.2 Law of Diminishing Marginal Utility

2.3.1.3 Law of Equi Marginal Utility

2.3.1.4 Marginal Utility and Demand Curve

2.3.2 Ordinal Utility Analysis

2.3.2.1 Indifference Schedule and Indifference Curve

2.3.2.2 Properties of Indifference Curves

2.3.2.3Marginal Rate of Substitution

2.3.2.4 Price Line

2.3.2.5Consumer’s Equilibrium

2.4 Summary

2.5 Glossary

2.6 Answers to Check Your Progress

2.7References

2.8Suggested Readings

2.9Terminal and Model Questions

2.0 OBJECTIVES


To understand the meaning and features of utility

To bring out the difference between cardinal utility analysis and ordinal utility

analysis

To comprehend the concept of consumer’s equilibrium

2.1 INTRODUCTION

An individual as a consumer forms the basis of all production. The individual

consumer has a role to play in two markets in the economy- the factor market and the product

market. The individuals own the productive resources to be used for production and sell these

inputs to the firms in the factor market. On the other hand, as a consumer the individual lays a

demand on goods and services produced by the firms and makes a decision about the quality

and quantity to be bought and at what price. Hence, the force of demand is determined solely

by the behavior of the consumers in the product market. Any change in this force of

consumer demand can altogether change the market solution involving the forces of demand

and supply. Moreover, it is this consumer demand which forms the basis of all production

taking place in the economy. Hence, it is very important rather essentially required for all the

business managers to study the consumer’s behavior in the market. Given his income, prices

of different commodities and other factors, the consumer tries to find optional solutions for

several issues important to him like how much to buy, from whom to buy, what quality to

buy, and at what price to buy. In turn, these issues influence and frame the force of demand

for that particular product in the market.

The producers or sellers also want to know and need to know the preference and

choice of consumers. This insight into the buying behavior of consumers helps the firms in

taking important decisions regarding product type, its pricing, advertisement, new products

and many others. The consumer’s buying behavior or the consumer demand and choice, thus,

is crucial to the process of business decision making. In economic theory the consumer’s

choice and buying behavior have been explained with the help of the concept of utility.

2.2 Utility: Meaning and Features

The entire process of production is guided by the behavior of consumers. The

consumer behavior is explained on the basis of utility. Man by nature is full of desires, all of

which cannot be satisfied as the resources to satisfy them are limited. So the consumer has to

allocate his limited income among unlimited wants in such a way that he gets maximum

possible satisfaction or utility. The term utility owes its original to British philosopher Jeremy

Bentham. It refers to that quality or power in a commodity or service that satisfies a human

want. Every consumer buys several commodities because these commodities can satisfy his

wants. This want satisfying power of a commodity or a service is called utility.

Utility is a psychological or subjective concept, slightly different from satisfaction.

For instance say a consumer wants to buy a chocolate. This shows that chocolate has utility

for the consumer. When the consumer eats it, the good feeling that he gets is satisfaction. Had

he not liked the chocolate he would not have got satisfaction (although it had utility for him,

that is why he bought the chocolate). Thus, utility implies expected satisfaction whereas

satisfaction stands for realized satisfaction. Another feature of utility is its ethical neutrality.

The commodities like liquor, drugs, tobacco and the like too have utility for the consumer but

may be unethical, immoral and even illegal in some cases. Further, utility is a relative term in

the sense that it varies from person to person, place to place and time to time. Cigarettes have

great utility for a chain smoker while no utility for a non-smoker. A person living in a

metropolitan city may have an intense want for a car while a person living in a remote village

may not need it at all. People have greater utility of woollens during winter months than in

summer season. Hence, utility is a relative concept which may vary from person to person,

place to place and even time to time.

2.3 Measurement of Utility

Two different views are found in economic literature regarding the measurement of

utility. The first view point assumes that the utility can be exactly measured in cardinal

numbers and like cardinal numbers the utility from different units of commodities can be

added or subtracted. This approach is called the cardinal utility analysis. On the other hand,

according to the second viewpoint the utility cannot be exactly measured in cardinal

numbers- it can only be ranked just like the ordinal numbers. Hence, this approach is referred

to as the ordinal utility analysis. Both these approaches to utility analysis are discussed

below.

2.3.1 Cardinal Utility Analysis

The cardinal approach to utility analysis is based on the assumption that the utility

derived from a commodity is quantifiable and can be exactly measured in numbers. Based on

the cardinal measurement of utility there are two main concepts of utility.

(i) Total Utility: Total Utility is the sum of utilities derived from the consumption of all

the units of a commodity or service within a given time period. Thus, if a consumer buys five

mangoes, the sum of utilities from all the five units of mangoes is the total utility. Total

utility is a direct function of the quantity purchased. As the quantity purchased increases it

leads to an increase in the total utility. This can be expressed as

TUx = f (Qx)

Where TUx is the total utility derived from x commodity and Qx refers to the units of x

commodity.

(ii) Marginal Utility: Marginal Utility refers to the utility derived from the last or

marginal unit of a given commodity. It is defined as the addition made to total utility by

consuming an additional unit of the commodity within a given period of time. It can be

measured as follows

MUn = TUn – Tun – 1

where MUn is the marginal utility of nth

unit

TUn = Total utility from n units.

TUn-1 = Total utility from (n-1) units

Alternatively marginal utility can also be defined as the rate of change of total utility

due to a unit change in the quantity of given commodity. On the basis of this definition,

marginal utility can be measured as follows:

where MUx is the marginal utility of x commodity

∆ TUX is the change in total utility of x commodity

∆ Qx is the change in quantity of x commodity consumed by one unit.

An important feature of the concept of marginal utility is that it can be either positive

or zero or negative. When total utility increases with purchase of an additional unit of the

commodity marginal utility is positive and marginal utility is negative if purchase of an

additional unit of the given commodity results in a fall in total utility. However, if there is no

change in total utility by purchasing an additional unit of the said commodity, marginal utility

is zero. When marginal utility becomes zero, total utility is maximum. This point of

maximum total utility and zero marginal utility corresponds to the point of maximum

satisfaction and is referred to as the point of saturation. If the consumer still continues to buy

more units of this commodity beyond the point of saturation, total utility begins to decline

and marginal utility becomes negative.

2.3.1.1 Assumptions of Cardinal Utility Analysis

The cardinal utility analysis maintains that utility can be added and subtracted.

However the explanation of consumer’s behavior- choices, tastes and preferences using

cardinal utility approach rests on the following main assumptions:

(i) Utility can be measured in cardinal numbers which means that it can be added or

subtracted.

(ii) Consumption of one commodity is not affected by its related goods. Utility of one

commodity is assumed to be independent of the utilities of other commodities.

(iii) Each unit of the given commodity being consumed should be homogenous or of

uniform quality.

(iv) The size of each unit of the commodity to be consumed should be standard, neither

very small nor very large.

TUxMU = X Qx

(v) The consumption of successive units should be continuous, that is no gap in

consumption of successive units should be there.

(vi) There should be no change either in the income of the consumer or in the price of the

commodity being consumed during the course of consumption.

(vii) There should be no change tastes and preferences of the consumer during the course

of consumption.

(viii) The commodity being consumed should be normal and non addictive in nature.

(ix) The most fundamental assumption in the cardinal utility analysis is that the consumer

is rational and aims to maximize his satisfaction.

The above stated assumptions of the cardinal utility analysis form the basis for the

two fundamental laws of economics- the law of diminishing marginal utility and the law of

equi marginal utility.

2.3.1.2 Law of Diminishing Marginal Utility

The law of diminishing marginal utility states that other things remaining the same, as

the consumer goes on buying more and more units of a commodity, the utility derived from

each successive unit goes on diminishing. This law is one of the basic laws of Economics and

is also called the first law of consumption. This diminishing marginal utility with each

additional unit of the commodity consumed can be attributed to two reasons:

(a) Each particular want is satiable. Inspite of the fact that there are unlimited wants, every

single want can be completely satisfied. Thus, when a consumer goes on consuming more

and more units of a commodity, his want gets fully satisfied and he does not wish to have any

more increase in the commodity. As such his marginal utility starts falling when consumption

increases.

(b) Goods are imperfect substitutes for one another. Satisfaction derived from any two

commodities is not same. Different goods satisfy different wants. If it were possible to

perfectly substitute a good for another good, it would have satisfied all other wants also.

Hence, its marginal utility would not have fallen rather would have increased.

The law of diminishing marginal utility can be explained with the help of a table and diagram

given below:

The above table shows that as the consumer goes on consuming more and more units of

apples, the total utility (TU) derived from the consumption of apples increases but marginal

utility (MU) declines continuously, so much so that it becomes zero when 6th unit of apple is

consumed. At this point TU is maximum corresponding which MU is zero. This is the point

of saturation or satiety or the point of maximum satisfaction. Beyond this point TU begins to

decrease as MU becomes negative. No rational consumer will continue consumption beyond

the point of satiety. The MU curve can be derived from the above schedule as below.

Marginal Utility

In the above figure, marginal utility is measured along Y-axis while units of apples

along X-axis. MU is the marginal utility curve has a negative slope as it falls downwards

from left to right. This is the diminishing MU curve. The above figure clearly shows that

marginal utility is zero when the consumer buys 6th apple. As he consumes more units,

marginal utility becomes negative.

Although the law of diminishing marginal utility is universal in nature yet in some

situations it does not hold true. In certain cases marginal utility from additional consumption

goes on increasing instead of decreasing like goods for display such as diamonds, luxury cars,

etc., rare collections such as rare coins or stamps; accumulation of money, etc. This law does

not hold even in case of abnormal consumer behavior as in the case of misers, drunkards or

even people showing excessive love for music or poetry. Despite these limitations the law

diminishing marginal utility still is a universal law of economics.

Activity A

To test the law of diminishing returns, it is possible to create a factory floor right in your own

classroom. Follow the instructions below to determine whether the law applies to your own

imaginary firm.

Your classroom is about to turn into a factory that manufactures paper chains (to hold paper

anchors for paper boats, of course!). A paper chain is made by taking two long, narrow strips of

paper, folding one into a ring and stapling the ends together, then folding the other into a ring and

connecting it to the first ring to make a chain. Two loops of paper stapled together make a chain.

The longer your chain, the more productive your factory and its workers are. The goal of your

paper chain factory, of course, is to make the longest chain possible in a fixed amount of time

using a fixed amount of land and capital, with labor as your only variable resource. This is

therefore an experiment to test the short-run law of diminishing marginal returns.

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2.3.1.3 Law of Equi marginal Utility

The law of diminishing marginal utility is based on the consumption of a single

commodity. However in real life a consumer buys many commodities simultaneously to

maximize his satisfaction. In such a situation, when a consumer spends his limited income on

two or more commodities, the law of equi marginal utility comes into operation. This law of

equi marginal utility is just an extension of the law of diminishing marginal utilityto two or

more than two commodities. This law of equi marginal utility is known by different names :

the Law of Substitution, the Law of Maximum Satisfaction, the Law of Indifference, the

Proportionate Rule and the Gossen’s Second Law. It may be defined as follows:

The household maximizing the utility will so allocate the expenditure between commodities

that the utility of the last penny spent on each item is equal.

--- Lipsey

Every consumer has unlimited wants but limited income. The consumer is, therefore,

faced with a choice among many commodities. The objective of a rational consumer is to

maximize the total utility derived by spending his limited income on two or more

commodities. A rational consumer, in order to get the maximum satisfaction from his limited

income compares (i) the utility of a particular commodity and its price and (ii) the utility of

the other commodities which he can buy with his limited resources. If he finds that a

particular expenditure in a commodity is yielding less utility than another, he will shift the

unit of expenditure from the commodity yielding less marginal utility to a commodity

yielding more marginal utility. The consumer will reach his equilibrium position when it will

not be possible for him to increase the total utility further. The equilibrium will be reached

when the marginal utility of each commodity is in proportion to its price and the ratio of the

prices of all goods is equal to the ratio of their marginal utilities. In other words, the objective

of maximum satisfaction is achieved when the consumer is able to spend his limited income

in such a way that the utility of the last rupee spent on the various commodities is the same.

This can be expressed mathematically as:

MUa / Pa = MUb / Pb = MUc /Pc = …….= MUn / Pn

Where a,b,c,…….,n are different commodities consumed.

In such a situation the consumer becomes indifferent among different commodities

and gets maximum possible satisfaction. Any change in spending pattern against the law of

equi marginal utility results in a loss in satisfaction.

However, in certain cases, the actual behavior of the consumer is found inconsistent

with this law such as change in income, prices, tastes and preferences, ignorance on the part

of the consumer or difficulty in measurement of utility. Still both the law of diminishing

marginal and the law of equi marginal utility are of great practical importance and can also be

used to derive the demand curve for a commodity and hence are crucial importance.

2.3.1.4 Marginal Utility and Demand Curve

Dr. Alfred Marshall derived the demand curve using the law of diminishing marginal

utitlity. The law of diminishing marginal utility states that as the consumer purchases more

and more units of a commodity, he derives lesser utility from each successive unit of the

commodity purchased. Also, as the consumer buys more and more units of one commodity,

he is left with lesser money at his disposal. A rational consumer, therefore, while purchasing

a commodity compares its price with the utility he receives from it. As long as the marginal

utility of a commodity is higher than its price (MUx > Px), the consumer would demand more

units of it till its marginal utility becomes equal to its price (MUx = Px) and the equilibrium

condition is achieved. In other words, as the consumer consumes more and more units of a

commodity, marginal utility derived from the commodity goes on diminishing. Hence, the

consumer would demand more units of a commodity only at a diminishing price.

(a) (b)

Marginal Utility and Demand Curve

The part (a) of the above figure shows that the marginal utility curve of commodity X,say,

being consumed by the consumer is negatively sloped. This shows that as the consumer buys

larger quantities of commodity X, its marginal utility decreases. As a result at diminishing

price, the quantity demanded of the commodity x increases as is shown in part (b) of the

above diagram. When the quantity purchased is X1, the marginal utility of the commodity x

is MU1. By definition, this is equal to P1. The consumer in this case demands OX1 quantity

of the commodity at P1 price. Similarly, X2 quantity of the commodity is equal to price P2 as

at P2 price, the consumer will buy OX2 quantity of commodity. As is clear now, at price P3,

the consumer will buy OX3 quantity and so on. Hence, as the purchase of the units of

commodity X is increased, its marginal utility goes on diminishing. Equivalently, at a

diminishing price, the quantity demanded of good X increases as is clear from the diagram.

The law of demand (to be discussed later) states that, other things remaining the same, when

price of a commodity falls, its quantity demanded increases and vice versa. In other words,

the demand curve, which shows the relation between price of a commodity and its quantity

demanded, has a negative slope. Hence, the marginal utility curve of a commodity depicts its

downward sloping demand curve.(The negative part of marginal utility curve does not form a

part of the demand curve as negative quantities make no sense).

Therefore, the concept of marginal utility enjoys an integral place in utility analysis.

Moreover the utility approach or the cardinal utility analysis is of paramount importance in

explaining the theory consumer behavior, rather the theory consumer behavior remains

incomplete without it.

Check your progress 1

1. _________ is the attribute of a commodity to satisfy a consumer’s wants.

2. The __________________ analysis maintains that utility can be added and subtracted.

3. The utility derived from an additional unit of a commodity is called __________.

4. When marginal utility is zero, the total utility becomes_________.

5. Total utility is the summation of __________________ from all the units of a

commodity.

2.3.2 Ordinal Utility Analysis

The traditional cardinal utility approach suffers from several serious limitations. Out

of these, exact measurement of utility and cardinal measurement of utility were the ones

which received a lot of criticism. In view of the defects in cardinal utility approach, an

alternative theory of consumer behavior known as indifference curve theory or ordinal utility

analysis was developed. This approach of indifference curve analysis was first introduced in

1915 by a Russian economist Slustsky. It was later developed by J.R. Hicks and R.G.D. Allen

in 1928. In contrast to the cardinal utility approach, the indifference curve analysis is based

on the ordinal measurement of utility. It totally ruled out the possibility of cardinal

measurement of utility. This approach emphasized that only ordinal measurements or

comparisons of satisfaction from different combinations of commodities were possible. The

ordinal approach assumes that utilityis purely subjective and cannot be measured. Further, an

individual is interested in a buying a combination of related goods and not in the purchase of

one commodity at a time. So this theory of consumption is based on a scale of preferences or

a list of priorities prepared by the consumer in his mind according to the satisfaction levels

got from different combinations of goods.

In ordinal utility analysis, a consumer’s tastes and equilibrium is shown by

indifference curves. An indifference curve is a curve which shows the various combinations

of two commodities X and Y which yield equal utility or satisfaction to the consumer. An

indifference curve shows an ordinal rather than a cardinal measure of utility. It is also called

an iso-utility curve and all the combinations lying on an indifference curve yield equal

satisfaction.

2.3.2.1 Indifference Schedule and Indifference Curve

In the scale of preferences of the consumer, there are certain combinations which yield

exactly equal satisfaction. The consumer will give equal importance to all such combinations

with no preference to any. He will be indifferent or neutral about these combinations. Such an

indifference on the part of the consumer about thecombinations of two commodities may be

explained with the help of an indifference schedule and indifference curve. An indifference

schedule is the tabular statement which shows the different combinations of two commodities

yielding the same level ofsatisfaction as shown below:

Indifference Schedule

Suppose the consumer is indifferent among the five combinations I, II, III, IV and V

of rice and wheat shown in the indifference schedule above. All these combinationsyield the

same level ofsatisfaction and the consumer gives equal preference to all. The consumer is

ready to give up four units of wheat(Y) to get one more unit of rice(X), only then

combination I and II will yield the same level ofsatisfaction. Similarly in combination III, the

consumer is ready to give up three units of wheat(Y) to get one more unit of rice(X) to get

same level ofsatisfaction, and so on. If a curve is drawn such that each point on the curve

shows a combinations of two commodities which yield the same level ofsatisfaction, such a

curve is called an indifference curve.

In the words of Leftwitch, “A single indifference curve shows the different

combinations of X and Y goods that yield equal satisfaction to the consumer.”

According to Hicks, “An indifference curve is the locus of the points representing

pairs of quantities between which the individual is indifferent.”

On the basis of the different combinations of two commodities yielding the same level

ofsatisfaction, an indifference curve can be shown as follows:

Indifference Curve

The indifference curve IC shown above indicates that the consumer gets equal level

ofsatisfaction from the combinations A, B, C, D, so he is indifferent among them, hence it is

called an indifference curve. Based on indifference curves, an indifference map can be drawn.

A set of indifference curves representing the scale of preference at different levels of

satisfaction is known as indifference map as shown below.

Indifference Map

All combinations lying on indifference curve 1 (IC1) provide the same satisfaction but

the level of satisfaction on Indifference curve 2 (IC2) will be greater than the level of

satisfaction on indifference curve 1 (IC1). Similarly, all combinations lying on indifference

curve 2 (IC2) provide the same satisfaction but the level of satisfaction on Indifference curve

3 (IC3) will be greater than the level of satisfaction on indifference curve 2 (IC2).

2.3.2.2 Properties of Indifference Curves

An indifference curve shows different combinations of two goods about which a

consumer is indifferent. The main properties or of indifference curvesare as follows:

An indifference curve slopes downwards from left to right.This means that when

the quantity of one good in the combination is increased, the quantity of the other

good should be reduced so that the total level of satisfaction remains constant.

However, if the indifference curve is a horizontal straight line parallel to x-axis

(figure (a)), it would mean that the consumer would remain indifferent between

various combinations even if the amount of good X increases while the amount of

good Y remains constant. This is not possible because the consumer always prefers

larger quantity of a good to lesser quantity of that good. Similarly an indifference

curve cannot be a vertical or upward sloping as shown below.

(a) (b) (c)

Higher the indifference curve higher is the level of satisfaction.This means thatthe

combination of commodities which lies on a higher indifference curve will be

preferred by a consumer to the combination which lies on a lower indifference curve.

Indifference Map

Indifference Curves are Convex to the Origin.As the consumer substitutes

commodity X for commodity Y, the marginal rate of substitution of X for Y decreases

along an indifference curve. As the consumer moves from combination A to B to C

to D, he is ready to give up lesser and lesser amounts of Y to get an additional unit of

X. Equivalently, the marginal rate of substitution of X for Y, that is, the quantity of Y

good that the consumer is willing to give up to get an additional unit of X, goes on

diminishing. The slope of IC is negative and it is convex to the origin as shown

below.

Two indifference curves can never intersect each other. An indifference curve

represents all those combinations of two goods which give equal level of satisfaction

to the consumer. In the figure given below the combinations represented by points A

and C will give equal satisfaction as they lie on the same indifference curve (IC2) just

as the combinations B and C will give equal satisfaction as they lie on IC1.

If combination A is equal to combination C and combination B is equal to combination C, it

means that the combination A will be equal to B. However, this is not possible as the

consumer will definitely prefer combination A to combination B. Hence, two indifference

curves can never cut each other.

2.3.2.3 Marginal Rate of Substitution

The concept of marginal rate of substitution (MRS)in the ordinal analysis was

introduced by Hicks and Allen. They used this concept to substitute the law of diminishing

marginal utility and to study the behavior of the consumer as to how the consumer prefers

one commodity to another and maintains the same level of satisfaction.The rate at which

commodities X and Y have to be exchanged is known as the marginal rate of substitution

(MRS)of X for Y. It may be defined as follows:

The marginal rate of substitution of X for Y measures the number of units of Y that must be

scarified for unit of X gained so as to maintain a constant level of satisfaction.

--- Hicks

Say there are two commodities X and Y which are imperfect substitutes of each other

and the consumer is willing to exchange good X for Y. The rate at which goods X and Y will

be exchanged is known as the marginal rate of substitution of X for Y (MRS

xy).Mathematically, marginal rate of substitution of X for Y (MRS xy) is expressed as

follows:

MRS xy = ∆Y∕∆X

where ∆Y shows change in quantity of Y commodity and ∆X shows change in quantity of X

commodity.

It is important to note that in case of indifference curve analysis the law of

diminishing marginal rate of substitution holds, which means that as the consumer increases

the purchase of X commodity, marginal rate of substitution of X for Y (MRS xy) goes on

diminishing.


1. State whether the following statements are True or False:

(i) The demand curve cannot be drawn using the marginal utility curve.

(ii) The ordinal utility approach is based on exact measurement of utility.

(iii) A single indifference curve shows the different combinations of X and Y goods that yield

equal satisfaction to the consumer.

(iv) Higher the indifference curve higher is the level of satisfaction.

(v) An indifference curve is always concave to the origin.

2.3.2.4Price Line

A price line or a budget line shows all those combinations of two commodities which

the consumer can buy given his money income and the prices of two commodities. The price

line is an important element of the theory of consumer behavior and preferences. The

indifference map reflects people’s preferences for different combinations of two goods under

consideration. Every consumer will try to to reach the highest possible indifference curve.

However, the actual choices made will depend on the income of the consumer and prices of

the two commodities. The price line or the budget line defines those combinations of two

goods under consideration which the consumer can actually buy within his income and prices

of the both commodities. Any combination lying outside the price line is beyond the reach of

the consumer and he cannot afford to buy it out of his limited income. The concept of price

line or the budget line can be explained with the help of the following diagram:

Price Line

Suppose a consumer has Rs.100 which he wants to spend on two commodities X and

Y. Let the prices of commodities X and Y be Rs.10 per unit and Rs. 5 per unit respectively. If

the consumer spends his entire income (Rs.100) on X, he would be able to buy 10 units of X,

and if he spends his total income on Y, he would buy 20 units of Y. If a straight line is drawn

joining 10 units of X and 20 units of Y, we get a line which is called the price line or budget

line.

The price line is drawn as a continuous straight line. Its slope is measured as the ratio

of prices of the two commodities. In the above diagram, slope of the price line is measured as

Slope of Price Line = Price of X Commodity/ Price of Y Commodity

If the prices of the two commodities remain the same but the income of the consumer

rises, the slope of price line will remain the same but it shifts its position to the right; and

vice-versa as shown in the figure below. It shows that if prices remain unchanged and income

rises, price line shifts to the right from L1 M1 to L2 M2.

Shift in Price Line

However, if the income of the consumer remains the same but the price of one commodity

say X falls, then the consumer is able to buy more of commodities X. In this situation price

line shifts from LM1 to LM2 as shown below

Shift in Price Line

Hence, various shifts are possible in the position of the price line depending on

whether there is a change in the income of the consumer or change in the price(s) of one or

both the commodities or both.

2.3.2.5 Consumer’s Equilibrium

The aim of a rational consumer is to maximize his satisfaction out of his limited

resources. So long as the consumer feels that he can increase his satisfaction by changing the

purchases of different commodities, he will continue to make adjustments in his purchases. A

situation in which the consumer gets maximum satisfaction and he is neither inclined to

increase or decrease the purchase of any commodity, signifies the equilibrium of the

consumer.

The consumer’s equilibriumindicates the amount of different commodities which the

consumer can buy given his income and given prices of those commodities. Given the price

line and the indifference map, a consumer is said to be in equilibriumat a point where the

price line touches the highest attainable indifference curve from below. Thus, the following

two conditions must be satisfied for consumer’s equilibrium :

(i) The price line should be tangent to some indifference curve, that is, slope of price line

should be equal to the slope of the indifference curve. In other words, the marginal rate of

substitution of X commodity for Y commodity (MRSxy) must

be equal to the price ratio of the two commodities. This condition can be expressed as:

MRSxy = Px / Py

(ii)The second condition is that the indifference curve must be convex to the origin at the

point of tangency which means that the marginal rate of substitution of X for Y (MRS xy)

should be diminishing.

In order to find the consumer’s equilibrium, we superimpose an indifference map on

the price line to get the figure as shown below. Based on the two conditions necessary for

consumer’s equilibrium we find that C is the point of consumer’s equilibrium. The quantity

of good X is measured on the X-axis and that of Y on the Y-axis. PT is the price line and IC1,

IC2, IC3 form the indifference map. The price line

Consumer’s Equilibrium

PT is tangent to the indifference curve IC2 at point C which is the point of maximum

satisfaction. Points R and S do not reflect maximum satisfaction as they lie on a

lowerindifference curve IC1 and lower the indifference curve lower is the level of

satisfaction. Similarly, point U also does not reflect maximum satisfaction level. Although it

lies on a higher indifference curve but it lies outside the price line PT and hence, is beyond

the reach of the consumer.

Therefore, indifference curve analysis explains the concept of consumer’s equilibrium

in a better and realistic way as compared to the cardinal utility approach as it adopts the

ordinal measurement of utility and also uses a practical, measurable concept of marginal rate

of substitution. Moreover, the indifference curve analysis has quite theoretical and extensive

applications in innumerable fields. Almost every aspect of economic analysis and policy has

been explained by the indifference curveapproach in a logical and scientific manner. There

has been a general recognition that ordinal utilityanalysis is superior to the cardinal utility

approach. Even then ordinal utilityanalysis also suffers from some serious limitations:

consumer is not always rational; consumer may buy more than two goods; even absurd

combinations of two commodities are studied; all commodities are not divisible and many

others. Yet no denying the fact that it is better than the traditional theory and occupies an

important place among the theories to analyze the consumer behavior..

Activity B

Critically examine the law of Equi marginal Utility with example:

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2.4 Summary

The consumer behavior is explained on the basis of utility. Utility is a psychological or

subjective concept which reflects the want satisfying power of a commodity. There are two

approaches regarding the measurement of utility- cardinal approach and the ordinal approach.

The former assumes that utility can be exactly measured in cardinal numbers while the latter

assumes that utility can only be ranked. Cardinal utility analysis studies the concepts of total

and marginal utility. Based on these concepts there are two basic laws of consumption: the

law of diminishing marginal utility and the law of equi marginal utility. Ordinal utility

analysis studies the consumer behavior using indifference curves. An indifference curve

shows the different combinations of X and Y goods that yield equal satisfaction to the

consumer. Indifference curves slope downwards, are convex to origin, do not intersect and a

higher indifference curve shows higher satisfaction. The rate at which commodities X and Y

are exchanged by the consumer is known as the marginal rate of substitution (MRS)of X for

Y In case of indifference curve analysis the law of diminishing marginal rate of substitution

holds. A price line, on the other hand, shows all the combinations of two commodities which

the consumer can buy given his money income and the prices two commodities. Using these

two concepts of indifference curves and the price line, consumer’s equilibrium, a situation of

maximum satisfaction, can be derived in the ordinal utility analysis.


1. Indifference curves ………………. intersect each other.

2. A …………… shows all those combinations of two commodities which the consumer can

buy given his money income and the prices two commodities.

3. For consumer’s equilibrium, marginal rate of substitution of X commodity for Y

commodity (MRSxy) must be equal to the ………….. of the two commodities.

4. The slope is of price line is measured as the ratio of ………………. .

5. The …………… analysis is superior to the cardinal utility approach.

2.5 Glossary

Utility: It is the want satisfying power of a commodity.

Total Utility: Total Utility is the sum of utilities derived from the consumption of all the

units of a commodity.

Marginal Utility: It is the addition made to total utility by consuming an additional unit of

the commodity.

Indifference Curve: It shows the different combinations of two goods that yield equal

satisfaction to the consumer.

Price Line: It shows all the combinations of two commodities which the consumer can

actually buy given his money income and the prices two commodities.

Marginal Rate of Substitution: The rate at which commodities X and Y are exchanged by

the consumer.

Consumer’s Equilibrium: A situation in which the consumer gets maximum satisfaction

given the prices and limited income.

.



1. Utility

2. Cardinal

3. Marginal

4. Maximum

5. Marginal utilities


1. False

2. False

3. True

4. True

5. False


1. Never

2. Price line

3. Price ratio

4. Prices of two commodities

5. Ordinal utility

2.7 References

1. Baumol, K.E., Economic Theory and Operations Analysis, Prentice Hall of India, New

Delhi

2. Dwivedi, D.N., Microeconomic Theory, Pearson Education, New Delhi

3. Koutsoyiannis, A., Modern Microeconomics, Macmillan.

4. Mithani D.M. : Managerial Economics, Himalaya Publishing House, Mumbai


1. Dewett, K.K., Modern Economic Theory, S. Chand Publication

2. Peterson and Lewis, Managerial Economic, Prentice Hall of India

3. Gupta, Managerial Economics, TataMcGraw Hills

4.Geetika, Managerial Economics, Tata McGraw Hills


1. What is utility? Give the difference between total utility and marginal utility?

2. Discuss the law of diminishing marginal utility in detail.

3. Explain the concept of marginal rate of substitution.

4. Define indifference curve. Explain the properties of indifference curves.

5. Give the assumptions of cardinal utility analysis.

6. Explain consumer’s equilibrium with ordinal utility analysis.

7. What is price line?

8. How will you derive demand curve using the concept of marginal utility?

LESSON – 3

Demand Analysis

Structure

3.0 Objectives

3.1 Introduction

3.2 Meaning of Demand

3.3 Types of Demand

3.4 Determinants of Demand

3.5 Law of Demand

3.5.1 Assumptions of Law of Demand

3.5.2 Demand Schedule and Demand Curve

3.5.3 Causes of Application of Law of Demand

3.5.4 Exceptions of Law of Demand

3.6 Changes in Demand

3.7 Summary

3.8 Glossary


3.10 References



3.0 OBJECTIVES


To understand the basics of demand and its importance in decision making

To understand the determinants and types of demand

To comprehend the demand schedule, demand curve and the law of demand

3.1 INTRODUCTION

Demand forms the basis of all economic activities as it is an important economic

decision variable. Economic analysis remains incomplete without understanding the concept

of demand. The analysis of consumer demand for the product being produced by a firm plays

a crucial role in business decision making as demand determines the size and pattern of

market. All the decisions to be taken by the business managers are mostly demand driven, for

instance, decisions relating to the levels of investment and production depend on the market

demand of the products. Even the profit of a firm is influenced by the demand and supply

conditions of its output and inputs. The concept of demand is relevant even if a firm pursues

objectives other than profit maximization objective. It is necessary to evaluate the needs of

customers and social preferences in order to achieve these objectives. All the important

aspects of business decision making, like production planning, sales targeting, profit

targeting, pricing policies, revenue maximizing, inventory management, advertisement

depend on the product demand. The very survival and growth of a firm also depends on the

product demand. Hence, it is very important to understand the various concepts of demand

and then the law of demand.

3.2 Meaning of Demand

Demand refers to the desire to have a commodity backed by enough money to pay for

the good demanded. Thus, in economics demand refers to that desire which is effectively

supported by an adequate purchasing power. In order to understand the concept of demand it

is essential to distinguish between desire and demand. For instance, if a person wishes to buy

a car but does not have the required money, his wish is a desire. On the other hand, if he has

enough money to buy that; then it becomes effective desire or demand. Moreover the demand

is not complete unless the consumer has willingness to buy the commodity. If a person has

the desire to buy a product and also has enough money for it, but at a particular point of time,

he may not have willingness to buy the good, maybe due to a sudden change in his taste or

preference or fashion, etc. For example, when a rich person goes to a showroom to buy an

expensive dress but declines to buy, just because he does not find the colour of his choice.

Moreover, demand for a commodity is always expressed in relation to a particular price and a

particular time. Therefore, the demand for a product has the following five aspects:

(i) Desire to buy

(ii) Ability to pay

(iii) Willingness to spend

(iv) Particular price

(v) Particular time period

On the basis of these aspects of demand, various eminent economists have defined it

differently. A few important definitions of demand are as follows:

The demand for anything at a given price is the amount of it which will be bought per unit of

time at that price. --- Benham

The various quantities of a given commodity or service which consumers would buy in one

market in a given period of time at various prices, or at various incomes, or at various prices

of related goods. --- Bober

The demand for a good is a schedule of the amount that buyers would be willing to

purchase at all possible prices at any one instant of time. ---Meyers

Hence , the quantity of a given commodity which is purchased at some particular

price and at some particular time is called the quantity demanded or the demand for that

commodity.

3.3 Types of Demand

It is very important for any business manager to have an in depth knowledge of the

various kinds of demand as it helps in rational decision making. Various concepts of demand

are categorized on the basis of nature of the commodity demanded, time period for which the

demand is made, relationship between two goods and so on. Distinct concepts of demand

have been enlisted below.

Direct demand and derived demand: Goods can be demanded for different purposes, for

consumption or for production. On this basis, direct demand refers to the demand for goods

which are meant for final consumption. The demand for all household goods such as sugar,

milk, tea, food items, furniture, medicines, television, refrigerator, etc., are examples of

consumer goods etc. Such commodities are demanded as they are, that is why their demand is

called direct demand. On the contrary, derived demand refers to the demand for those goods

which are needed as a raw material or as an intermediary good in the production of any other

commodity. Such a good is called a capital good and its demand is called derived demand.

For instance, the demand for steel in the production of steel utensils is a case of derived

demand. Hence, derived demand is the demand for goods by the producers like the demand

for raw materials, intermediate goods, machine tools and equipment, etc. Similarly the

demand for factors of production is also an example of derived demand.

Final demand and intermediate demand: Based on the types of goods - final or

intermediate, the demand may befinal demand or intermediate demand. It is quite similar to

the distinction given above. The demand for goods for final consumption is called final

demand while the demand for semi-finished goods and raw materials is intermediate demand.

The demand for final goods is a direct demand. While the demand for semi-finished goods

and raw materials is derived and induced demand as it is dependent on the demand for final

goods. The usage of this type of distinction in demand is often employed in the input-output

models.

Domestic demand and industrial demand: Goods for domestic use have a domestic

demand while goods for industrial use or commercial use have an industrial demand. Such a

distinction between domestic and industrial demand is very significant in the context of

pricing and distribution of a product. For instance, the price of water, electricity, coal etc. is

intentionally kept low in case of domestic use as compared to their price for industrial use or

commercial use.

Autonomous demand and induced demand: Autonomous demand for a good is the

demand which is completely independent of the use of other product. However, this is a rare

phenomenon in the present world of dependence. On the other hand, the demand for

complementary goods (jointly demanded goods like bread and butter, pen and ink, tea, sugar

milk) is induced demand. In this case the demand for a product is dependent on the demand

of some other product. For instance, the demand for sugar is induced by the demand for

coffee.

New demand and replacement demand: The demand meant for an addition to stock is

called new demand, for example, demand for new models of a particular good say computer,

mobile, tractor, car or machine is new demand. On the other hand, replacement demand is the

demand for maintaining the old stock of capital or asset intact like the demand for spare parts

of a computer, mobile, tractor, car or machine is replacement demand. New demand is

usually an autonomous demand while the replacement demand is induced one, as it is usually

induced by the various factors like quantity and quality of existing stock.

Demand for perishable goods and demand for durable goods: Consumer goods can be

divided into two categories – Perishable and durable. Perishable goods are also non-durable

in nature or single use goods, while durable goods are non- perishable in nature or repeated

use goods. Milk, bread, butter, ice-cream, etc. are examples of perishable goods, and

furniture, computer, mobiles, house, etc. are durable goods. Perishable goods meet the

immediate demand and durable goods fulfill present as well as future demand. Demand for

durable goods is influenced by the replacement of old products and expansion of stock and

hence, changes with change in business conditions and price expectations.

Short run demand and long run demand: The demand for a good also depends on the time

for which it is demanded. Short- run demand is immediate demand as it is based on the

available taste and technology, products improvement and promotional measures operating in

the short run. Price-income fluctuations play an important role in case of short run demand.

Long run demand, on the other hand, is more influenced by changes in consumption pattern,

urbanization and work culture. Generally, short run demand is for immediate consumption

long-run demand is for future consumption.

Individual demand and market demand: The demand of a consumer for a product over a

period of time is called individual demand, whereas the sum total of demand for a product by

all individual consumers in a market is known as market demand,

Joint demand and Composite demand: When two or more goods together satisfy a

particular want, the demand for such goods is called joint demand. The demand for

complementary goods is a joint demand, like bread and butter or car and petrol. On the other

hand, when a commodity can be put to several uses its total demand in all the uses is called

composite demand. For instance, milk, electricity, etc. can be put to multiple uses.

Company demand and industry demand: Similar to the concept of individual demand and

market demand, is the distinction between company demand and industry demand. The

demand of a company or a single firm involved in the production of a particular product is

company demand. Alternatively, the demand of an industry (group of firms engaged in the

production of the same product) is the industry demand.

3.4 Determinants of Demand

Other than price, the quantity demanded for a particular commodity is influenced by

various other factors also. A mathematical function showing the functional relationship

between the demand for a product and various factors influencing it, is called a demand

function. A demand function may be expressed as follows:

DX = f ( Px, Ps, Pc, Yd, T, A, W, C, E, P, G, U)

where

Dx = Demand for commodity X

Px = Price of commodity X

Ps = Price of substitute of commodity X

Pc = Price of complementary goods of commodity X

Yd = Disposable income of the consumer

T = Taste and preferences of the consumer

A = Advertisement of commodity X

W = Wealth of the consumer

C = Climate

E = Price expectation of the consumer

P = Population

G = Government policies

U = Other unspecified and unidentified factors

The effect of these determinants of demand on the quantity demanded of a particular

commodity under normal circumstances is explained below:

Price of the product: It is the single most important determinant of demand of good.

Normally price has a negative effect on demand. Other things remaining the same, as price

increases, the demand for the good tends to fall and vice-versa. This negative relation

between price and demand is known as the law of demand. This type of demand showing the

effect of changes in price of a commodity on its quantity demanded other things remaining

same, indicates the price effect and is known as price demand.

Income of the consumer: Disposable income of the consumer an important variable

influencing the demand. As income increases, people have a tendency to buy more of

superior or normal goods and less of inferior goods. A normal good is a good whose quantity

demanded increases with increases in income, like higher segment cars. An inferior good is a

good whose quantity demanded decreases with increase in income, like inferior quality

cereal. The income effect changes the quantity demanded by allowing consumers to purchase

goods which they could not afford earlier. This type of demand explains the effect of changes

in the income of the consumer on the demand for a commodity, other things remaining same

and it is called income effect.

Taste and preferences of the consumer: These are important factors which affects the

quantity demanded of a product. The demand for a good will be large if tastes and

preferences are favourable and vice-versa. Many factors play a role in developing the tastes

and preferences like age, gender, professional status, level of education, social and cultural

factors, advertising, to name a few.

Prices of related goods: Related goods are of two types—substitutes and complements and

their prices affect the quantity demanded of a product. Substitutes are those goods which can

be interchangeably used. For example, tea and coffee are substitutes. If price of tea increases

the consumer can use coffee and vice versa. Complementary goods are those goods which are

demanded together and jointly satisfy a demand, like bread and butter or car and petrol. In

case of substitutes, the rise in price of one commodity results in an increase in the quantity

demanded of the other. If the price of substitute (say coffee) rises, the demand for tea

increases. However, in case of complementary goods, the change in the price of any of the

two goods surely affects the demand of the other good. For instance, if price of motor cars

rises, there will be a fall in the demand for motor cars. Along with it, the demand for petrol

also falls.

Consumer’s expectation of future income and prices: The purchases made by a consumer

also depend on future expectations along with present income and prices. If the price for

petrol is expected to rise in the near future, then the demand for petrol will increase now. If

the price for petrol is expected to drop in the near future, then the demand for petrol will

decrease now. Similarly, if a consumer expects a raise in salary in coming times, he will

postpone the demand for some good and buy it later.

Population: Important demographic features of the population like its size, age distribution,

gender ratio, rural urban ratio, etc. have a striking noticeable impact on the level of demand

in the economy.

Advertisement : Publicity measures have a great influence on demand. Sales turnover of

firms increases due to advertisement which is known as the promotional effect on demand.

Climate: The weather and climatic conditions of a region also influence the demand for

different goods. For instance, the demand for coolers and air conditioners increases in

summers, while that of heaters increases in winters.

Government policy: The government policy on taxes and subsidies of different

commodities also influences the demand of different goods differently. An increase in tax

rates or the imposition of new taxes results in a decrease in the demand and an increase in

subsidies increase the demand.

There are many other factors also which may not be specified or identified but

influence demand. Hence, a demand function shows the effect of different factors influencing

the level of demand.

Activity A

Explain the effect of demand for butter in following cases

a)The price of bread rises

-----------------------------------------------------------------------------------------------------------------

b)The price of jam falls

-----------------------------------------------------------------------------------------------------------------

c)The price of butter rises

-----------------------------------------------------------------------------------------------------------------

d)An increase in family income

-------------------------------------------------------------------------------------------------------------------

3.5 Law of Demand

In economics, the law of demand expresses the functional relationship between price

and quantity demanded for a particular commodity. The law states that other things remaining

the same or ceteris paribus, if the price of a commodity falls its quantity demanded will rise

and if price of the good rises quantity demanded will fall. In other words, there is an inverse

relationship between price and quantity demanded. The lawof demand is defined as follows:

People will buy more at lower prices and buy less at higher prices, ceteris paribus or other

things remaining the same. --- Samuelson

Other things being equal, the quantity demanded per unit of time will be greater, the lower

the price and smaller, the higher the price. ---Bilas

The amount demanded increases with a fall in price and diminishes with a rise in price.

---Marshall

Therefore, it can be said that the lawof demand states that other things remaining the

same, demand varies inversely with price.

3.5.1 Assumptions of the Law of Demand

The law of demand is based on the following assumptions:

1. The commodity is normal.

2. There is no change in the incomes of consumers.

3. There is no change in the tastes and preferences of consumers.

4. There is no change in the prices of related goods.

5. The goods are perfectly divisible.

6. There are normal conditions in the economy.

These assumptions refer to the ‘other things remaining the same or ceteris paribus’ clause

of the statement of the law of demand. In other words, assumptions refer to those conditions

which must be met for the law of demand to be valid.

3.5.2 Demand Schedule and Demand Curve

A demand schedule is a tabular representation showing the different quantities of a

commodity that would be demanded at different prices. It shows the quantities of a good that

will be purchased at different possible prices. A demand schedule can be shown as below:

Demand Schedule

The above demand schedule clearly shows that for a commodity X, as price rises,

quantity demanded falls, other things remaining the same. Such a demand schedule which

shows the quantities of a commodity that would be demanded at different prices for an

individual consumer is called an Individual Demand Schedule. This demand schedule can be

represented in the form of a diagram to get a demand curve as shown as below:

Demand Curve

The above figure is a diagrammatic representation of the individual demand schedule

which shows the quantities of a commodity that would be demanded at different prices for an

individual consumer. This curve is called Individual Demand Curve.

When we study relationship between the quantities of a commodity that would be

demanded at different prices for all the individuals in the market, other things remaining the

same, it is called Market demand. The market demand or aggregate demand for a commodity

refers to the alternative quantities of a commodity that would be demanded at different

pricesper time period, by all the individuals in the market. Thus, the market demand for a

commodity depends on all the factors that determine the demand of one individual and also

on the total number of individual buyers of the commodity in the market. A market demand

schedule is a tabular representation showing the different quantities of a commodity that

would be demanded at different prices by all the individual buyers of the commodity in the

market. Similarly, a diagrammatic representation of the market demand schedule which

shows the quantities of a commodity that would be demanded at different prices for all the

individual consumers of the commodity in the market, is called a market demand curve.

Market Demand Schedule

The above market demand schedule clearly shows that for a commodity A, as price

rises, the total quantity demanded in the market or the market demand falls, other things

remaining the same. Such a market demand schedule which shows the quantities of a

commodity that would be demanded at different prices for all the individual consumers in

the market is called an MarketDemand Schedule. It is clear that market demand is the sum of

individual demands of the three individual consumers in the market, X, Y and Z. This market

demand schedule also establishes the negative relation between price and quantity demanded,

other things remaining the same. It can be represented in the form of a diagram to get a

demand curve known as the as shown as below:

The market demand curve can be obtained by the lateral summation of all individual demand

curves in the market. The market demand schedule and market demand curve have much

significance from practical point of view. First of all market demand schedule can assist the

business managers in deriving the revenue curves of a particular business firm. Further a

market demand schedule can assist the government authorities in assessing the impact of a

particular tax measure on the market demand. Moreover, the businessmen or the producers,

particularly the monopolists, make use of the market demand schedule in the fixation of the

prices of their products. Hence, market demand schedule and market demand curve are of

great practical importance in assisting the business managers in the process of business

decision making.

3.5.3 Causes of Application of the Law of Demand

According to the law of demand there is an inverse relationship between price and quantity

demanded, other things remaining the same. Consequently, the demand curve slopes

downward from left to the right. The demand schedules, both individual and market, have

shown that lower the price of a commodity, the greater is the quantity demanded of the

commodity by the individual or the market. This inverse relationship between price and

quantity is reflected in the negative slope of the demand curve. Hence, with a few exceptions,

the demand curve always slopes downward from left to the right. Why does the demand

curve slope downward from left to the right, can be attributed to the following reasons:

(a) An important reason is the operation of the law of diminishing marginal utility.

According to the law of diminishing marginal utility, other things remaining the same,

as the consumer goes on buying more and more units of a commodity, the utility

derived from each successive unit goes on diminishing. In equilibrium, there is an

equality between marginal utility and price. This means that the purchase of more

units of the commodity is associated with lower price. Hence, the inverse relationship

between price and quantity demanded is on account of the law of diminishing

marginal utility.

(b) Income effect: When the price of a commodity falls, real income of the people

increases. In other words, consumers are now able to buy more goods and services

with the same amount of money they have. Hence, the desire to buy intensifies and

people buy more at lesser price. This is called income effect.

(c) When the price of a commodity decreases, new demand is created for it as many

people who could not earlier afford it, can now buy it. Also that existing buyers tend

to buy more. As a result demand curve slopes downward from left to the right.

(d) As price of a commodity decreases, some people will purchase it in preference to

other commodities which means cheaper commodity tends to be substituted for other

commodities, which are relatively costly. This is called substitution effect.

Both the income effect and the substitution effect together increase the capacity of the

consumers to buy more quantity of a commodity, at a lower price.

(e) A commodity can be put to several uses as it becomes cheaper. For example, coal can

be put to many uses. If the price of coal is high, it is possible that it is used only in the

factories. As its price falls, it may be used by railways and power plants. If there is a

further fall in price, the households may also start using it as fuel. Thus, with a fall in

price, the demand for a commodity expands and the demand curve slopes downward

from left to the right.

3.5.4Exceptions to the Law of Demand

If the assumptions of the law of demand are not met, this law fails to apply. There are

a few exceptions to the law of demand. It means those conditions when the law does not hold

good or the inverse relationship between price and quantity demanded may not remain valid.

In such cases the demand curve does not slope downward from left to the right. These

exceptions are:

1. The law of demand does not hold in case of certain goods known as Giffen goods. In case

of such goods, quantity of a commodity that would be demanded rises with the rise in price.

These goods were first discussed by Sir Francis Giffen. According to him, a Giffen good is

a strongly inferior good where consumer buys more of an inferior good when the price of the

good rises, which is in direct violation of the Law of Demand. For example, staple foods like

rice. If the price of rice rises then people with less income will spend less on superior foods

and instead buy more rice. This is called Giffen Paradox.

2. Thorstein Veblen observed that in case of conspicuous consumption, the demand

curve does not slope downwards. Many times people buy certain commodities to show their

higher status in the society, like Rolls Royce cars, diamonds and other precious stones, etc.

Richer people buy more of such goods even at very high price to show off in the society,

violating the law of demand. These goods are called Veblen goods.

3. People may buy more of a commodity even at high prices, out of sheer ignorance. Hence,

the law of demand also not apply to such a commodity also.

4. Speculation, where people make 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 rising

and consumers expect a further rise in the price, they will tend to buy more of the commodity

in the present even at a higher price.

Hence, Giffen goods and Veblen goods are exceptions to the Law of Demand. They are

extreme cases and show how these goods violate the Law of Demand. The Veblen effect

representing a form of irrational consumption, is an anomaly in the law of demand in

economics. There are two other related effects as given below:

1. The snob effect- It shows that the preference for a good decreases as the number of

people buying it increases. This effect may lead to a demand curve sloping upwards,

violating the law of demand which causes the demand curve to have a negative slope.

The snob effect is a phenomenon indicating a situation where the demand for a certain

good by consumers having a higher income level is inversely related to the demand

for that good by consumers of a lower income level. This situation arises due to the

desire to own unusual and expensive goods, which have a high economic value, but

very low practical value. The snob value of a commodity is reflected in its

availability. Lesser is the quantity available of the commodity, the higher will be

its snob value. For examples goods like rare works of art, designer clothing, etc., have

a high snob value.

2. The bandwagon effect - It indicates that the preference for a good increases as the number

of people buying it increases, that is the bandwagon effect reflects the tendency to follow the

actions or beliefs of others.Thus, the bandwagon effect describes the interactions of demand

and preference. It comes into force when people's preference for a commodity increases when

the number of people buying it increases. Such an interaction disturbs the normal results of

http://intelligenteconomist.com/demand/

http://en.wikipedia.org/wiki/Good_(economics)

http://en.wikipedia.org/wiki/Works_of_art

http://en.wikipedia.org/wiki/Designer_clothing

the theory of supply and demand, which assumes that consumers make buying decisions only

on the basis of price and their own personal preference. The bandwagon effect may be so

strong that it may make the demand curve slope upwards, violating the law of demand. The

bandwagon effect is also known as demonstration effect. In this case, the demand for a

product appears to be determined by consumption pattern of trend setters like cricket stars,

film stars, models, etc., and not by the utility derived from it.


State whether the following are true or false.

1. Demand refers to the desire to have a commodity.

2. As income increases, people buy more of a given good if it is a normal good.

3. Direct demand refers to the demand for goods which are meant for final consumption.

4. Population structure has no impact on the level of demand in the economy.

5. A demand function shows that quantity demanded for a particular commodity is

influenced by price alone.

3.6 Changes in Demand

In economic analysis, the law of demand expains the changes in demand due to changes

in price. However, sometimes changes in demand are not associated with changes in price but

with certain other non price factors. Based on the factors causing the changes in demand –

price factors or non price factors, the changes in demand can broadly be of two types:

(1) Extension and Contraction in Demand

(2) Increase and Decrease in Demand

Extension and Contraction in demand

When the changes in quantity demanded for a commodity take place on account of

changes in its price, these signify either extension or contraction in demand. Hence,

extension or contraction in demand relates to the law of demand as in this case, changes in

the quantity demanded take place only in response to the own price of the commodity. This

means all the components of the demand function remain unchanged except the price the

commodity under consideration.

If the price of a commodity falls, other things remaining the same, it leads to larger

purchase of this commodity. This is called extension in demand. It signifies more demand at

a lower price. On the other hand, if the price of a commodity rises, other things remaining the

same, it leads to smaller purchase of this commodity.

http://en.wikipedia.org/wiki/Supply_and_demand

Extension and Contraction in Demand

Extension and Contraction in Demand may be diagrammatically explained with the help of

the above figure. It is clear from the figure that the changes in quantity demanded are shown

by the movement along the same demand curve. A downward movement from one point to

another on the same demand curve, showing more demand at a lower price, indicates an

extension of demand. On the contrary, an upward movement from one point to another on the

same demand curve implies contraction of demand, showing that lesser quantity is demanded

at higher price.

Increase and Decrease in Demand

When the changes in quantity demanded for a commodity take place not on account

of changes in its price, but due to other non price factors, these signify either increase in

demand or decrease in demand. Hence, increase and decrease in demand do not relate to the

law of demand as in this case other components of the demand function change except the

price the commodity under consideration. Only the non price factors like income, taste and

preferences, price of related goods, climate, population, etc., change while the price the

commodity under consideration remains the same.

Increase or decrease in demand, is graphically represented by a shift in the demand

curve from one position to another. In case of an increase in demand, the demand curve is

shifted to the right in the upward direction as shown below:

Increase in Demand

The increase in demand takes place due the non price factors, in two situations:

(1) More demand at the same price

(2)Same demand at higher price

As the above diagram clearly shows the demand curve shifts to the right from DD to

D1D1 indicating an increase in demand.

Similarly, decrease in demand takes place again due the non price factors, in the

following two situations:

(2) Less demand at the same price

(2)Same demand at lower price

Decrease in Demand

The above diagram clearly shows that the demand curve shifts to the left from DD to D2D2

indicating a decrease in demand.

Activity B

Plot the following demand schedule on a graph paper.

Demand of X

Price of X

Buyer 1

Buyer 2 Total demand

10

8

6

4

2

5

8

12

20

50

8

10

15

20

50

13

18

27

40

100

3.7 Summary

Demand is one of the most important economic decision variables. The analysis of consumer

demand for the product being produced by a firm plays a crucial role in managerial decisions

related to market strategy, pricing, advertising, production planning, inventory management,

financial evaluation and investment decisions. Demand is the quantity of a given commodity

which is purchased at some particular price and at some particular time. The quantity

demanded is determined by both price and non price factors. The demand function expresses

the functional relationship between the demand for a product and various factors determining

the demand. The law of demand expresses the functional relationship between price and

quantity demanded for a particular commodity, other things remaining the same. It shows that

the demand curve slopes downward from left to the right. Changes in demand take place due

to change in price of the commodity - extension or contraction in demand and also due to

changes in non price factors - increase or decrease in demand.

3.8 Glossary

Demand: It refers to the quantity of a commodity which will be purchased at a given price

and at a given time.

Demand function: It expresses functional relationship between the demand for a commodity

and the determinants of demand.

Law of demand: The law of demand expresses the functional relationship between price and

the quantity demanded for a particular commodity, other things remaining the same.

Substitutes :Those goods which can be interchangeably used in place of each other for

satisfying a specific want like tea and coffee.

Complementary goods: When two or more goods together satisfy a particular want, the

demand for such goods is called joint demand and the goods are called complementary goods

like bread and butter or pen and ink.

Giffengoods :Those goods whose demand falls with increase in income of the

consumers, for example, inferior quality cereal.


1. The law of demand expresses the functional relationship between ………….. and quantity

demanded for a particular commodity.

2. The law of ……………………….. utility explains why the demand curve slopes downward

from left to the right.

3. The …………. effect shows that the preference for a good decreases as the number of people

buying it increases.

4.……….. goods and ……….. goods are exceptions to the law of demand.

5. The ………… in demand shows that the demand curve shifts outwards to the right.



1. False

2. True

http://intelligenteconomist.com/demand/

3. True

4. False

5. False


1. Price

2. Diminishing marginal

3. Snob

4. Giffen, Veblen

5. increase

3.10References

Koutsoyiannis, A : Modern Microeconomics, The Macmillan Press Ltd.,, London

Dewett, K.K., Modern Economic Theory, S. Chand Publication

.

Geetika, Managerial Economics, Tata McGraw Hills


Mithani D.M. : Managerial Economics, Himalaya Publishing House, Mumbai

Dwivedi, D.N. : Managerial Economics, Vikas Publishing House Pvt. Ltd, New Delhi

Misra&Puri : Economics for Managers, Himalaya Publishing House, Mumbai

Adhikary M. : Managerial Economics, Khosla Educational Publishers, Delhi


1. Define demand.

2. Explain the law of demand. Illustrate your answer with an appropriate diagram.

3. What is the shape of a demand curve?

4. What is demand function?

5. Distinguish between increase in demand and extension in demand.

6. What is market demand?

7. Show the shifts in the demand curve and movement along the demand curve with the help

of diagrams.

8. What do you mean by substitutes and complementary good?

LESSON – 4

Elasticity of Demand

Structure

4.0 Objectives

4.1 Introduction

4.2 Meaning of elasticity of demand

4.3 Types of elasticity of demand

4.3.1 Price elasticity of demand

4.3.1.1 Degrees of price elasticity of demand

4.3.1.2 Measurement of price elasticity of demand

4.3.2 Income elasticity of demand

4.3.3Cross elasticity of demand

4.3.4 Promotional or advertisement elasticity of demand

4.4 Factors determining elasticity of demand

4.5 Importance of elasticity of demand

4.6 Summary

4.7 Glossary


4.9 References



4.0 OBJECTIVES


To understand the meaning of elasticity of demand and its importance in decision

making

To understand the different types of elasticity of demand used in business decisions

To comprehend the degrees of elasticity of demand

To know the methods of measurement of elasticity of demand

4.1 Introduction

Demand plays an important role in economics as well as in the economy as a whole.

The law of demand explains that demand rises with a fall in price and vice-versa, other things

remaining the same. Hence, the law of demand deals only with the direction of change in

demand due to a change in price. However, the law of demand fails to explain what will be

the extent of change in demand due to a given change in price. Thus, the law of demand

makes only a qualitative statement of the relationship between demand and price and does not

consider the quantitative relationship between demand and price. The concept of elasticity of

demand deals with the quantitative aspects regarding the inverse relationship between price

and demand. The knowledge of the nature of relationship between the demand for a product

and the factors determining the quantity demanded (that is, the knowledge of the demand

function) is not sufficient from the point of view of the business managers of a firm. The

degree of responsiveness of demand to changes in its determinants is more important for

rational decision making by the business managers. This degree of responsiveness of demand

to changes in its determinants is referred to as theelasticity of demandfor the product under

consideration. This concept of elasticity of demand is highly significant in the pricing

decisions of the business firms. In rational business decisions making, the firms intend to

shift the increases in cost over to the consumers through price increases. How far this

increase in price due to increasing cost is favourable for the firm, will depend on the elasticity

of demand for that product. Therefore, an in depth study of the concept of elasticity of

demand is extremely essential for the business firms as it helps the firms in making major

business decisions.

4.2 Meaning of Elasticity of Demand

Generally speaking the term elasticity is concerned with the responsiveness of one

variable to changes in another. Specifically, the elasticity of demand indicates the degree of

responsiveness of demand to the changes in its determinants. It shows the response of the

demand of a commodity when there is either increase or decrease in its price. Business

managers of the firms have great advantages by knowing elasticity of the products of the

firm. A greater response in the demand of a commodity indicates greater elasticity and a

smaller response indicates less elasticity. For example, a business manager will definitely be

interested in knowing whether sales will increase by six percent, twelve percent or maybe

more by cutting down price by say, seven percent. Thus, elasticity of demand of a commodity

measures the degree of responsiveness of demand to a change in price of that commodity.

The concept of elasticity of demand in the economic theory was introduced by Prof. Alfred

Marshall. He defined it as:

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. -------- Alfred Marshall

Other important definitions of elasticity of demand by eminent economists are listed below.

The elasticity of demand may be defined as the percentage change in the quantity demand

which would result in one percent change in price. ------Boulding

The elasticity of demand at any price or at any output is equal to the proportional change of

amount demanded in response to a small change in price divided by the proportional change

in price. ------Mrs Joan Robinson

Elasticity of demand is the responsiveness of demand to change of prices.

-------Hanson

Thus, elasticity of demand may be defined as the ratio of the percentage change in quantity

demanded to the percentage change in price. Other things remaining the same, if certain

percentage changes in demand of a commodity take place due to certain percentage change in

a price of that commodity, it is known as elasticity of demand. Boulding has given the

following formula to compute the elasticity of demand as follows:

Another formula for calculation of the elasticity of demand has been given by

Robinson which measures elasticity of demand as the ratio of the percentage change in

quantity demanded to the percentage change in price.

Theoretically it is possible to discuss the elasticity of demand for all the different

factors affecting demand, represented in the demand function, but in real practice, broadly

there are four main types of elasticity of demand which can be measured and examined.

These four types of elasticity of demand correspond to four specifically important factors in

the demand function: price of the commodity, income of the consumer, the price of a related

product and promotion or advertisement and are referred to as the price elasticity of demand,

income elasticity of demand, cross elasticity of demand and promotional elasticity of demand

respectively. A detailed analysis of each of these elasticity of demand is given ahead.

4.3 Types of Elasticity of Demand

As mentioned above, depending on the factors influencing the level of quantity

demanded, four main types of elasticity of demand can be listed. Price elasticity of demand

measures the responsiveness of demand of a commodity to change in the price of that

commodity. Income elasticity of demand measures the responsiveness of demand of a

commodity to change in the income of the consumer. Similarly, cross elasticity of demand

captures the responsiveness of demand of a commodity to change in the price of a related

commodity, and promotional elasticity of demand measures the responsiveness of demand of

a commodity to change in advertisement measured in terms of expenditure on advertisement.

4.3.1 Price elasticity of demand

Price elasticity of demand is a measure of the responsiveness by which consumers

change their quantity demanded due to a change in price. If demand is more price elastic

demand, it means that the consumers are more responsive to changes in price. On the other

hand, if demand is less price elastic demand , then the consumers are less responsive to a

price change. The price elasticity of demand is measured as the percentage change in quantity

demanded divided by the percentage change in price. Demand may be less elastic, more

elastic or inelastic. When a small change in price leads to a great change in demand, demand

is said to be elastic. If a two percent cut in prices of bike results in an increase of twenty

percent in sales, then the demand is said to be highly elastic (as demand has responded

greatly). On the other hand, if a great change in price leads to a small change in demand, the

demand is said to be inelastic demand. Price elasticity of demand is expressed as under:

Price elasticity of demand is defined by some eminent economists as follows:

The responsiveness of the quantity demanded of any good X to a change in its own price, is

called the price elasticity of demand. -----Ryan

The elasticity of demand is a measure of the relative change in amount purchased in response

to a relative change in price on a given demand curve.

----Meyers

Elasticity of demand may be defined as the ratio of the percentage change in quantity

demanded to the percentage change in price. ---- Lipsey

Hence, price elasticity of demand is a measure of the relative change in the demand

for a commodity to a change in its price.

4.3.1.1 Degrees of Price elasticity of demand

The price elasticity of demand measures the percentage change in the quantity demanded of a

commodity per unit of time due to a given percentage change in the price of the commodity.

There are five degrees of price elasticity of demand each of which is discussed as follows:

(1) Perfectly Inelastic Demand: Demand for a commodity is said to be perfectly inelastic, if

the quantity demanded of a commodity does not change at all in response to a given change

in price. For example, if a ten percent change in price results in zero percent change in

demand, it is perfectly inelastic demand.

In this case, the demand curve is vertical straight line perpendicular to X-axis as shown

above. When demand for a commodity is perfectly inelastic demand, the coefficient of price

elasticity of demand, e is equal to zero (e=0).

(2) Inelastic or less than Unit Elastic Demand: Demand for commodity is said to be

inelastic (or less than unit elastic) if the percentage change in quantity demanded of a

commodity is less than the percentage change in price. For example, if a ten percent change

in price results in six percent change in demand, it is called inelastic or less elastic demand.

This is shown in the figure given below:

In this case, the coefficient of price elasticity of demand, e is less than one (e‹1).

(3) Unitary Elastic Demand: Demand for a commodity is said to be unitary elastic if the

percentage change in quantity demanded is exactly equal to the percentage change in price.

For example, if a ten percent change in price results in ten percent change in demand, it is

called a unitary elastic demand, as shown below:

The demand curve in in case of unitary elastic demand s shown above is called rectangular

hyperbola. In this case, the coefficient of price elasticity of demand, e is equal to one (e=1).

(4) More than Unitary Elastic: Demand for a commodity is said to be more than unitary

elastic demand if a given change in price results in a significant more than proportionate

change in demand for this commodity. For example, if a ten percent change in price results in

a fourteen percent change in demand, it is called more than unitary elastic demand. This can

be shown with the help of the following figure:

In this case, the coefficient of price elasticity of demand, e is more than one (e›1).

(5) Perfectly Elastic Demand: Demand for a commodity is said to be perfectly elastic, when

a small change the price of the commodity results in an infinitely large change in its quantity

demanded. It is a situation in which demand of a commodity continuously changes without

almost any change in price. For example, if say half a percent change in price results in an

infinite percent change in demand, it is called exactly elastic demand. This can be shown as

below:

In this case, the demand curve is horizontal straight line parallel to the X-axis and the

coefficient of price elasticity of demand, e is equal to infinity (e=∞).

4.3.1.2 Measurement of price elasticity of demand

The extent of responsiveness of demand to changes in price can be measured in different

ways. The important methods of measurement of price elasticity of demand are:

1. Percentage method.

2. Arc method.

3. Point method.

4. Total outlay method.

5. Revenue method.

1. Percentage method.

Price elasticity of demand can be measured using the percentage method or proportionate

method. According to this method, price elasticity of demand is measured as the ratio of the

percentage change in quantity demanded to the percentage change in price as shown below:

Where ep= price elasticity of demand; Δq= change in the quantity demanded and Δp=

change in price. Also p = price of the commodity and q = quantity demanded. It is important

to note thatthe price elasticity of demand is always negative because of the fact that the price

and quantity are, in general, inversely related. By convention the negative sign is dropped.

2. Arc Method

Arc method is another important method to measure the price elasticity of demand. If there

are relatively larger changes in price and demand, the proportionate method does not give

accurate results. In this method, the averages of original and new prices and quantities are

used to measure the price elasticity of demand. Arc method is so called because in measuring

big changes in demand and price, an arc is formed on the demand curve. Price elasticity of

demand, using arc method can be measured by using the formula shown below:

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

3. Point Method

The point method measures price elasticity of demand at a particular point on the demand

curve. Therefore, it is also known as geometrical method of measuring price elasticity of

demand. Using this method, different types of elasticity on a demand curve can be measured

as follows. D''D is a linear line demand curve (indicated by a straight line having a constant

slope). Price elasticity of demand at any point on the demand curve is measured using the

following formula

At different points the price elasticity of demand is as shown in the figure given

below. It is obvious that price elasticity of demand falls steadily as we move from from point

D'' (e=∞) towards D(e=0), where D''D is the linear line demand curve. At the mid

pointR,where lower segment is equal to the upper segment, the price elasticity of demand is

one (e=1). Between point D'' and the mid point R, the price elasticity of demand is greater

than one (e›1). Similarly between point R and the point D, the price elasticity of demand is

less than one (e‹1).

For instance, elasticity at point R can be calculated using the above expression as follows

Similarly, elasticity of demand at different points on the demand curve is shown as under:

At the point D'' touching the Y-axis, price elasticity of demand is

At the point D touching the X-axis, price elasticity of demand is

At the point S, price elasticity of demand is

And at point T, price elasticity of demand is

4. Total outlay method.

Total outlay method to measure the price elasticity of demand was primarily used by Prof.

Alfred Marshall. According to this method, elasticity is measured by comparing the total

money spent by the consumer on the goods before and after the changes in price. Hence, this

method of measuring the price elasticity of demand is also known as the total expenditure

method. In this method, the price elasticity of demand for a commodity is measured with the

help of the total expenditure incurred by a consumer on the purchase of that commodity.

Total outlay or total expenditure can be expressed as

TQ = p × q

where TQ stands for total expenditure or outlay, p for the price of the commodity and q for

the quantity of the commodity.

Using this method elasticity can be measured for the following three situations:

(1) Less than Unitary Elastic Demand (e < 1)

(2) More than Unitary Elastic Demand (e > 1)

(3) Unitary Elastic Demand (e = 1)

Less than Unitary Elastic Demand (e < 1): If the total expenditure incurred by consumer on

a given commodity rises with an increase in price and falls with a fall in price, it is the case of

inelasticity of demand or less than unitary elastic demand (e < 1). Such a case of fall in total

expenditure with a fall in price indicating a direct relationship between price and total

expenditure can be shown as follows:

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

(Rs.)

25 12 300

20 13 260

When price falls from Rs. 25 to Rs. 20 per unit, total expenditure falls from Rs. 300 to Rs.

260.

More than Unitary Elastic Demand (e > 1): If the total expenditure incurred by consumer

on a given commodity falls with an increase in price and rises with a fall in price, it is the

case of elastic demand or more than unitary elastic demand (e >1). Such a case of rise in total

expenditure with a fall in price indicating an inverse relationship between price and total

expenditure, can be shown as follows:


(Rs.)

25 12 300

20 18 360

When price falls from Rs. 25 to Rs. 20 per unit, total expenditure rises from Rs. 300 to Rs.

360.

Unitary Elastic Demand (e = 1): When the total expenditure (TQ) on a given commodity

remains unchanged even after a change (rise or fall) in the price of the commodity, then the

price elasticity is said to be unitary elastic. This case of unitary demand can be illustrated

with the help of the following example, where TQ remains the same even when there is a fall

in the price.


(Rs.)

25 12 300

20 15 300

As is evident from the above table, when price falls from Rs25 per unit to Rs. 20 per unit, the

total expenditure does not change, it remains the same at Rs. 300. Hence, the demand is a

unitary elastic demand.

The measure of the price elasticity of demand using the total expenditure method can be

depicted with the help of the following figure:

The above diagram clearly shows that the demand is more than unitary elastic over the price

range P and Q, that is AB segment of the total expenditure curve; it is less than unitary elastic

over the price range S and R, that is CD segment of the total expenditure curve and unitary

elastic over the price range Rand Q, that is BC segment of the total expenditure curve.

5. Revenue method.

Revenue means the amount that a firm earns by selling its output. What is sold by a firm

reflects the demand by the buyers. Two concepts related to revenue- average revenue and

marginal revenue, are used in this method. Average revenue is the ratio of the total revenue to

the units of output sold. Total revenue is measured by multiplying price with total units of

the product sold. If 10 kg of apples are sold and total revenue is Rs. 600, then the average

revenue is 600/10 = Rs. 60. Marginal revenue is the addition made to and total revenue by the

sale of an additional unit of the output. If total revenue from the sale of 10 kg of apples is Rs.

600 and total revenue from the sale of 11 kg of apples is Rs. 650, then marginal revenue is

650 – 600 = Rs. 50.

Using the concepts of average revenue and marginal revenue, price elasticity of demand can

be measured using the following formula:

Therefore, depending on the given situation, there are different methods to measure the price

elasticity of demand.

4.3.2Income elasticity of demand

The demand for a commodity changes not only on account of a change in its price but also

due to a change in the income of the consumer. Income is an important component of the

demand function. Income elasticity of demand indicates the extent by which demand for a

commodity changes due to a given change in the income of the consumer. Thus, income

elasticity of demand measures the level of responsiveness of consumer demand to the

changes in income, other things remaining same. The income elasticity of demand has been

defined by different economists as follows:

Income elasticity of demand means the ratio of the percentage change in the quantity

demandedto thepercentage change in income. ---- Watson

The responsiveness of demand tochange in income is termed as income elasticity of demand.

--- Lipsey

Using the proportionate method or the percentage method, income elasticity of demand can

be measured as

The coefficient of income elasticity of demand measures the percentage change in the

quantity demanded of a commodity per unit time due to a given percentage change in a

consumer’s income. Thus, the income elasticity of demand can be depicted as given below

Where Q is the quantity demanded and Y is the income of the consumer ∆Q is the change in

the quantity demanded and ∆Y is the change in the income of the consumer.

Income elasticity of demand also has different degrees similar to that of price elasticity of

demand. If the proportionate change in the quantity demanded of a commodity is more than

the proportionate change in the income of the consumer, demand is highly elastic or to be

precise, highly income elastic (e>1). On the other and, if the proportionate change in the

quantity demanded of a commodity is less than the proportionate change in the income of the

consumer, demand is less elastic or less income elastic (e < 1). If the proportionate change in

the quantity demanded of a commodity is equal to the proportionate change in the income of

the consumer, demand is unitary elastic or unitary income elastic (e=1). Two extreme

possibilities are e=0, when there is no change in demand at all in response to a change in

income, and e=∞, there is infinite change in demand in response to a given change in income.

We know that usually with an increase in income of the consumer, the quantity demanded

also increases, that is, income elasticity of demand is positive. But in certain cases the income

elasticity of demand is negative. Goods whose income elasticity of demand is positive

(greater than zero) are normal goods while the goods that have a negative (less than zero)

income elasticity of demand are known as inferior goods. Therefore, depending on whether a

good is normal or inferior, the income elasticity of demand may be positive, negative or zero,

as discussed ahead:

Positive Income Elasticity of demand (e > 0):

A good having positive income elasticity of demand is called a normal good. Hence, a normal

good is one whose consumption increases with the increase in the income of the consumer,

for example food, clothes, jewellery, etc. As income increases, demand increases and vice

versa. Positive income elasticity of demand may be of three types- unitary elastic (e=1), more

than unitary elastic or highly income elastic (e>1) and less than unitary elastic or highly

income inelastic demand (e < 1).

Negative Income Elasticity of demand (e < 0):

A good having negative income elasticity of demand is called an inferior good. Hence, an

inferior good is one whose consumption decreases with the increase in the income of the

consumer, for example inferior quality of gur or cereal. As income increases demand

decreases and vice versa. Negative income elasticity of demand reflects that e < 0. With a rise

in the income, the consumer reduces the consumption of the inferior good but increases the

consumption of better quality or superior goods, which he could not afford earlier due to

lesser income.

Zero Income Elasticity of demand (e=0):

A good having zero income elasticity of demand is called a neutral good. Hence, a neutral

good is one whose consumption does not change with an increase or decrease in the income

of the consumer, for example necessaries such as salt, matchbox, etc. The quantity demanded

of such goods does not change with change in income.

Hence, the income elasticity of demand is positive for all normal goods, but the

degree of income elasticity depends on the nature and type of commodities. Broadly

speaking, the consumer goods may be divided into three categories- necessaries, comforts,

and luxuries.Necessaries or essential goods have less than unitary elastic income elasticity of

demand (e < 1); comforts have income elasticity of demand almost equal to unity (e=1) and

luxuries have more than unitary elastic income elasticity of demand (e>1).

The concept of income elasticity of demand provides extremely useful information for

the managers of business a firm. The firm may want to improve its product if it has

information that the income elasticity of its product is low. Income-elasticity of products is

very important in long run planning and management of production. It can also be used to

estimate the future demand which in turn helps in demand forecasting, other things remaining

the same. Income elasticity of demand can also help avoid over production and under

production.


1. Select the correct statement about price elasticity of demand?

A. It determines the relationship between price and revenue.

B. It determines the relationship between supply and demand.

C. It can be calculated by dividing price by revenue.

D. It is a relationship between price changes and the responsiveness of consumer demand to

these changes.

2. If the price of a good is increased by four percent and in response the quantity demanded

decreases by two percent, then the demand is

A. More elastic.

B. Less elastic.

C. Unitary elastic.

D. The quantity demanded is not affected at all.

3. Select the correct statement relating to price elasticity of demand?

A. It does not study the relationship between complements.

B. It measures the value of total national income.

C. It does not study the relationship between substitutes.

D. It measures the quantitative relationship between changes in price of a good and quantity

demanded.

4. In case of unitary elastic demand, the shape of demand curve is

A. Straight line parallel to X-axis

B. Straight line parallel to Y-axis

C. Rectangular Hyperbola

D. None of the above

5. Price elasticity of demand measures the

A. Quantitative relation between price and demand

B. Qualitative relation between price and demand

C. Psychological relation between price and demand

D. None of the above

4.3.3 Cross elasticity of demand

The demand for a commodity changes also due to a change in the prices of related goods like

substitutes or complements. The demand of tea is affected by the price of its substitute coffee

and also the demand of car is affected by the price of its complement petrol. The cross

elasticity of demand indicates the extent by which demand for a commodity changes due to a

given change in the price of its related good. Hence, the cross elasticity of demand measures

the correlation between a commodity and its substitutes or complements. Or, the

responsiveness of quantity demanded to a change in the prices of related commodities –

substitutes or complements, is called cross elasticity of demand. It is defined as follows:

The responsiveness ofdemand to a change in the prices of other commodities is called cross

elasticity of demand. --- Lipsey

The cross elasticity of demand is a measure of the responsiveness of purchases of Y to

change in the price of X. --- Liebhafsky

The cross elasticity of demand is the proportionate change in the quantity of X demanded

resulting from a given relative change in the price of the related good Y.

--- Ferguson

Using the proportionate method or the percentage method, cross elasticity of demand can be

measured as

Where QX is the quantity demanded of commodity X and PY is the price of the related

commodity Y. ∆QX is the change in the quantity demanded of X and ∆PY is the change in

the price of the related commodity Y.

The cross elasticity of demand also has the following main degrees:

Positive cross elasticity of demand: If a certain percentage increase in the price of X causes

an increase in the quantity demanded of related good Y, the cross elasticity of demand is said

to be positive (e>0). Thus, in case of positive cross elasticity of demand, the demand of Y

moves in the same direction as the price of X. Such goods are known as substitutes, those

goods which can be interchangeably used. Suppose the price of coffee rises by 5 percent and

it causes the demand of tea to rise by 3 percent, the cross elasticity of demand is positive.

Negative cross elasticity of demand: If a certain percentage increase in the price of X

causes a decrease in the quantity demanded of related good Y, the cross elasticity of demand

is said to be negative (e <0). When the goods are complements such as car and petrol, milk

and sugar, paper and pen, bread and butter, the cross elasticity of demand is negative. Thus,

in case of negative cross elasticity of demand, the demand of Y moves in the opposite

direction as the price of X. Such goods are complementary goods which are jointly demanded

to satisfy one want. Suppose the price of petrol rises by 6 percent and it causes the demand of

cars to fall by 4 percent, the cross elasticity of demand is negative.

Zero cross elasticity of demand: If a certain percentage increase in the price of X causes no

change in the quantity demanded of related good Y, the cross elasticity of demand is said to

be zero (e=0). Thus, in case of zero cross elasticity of demand, the demand of Y does not

change at all as the price of X changes. Such goods are not related to each other.

The knowledge of cross elasticity of demand of their products is important for the business

firms in order to assess the pricing and marketing strategies of their competitors. Using the

concept of cross elasticity of demand, the business managers can estimate the impact of their

price changes in relation to substitutes or complements. Hence, the information relating to

cross elasticity of demand is important for the purpose of product planning and forecasting.

4.3.5 Promotional or advertisement elasticity of demand

Advertisements and sales promotion activities are vital for any competitive business firm.

Expenditure on publicity or advertisement brings about different degrees of changes in the

sales of different products. The optimum level of expenditure on advertisement can be

determined using the concept of advertisement elasticity. The advertisement elasticity may be

defined as the degree of responsiveness of sales of a firm to the changes in expenditure on

advertisement. It can be computed by the following formula

where S shows the sales, ΔS indicates the change in sales, A is the initial advertisement cost,

and ΔA represents the increase in advertisement expenditure. The coefficient of

advertisement elasticity lies between zero and infinity (0 ≤ eA ≤ ∞). Normally the

advertisement elasticity is positive as an increase in advertisement expenditure leads to an

increase in sales. However, other factors influencing the advertisement elasticity include the

level of total sales (as total sales increase, the advertisement elasticity decreases);

advertisement by rival firms; change in price and consumer income.

In addition to the above mentioned types, another type of elasticity of demand is the

price expectation elasticity. It studies the impact of price expectations of the consumer on the

demand for a given commodity. The price expectation elasticity is defined as the expected

change in future prices of a commodity due to changes in its current prices. It can be

measured as follows:

where Pc is the current price and Pf is the future price of the given commodity.

If ex > 1 it means that future change in price will be more than the current change in price,

and vice-versa, and ifex = 1, it means that the future change in price will be exactly equal to

the change in current price. This concept of elasticity of price expectation is very useful for

business firms in working out their future pricing policies.

4.4 Factors determining elasticity of demand

The elasticity of demand for a given commodity is different for different types of goods and

different types of markets. It is affected by a number of factors as discussed below:

Nature of commodity: The commodities can be broadly classified as necessaries, comforts

and luxuries. The demand for necessaries like wheat, salt, etc. is inelastic meaning very little

or no change in the quantity demanded due to a given change in price. As regards comforts,

the demand changes in almost the same proportion as the price, that is demand is unitary

elastic. In case of luxuries like gold, diamonds, luxury cars, etc. a small change in price

causes relatively much larger change in the quantity demanded and elasticity of demand is

more than unity.

Existence of substitutes: If a commodity has different substitutes, a slight increase in its

price causes a substantial degree of substitution of other commodities in its place, and the

demand will be more elastic. However, the demand will be inelastic in case of commodities

having no substitutes.

Goods with several uses: If a commodity can be put to many different uses, its demand will

be highly elastic. For instance, in a household, milk can be used for various purposes such as

for making curd, cake, sweets, buttermilk, etc. With a fall in price, demand increases but a

little rise in its price causes the demand to fall greatly.

Possibility of postponement of use: If it is possible to postpone the consumption of a

commodity (like new clothes, new sofa, mobile, computer, etc.) then its demand will be

elastic and if the demand is urgent and cannot be postponed at all (like, electricity) the

demand will be inelastic.

Level of income – At very high and very low levels of income, the overall demand for

commodities tends to be relatively less elastic. On the other hand, in the middle income

range, the demand is relatively more elastic.

Proportion of income spent: The elasticity of demand is also influenced by the percentage

of income spent on a given commodity. If the percentage is very low, like salt, pen, pencil,

etc., then the demand will be inelastic.

Influence of habit, fashion and customs- Those commodities whose consumption is

influenced by conventions, customs or habit, will have an inelastic demand. For example

demand for cigarettes and liquor or some latest brand of clothing. In this case people do not

compromise with price and do not cut demand even if the price is high.

Complementary goods- Those goods which are jointly demanded, such as petrol, ink, etc.

have less elastic demand as their demand depends not only on their respective prices but also

on the demand of other products.

Durability of the commodity- If the commodity is a durable one like a house, the demand is

generally inelastic because consumer buys a house only after a very long period. On the other

hand, in case of perishable commodities, like milk, vegetables, the demand is relatively

elastic.

These factors enable the managers to make an assessment about the greater or lesser

elasticity of demand in case of different commodities.

Activity A

Explain the following term and factor determining each of them.

a)Price elasticity of demand

b)Income elasticity of demand

c)Cross elasticity of demand

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4.5 Importance of determining elasticity of demand

The concept of elasticity of demand is of much significance in various situations both from

theoretical and practical viewpoints. The role of elasticity of demand is discussed below:

Importance in taxation policies- The concept of elasticity of demand also proves helpful to

the finance minister in the formulation of taxation policies. He considers the nature of a

commodity and its elasticity of demand before levying a tax on it. If taxes are levied on goods

with more elastic demand, rise in price after tax imposition will cause a large contraction in

demand and tax revenues may fall, and vice-versa.

Price fixation under monopoly: The monopolist has to consider the elasticity of demand for

his product while fixing its price. In case his product has a less elastic demand, he fixes a

higher price and tries to appropriate a larger revenue even if he is selling a limited quantity.

Price discrimination: A monopolist sometimes follows the policy of price discrimination by

charging different prices for the same product in different markets. The basis of price

discrimination is difference of elasticity of demand in different markets. He charges a higher

price in the market where the demand is less elastic and vice-versa.

Price determination in case of joint products: There are many products which are

produced jointly like rice and bran, wheat and straw, sugar and alcohol, etc. The cost of

production in such cases cannot be ascertained separately. In such a situation, the price of the

major product is determined at a higher level if elasticity of demand is low and vice-versa;

while the price of the by-product is fixed keeping in mind the total costs and a reasonable

amount of profit.

Wage determination: If the demand for labour for a particular industry is relatively less

elastic, the employer will have to give in to the demand of trade unions to get their wages

raised. The same applies to other factors of production also with a relatively inelastic

demand.

Determination of terms of trade- Terms of trade between two countries can be calculated

by taking into account the mutual elasticities of demand for the products of each other.

Determination of the Rate of Exchange- The rate of exchange between the currencies of

different countries is determined by the elasticities of demand for the currencies of one

another. Hence, this concept is very important in the field of international trade.

Also the concept of other types of elasticities is very helpful in framing crucial economic and

financial policies.

Activity B

How is demand elasticity is useful for a manager?

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1. In case of luxuries, the elasticity of demand is……………

2. A good having ………… income elasticity of demand is called a normal good.

3. In case of ……….. cross elasticity of demand, the demand of Y does not change at all as the

price of X changes

4. If a commodity has different substitutes, its demand will be ……… elastic.

5. Complementary goods such as petrol, ink, etc. have ……. elastic demand.

4.6 Summary

Elasticity of demand indicates the degree of responsiveness of demand for a

commodity to the changes in its determinants – mainly its own price, income and price of

related goods.Thus, price elasticity of demand may be defined as the ratio of the percentage

change in quantity demanded to the percentage change in price.There are five degrees of

price elasticity of demand depending on the proportionate change in the quantity demanded

in response to a given proportionate change in the price. There are different methods to

measure price elasticity of demand. In percentage method price elasticity of demand is

measured as the ratio of the percentage change in quantity demanded to the percentage

change in price. Arc method measures the price elasticity of demand if there are relatively

larger changes in price and demand.The point method measures price elasticity of demand at

a particular point on the demand curve. In total outlay method the price elasticity of demand

is measured with the help of the total expenditure incurred by a consumer on the purchase of

that commodity. Income elasticity of demand indicates the extent by which demand for a

commodity changes due to a given change in the income of the consumer. It is positive for

normal goods and negative for inferior goods. The cross elasticity of demand refers to the

proportionate change in the quantity of X demanded resulting from a given relative change in

the price of the related good Y. It is positive for substitutes and negative for complements.

4.7 Glossary

Elasticity of demand: It indicates the degree of responsiveness of demand for a commodity

to the changes in its determinants – mainly its own price, income and price of related goods.

Price elasticity of demand: It is defined as the responsiveness of the quantity demanded of

any good X to a change in its own price.

Income elasticity of demand: It is the ratio of the percentage change in the quantity

demandedto thepercentage change in income.

Normal good: A good having positive income elasticity of demand

Inferior good: A good having negative income elasticity of demand

Advertisement elasticity: The degree of responsiveness of sales of a firm to the changes in

expenditure on advertisement.



1. D

2. B

3. D

4. C

5. A


1. more than unity

2. positive

3. zero

4. more

5. less

4.9 References



.





Misra&Puri : Economics for Managers, Himalaya Publishing House, Mumbai

Adhikary M. : Managerial Economics, Khosla Educational Publishers, Delhi


1. What is the shape of the perfectly inelastic demand curve?

2. Discuss the degrees of price elasticity of demand with the help of diagrams.

3. Define price elasticity of demand for a commodity and state its importance.

4. When is demand said to be inelastic?

5. How would you measure price elasticity of demand by the total outlay method?

Explain.

6. What is cross elasticity of demand?

7. Discuss the factors which determine the elasticity of demand?

LESSON – 5

Demand Forecasting

Structure

5.0 Objectives

5.1 Introduction

5.2 Meaning of demand forecasting

5.3 Importance of Demand Forecasting

5.4 Scope of Demand Forecasting

5.5 Objectives of Demand Forecasting

5.6 Factors Affecting Demand Forecasting

5.7 Steps in Demand Forecasting

5.8 Check your progress 1

5.9 Demand forecasting Techniques

5.9.1Qualitative Methods

5.9.2 Quantitative Methods

5.10 Methods of Demand Forecasting in case of New Products


5.12 Summary

5.13 Glossary


5.15 References



5.0 OBJECTIVES


To understand the meaning and scope of demand forecasting

To identify the factors that affect demand forecasting

To understand various methods of demand forecasting

5.1 Introduction

In modern business environment, every business firm seems to be operating under the

conditions of uncertainties. Generally, there is risk and uncertainty involved in every decision

making process and almost every business firm or even the government needs to keep in

mind the existing level of demand for a given commodity and estimate the existing gap

between demand and supply. This is essential because uncertainties can be minimised to quite

an extent by planning and forecasting. The ability to forecast future events plays an important

role in the success of a business firm. The business decision maker must not only estimate the

present level of demand but also forecast the future level of demand. Demand forecasting is

also one of the techniques to minimize the risk and uncertainty involved in

business.Generally forecasting refers to knowing the status or nature of an event or variable

before it occurs and it is possible only when we know the status of its respective cause or

causes. In this context, demand forecasting refers to measuring a property of demand and

representing it with a number. The concept of demand forecasting is explained in detail in the

coming sections of this lesson.

5.2 Meaning of Demand Forecasting

Demand forecasting refers to estimating the future demand on the basis of past data.

In fact forecasting of demand is the art of predicting demand for a given commodity or a

service at some future date based on present as well as past behaviour patterns of some

related events. Here it is important to note that demand forecasting is not merely a simple

guess work, rather it refers to scientific and objective estimation made on the basis of some

relevant facts and events. It may be defined as follows

Sales forecasting is an estimate of sales during a specified future period on which

estimates is tied to a proposed marketing plan which assumes a particular set of

uncontrollable and competitive forces. --- Cundif and Still

The company sales forecast is the expected level of company sales based on a chosen

marketing plan and assumed marketing environment. --- Philip Kotler

The above definitions of the concept of demand forecasting help us to know its basic

features. It is clear that the concept of demand forecasting is based on both the past data as

well as the present positions. Also such a demand forecasting may be expressed in monetary

terms or even in physical terms. Moreover, it is demand forecasting which forms the very

basis for future planning and hence, helps to obtain an estimate for the future sales and profit.

As a result, all firms strive to forecast the demand for their goods and services (as demand for

a commodity is a strategically critical variable for every business firm since its very

inception). The term demand in fact refers to a group of three closely associated factors or

variables - the need for the commodity, willingness to buy, and the capacity to buy (the

purchasing power) or

the money income. In this context, forecasting, in general, refers to assigning a value to a

variable at a future point of time, and in particular, demand forecasting refers to measuring

and assigning a specific value represented by a number to the quantity of a given commodity,

say X that will be demanded at a future point of time.

5.3 Importance of Demand Forecasting

Demand forecasting is extremely important for every business firm (whether a

supplier, manufacturer, or retailer) involved in the process of production as forecasts of future

demand help to determine the quantities that should be purchased, produced, and shipped.

The importance of the concept of demandforecasting arises from the fact that the basic

production process from raw materials to finished goods reaching the final consumer involves

a lot of time. Hence, the level of demand needs to be anticipated in advance by the producers

so that they can react immediately to changes in customer demand. The process of production

is based on future planning as the business firms deploy inventories of finished goods into

field locations to immediately cater to a customer order rather than keep the customer waiting

for a long time. A firm which is capable of fulfilling the market order in a short span of time

(that is, having a smaller order cycle) definitely gets an edge over its competitors and will

also indirectly force all competitors in the market to keep finished product inventories so as

to provide fast order cycle times.As a result, almost every business organisation involved will

have to manufacture or at least order parts on the basis of a forecast of future demand. If a

firm develops its expertise in its ability to forecast future levels of demand accurately, it gets

in a relatively commanding position to control costs through leveling its production

quantities, rationalizing its transportation, and generally planning for efficient logistics

operations.

Therefore, generally speaking, accurate demand forecasts of future demand definitely

lead to efficient operations and high levels of customer service. On the other hand, less

efficient forecasts lead to inefficient, high cost operations and/or poor levels of customer

service. Thus, the most important action towards improving the efficiency and efficacy of all

the business processes is paying more attention to and improving the quality of the demand

forecasts.

5.4 Scope of Demand Forecasting

The managerial uses of demand forecasting can be discussed separatele for the

short run and the long run. Demand forecasts for short periods are made on the assumption

that the company has a given production capacity and the time period is too short to change

the existing production capacity. In this context demand forecasting helps in the following

areas:

Production planning: It helps in determining the level of output at various periods and

avoiding under or over production.

Formulating appropriate purchase policy: It helps in better material management, of

buying inputs and control its inventory level which, in turn, cuts down cost of operation.

Appropriate pricing policy: A rational pricing policy can be formulated to suit short run and

seasonal variations in demand.

Sales forecasting: It helps the company to set realistic sales targets for each individual

salesman and for the company as a whole.

Estimating short run financial requirements: It helps the company to plan the finances

required for achieving the production and sales targets. The company will be able to raise the

required finance well in advance at reasonable rates of interest.

Framing a suitable labour policy: A proper sales and production policies help to determine

the exact number of labourers to be employed in the short run.

Further in the long run forecasting of probable demand for a product of a company is

generally for a period of 3 to 5 or 10 years. . This helps in the following areas:

Business planningwhich helps to plan expansion of the existing unit or a new production

unit. Capital budgeting of a firm is based on long run demand forecasting.

Financial planning which helps to plan long run financial requirements and investment

programs by floating shares and debentures in the open market.

5.5 Objectives of Demand Forecasting

The scope of demand forecasting can be confined to a given commodity or service

being supplied by a small business firm in a local area; or even could be extending to the

international level depending upon the area of operation of a given firm. It is also influenced

by the cost and time involved in relation to the benefit of the information acquired through

the study of demand. Besides these factors, the scope of demand forecasting is also

determined by the relevant time period, nature of the commodity, and other miscellaneous

factors like social factors, psychological factors, degree of competition, impact of risk and

uncertainty.

On these grounds, based on the time period, the objectives of demand forecasting, can

be studied under the following two categories

(i) Short Term Objectives: These are the objectives dominating in the short term and

can be listed as follows:

1. Preparing appropriate sales and production policies.

2. Ensuring a regular supply of raw materials required for the production process.

3. Reduction in the cost of purchase and avoiding unnecessary purchases.

4. Best possible or optimum utilisation of machines and other capital equipment.

5. Maintaining suitable labour force and accordingly making arrangements for skilled and

unskilled workers as per requirement.

6. Determination of a suitable price policy.

7. Determination of the financial requirements of the business firm.

8. Preparation of separate sales targets for all the different sales territories.

9. Checking the problem of under production or over production.

(ii) Long Term Objectives: These are the objectives operating in the long term and

can be listed as follows:

1. Planning of the long term production.

2. Planning appropriate plant capacity.

3. Estimating and evaluating the requirements of workers over a long period of time and

making necessary arrangements thus required.

4. Preparing an appropriate dividend policy.

5. Proper capital budgeting.

6. Plan for long term financial requirements of the business firm.

7. Forecasting the future problems of material supplies and energy crisis.

5.6 Factors Affecting Demand Forecasting

Various factors influencing the process of demand forecasting and hence, governing a good

forecast can be listed as follows.

Existing business conditions: The general economic conditions prevalent in the economy

like change in national income, price level, consumption pattern, saving and investment

patterns, employment, etc. strongly influence the demand forecasts.

Conditions within the industry: It is very essential to study the changes in the demand of

the whole industry, number of units within the industry, design and quality of product, price

policy, competition among the firms within the industry etc. as every firm is just a part of a

particular industry.

Conditions within the firm: Internal factors, specific to a given firm like quality and price of

the product, plant capacity of the firm, production policies, financial policies, advertising and

distribution policies, etc. also affect the demand forecast.

Factors affecting exports: These factors include import and export control, terms and

conditions of export, export import policy, export conditions, export finance etc.

Market behaviour: It is essential to study the market behavior also as it, too, brings about

changes in demand.

Sociological factors: Sociological factors relate to size of population, density of population,

changes in age groups, size of family, family life cycle, level of education, family income,

social awareness etc.

Psychological conditions: As the level of demand is strongly influenced by psychological

factors, so it becomes necessary to study changes in factors like changes in consumer tastes,

habits, fashions, life styles, cultural and religious preferences, etc.

All these factors influence the demand forecasts to a large extent.

5.7 Steps in Demand Forecasting

The process of demand forecasting involves the following steps:

1. Determination of the purpose of forecasts.

2. Subdividing the demand forecasting programme into small parts on the basis of

sales territories.

3. Determination of the factors affecting the sale of each product.

4. Selection of appropriate forecasting methods.

5. Analysing the activities of rival firms.

6. Collection of necessary data.

7. Preparation of preliminary sales estimates

8. Analysing the advertisement policies for promoting sales.

9. Estimation and interpretation of the results

9. Evaluation of the demand forecasts

10. Preparation of the final demand forecast on the basis of preliminary forecasts.


1. Generally there is …………….. involved in every decision making process.

2. The concept of demand forecasting is based on both the ……………. as well as ……………..

positions.

3. Demand forecasting is a technique to ……………. the risk and uncertainty involved in

business.

4. The scope of demand forecasting can be confined to a given ………… being supplied by a

small firm in local area; or could be extending to ……………..

5. Estimating the …………… of workers over a …………. and making necessary arrangements is

one of the long term objectives of demand forecasting.

6. ……………........., specific to a given firm tend to affect the demand forecast.

7. The first step in the process of demand forecasting is to determine the …………………

8. Analysing the activities of ………. firms is an important step in demand forecasting.

9. Changes in consumer tastes, habits, fashions, life styles, cultural and religious preferences, etc.

are the ………………. influencing the level of demand.

10. The most important action towards improving the efficiency of all the business processes is

paying more attention to the……………...

5.9 Demand forecasting Techniques

The problem of demand forecasting arises in many economic and managerial

decisions. Numerous forecasting procedures have been developed over the years, for many

different purposes. The performance of most firms depends on the efficient use of accurate,

disaggregated demand forecasts. An important issue for all forecasts is the time horizon for

which the forecast is made. Generally long range forecasts tend to be less accurate that short

range forecasts. The demand forecasting techniques can be broadly divided into two

categories – qualitative methods and the quantitative methods. Each of these can be further

subdivided as shown in following chart.

5.9.1 Qualitative Methods: The qualitative or subjective methods are basically designed to

know the intentions or the willingness of the buyers keeping in view the determinants of

demand. These are judgement based methods and make use of intelligent questions,

interviews or questionnaires (direct or mailed), surveys, etc. for demand forecasting.

Qualitative methods comprise of the following:

Expert Opinion Method: Expert opinion survey method gives a subjective forecast of

demand based on the opinion of experts and not the consumers. The experts make

judgement about the future quantity of demand. If this forecast quantity is reasoned

through an interactive procedure which is justified by the experts, then this method is

called as the reasoned expert survey. On the other hand, if this forecast is not reasoned

out then it is known as the simple expert opinion poll.

Survey Methods: These methods are used for short term forecasting and are based on

information collected from the potential consumers about their plans regarding future

purchases. In survey method, a few consumers are selected and their views are

collected. The sample is considered to be a true representation of the entire

population. The selection of an optimum sample size is a must for this method.

Survey methods can further be of the following types

Complete Enumeration Survey Method: Under this technique all the

consumers are taken into consideration. They may be divided in to several

groups, either on the basis of income, caste, gender, education or any other

variable or even may be divided into groups according to geographical

regions. All the units of observation are studied and data

are collected either through direct interview or by mailing questionnaires or

filling up schedules. The results would be reliable provided the sample is

representative of the population.

Sample Survey Method: Sample survey methodtakes into consideration only a

selected representative sample of the whole population of consumers. The

results so obtained are then logically extended to the whole population. Hence,

a sample of only a few consumers is selected and their opinion on the probable

demand is collected. Such a sample is considered to be a true representation of

the entire population. Sample survey method assumes that demand is based

purely on consumers' opinion and not on the demand-determinants or the end-

use. This method could further take one of the following types:

- Consumers’ interview method: The total demand for the product is

calculated by adding up all individual demands. These individual demands

are obtained on the basis of direct interviews of the consumers. However,

either all the consumers may be interviewed (then it is called complete

enumeration method) or only a selected group of consumers may be

interviewed (then it is called sample survey method). Consumers’

interview method or the consumers’ survey method, as it is also called, is a

relatively simple method because it is not based on past record. It is

suitable for industrial products and can be conveniently used for

forecasting the demand of a new product. However, it may be expensive

and time consuming and may not be for long term forecasting or when the

number of consumer is large. Also the consumers may not divulge correct

buying plans.

- Collective opinion or sales force opinion method: In this method the

salesmen try to estimate the expected sales in their respective territories.

The individual forecasts of the salesmen (on the basis of previous

experience) are then combined to estimate the total demand. This method

enjoys the advantage of first hand knowledge of salesmen who are in close

touch with the market. However, the forecasts may not be reliable if the

salespeople are not trained.

- Experts opinion method: In this method the demand is estimated on the

basis of opinions of skilled and experienced experts rather than salesmen

and consumers. Hence, it is a reliable method and forecast can be made

quickly and economically.

- Consumers’ clinic: In this method the response of the consumers to

changes in prices are observed. Some consumers are selected and are

asked to buy the commodities with certain amount of money at given

prices. Then the prices are changed and change in their purchases is

studied. Thus, the forecast of demand is based on actual consumer

behaviour. Hence, this method provides a reliable and a realistic picture

about future demand and gives useful information to help in the decision

making process. However, it may turn out to be a time consuming and

costly method. Moreover, there is no standard method for the selection of

participating consumers. This method is quite similar to the test market

method which is based on learning about the demand for a product by

actually selling the product or in other words experimenting with the sales

of the given product. The given product is simply introduced in to a test

market; and its demand is observed. This observed behavior of the

consumers is then logically extended to study the behaviour of total

demand in the markets.

End use method: This method is relies on the fact that a product generally has

several uses. So first of all a list of final consumers or the end users is

prepared and then the future demand for the product is found. Total demand

for the product is got by adding the individual demands for all the end users.

5.9.2 Quantitative Methods: The quantitativemethods or the statistical methods are

based on historical (past data) quantitative data as a guide to know the level of future

demand. These methods are generally used for long run forecasting and are based on

the application of a statistical concept to the existing quantitative data. This process

generates a forecast of the demand for the given period. These methods are usually

used for established products rather than for new products. Statistical methods may of

the following types:

Trend projection method or trend method: This method forecasts demand on

the basis of past data analysis. A firm generally does have considerable data

on sales pertaining to different time periods. These data over a period of time

yield time series which also represents the past pattern of effective demand for

a particular product. These time series can be used to project the trend in

future using one of the following methods: free hand method or the graphical

method; least squares method; semi average method; or the moving average

method.

Regression Method:- Under this method a relationship is established between

quantity demanded or sales as the dependent variable and the determinant(s)

of demand (such as price, income, price of the related goods, advertisement

cost etc.) as one or more independent variables . Again this relationship is

based on the past data and is used to project future demand by combining the

economic theory with the statistical techniques of estimation. The regression

and correlation analysis is also called the econometric model building.

The econometric methods of demand forecasting involve the estimation of

demand equation on the basis of influence of the causes (determinants) of

demand. The relationship between demand and its determinants is established

as an equation estimated from their past behavior using the least squares

method.

Simultaneous Equations Method: This method of demand forecasting is also

called the complete system approach to forecasting. It is considered to be one

of the most sophisticated econometric techniques of forecasting. It makes use

of detailed and complicated mathematical as well as statistical tools.

Simultaneous equation method is an improvement over the regression method.

Besides simultaneous equation method, a few more methods are also based

on the causal or the relational approaches to demand forecasting. The basic

assumption is that if we can find relationships between the explanatory

variables (population, income, and so forth) and sales or the quantity

demanded for the firms, then these relationships can be extended also. Data

on the explanatory variables are collected and these relationships are applied

to estimate demand. Mathematical and statistical procedures are then used to

develop and test these explanatory relationships and also to forecast demand

from them. Causal methods generally include the following:

- Econometric models, such as discrete choice models, multiple

regression or more elaborate systems involving sets of simultaneous

regression equations. These are highly advanced and complex models.

- Input-output models which are used to estimate the flow of goods

between markets and industries.

- Life cycle models which examine the various stages in a product's life

from its launch, to its maturity, and to its phasing out. Such models are

used extensively in industries such as high technology, fashion, and some

consumer goods facing short product life cycles.

Graphical Method: This method is used to estimate the trend with the help of

a graph. The past data are plotted on a graph and the trend behaviour so

indentified is extended further in the same pattern to project the demand in

the forecast period. The preparation of such a graph with time & quantity

demanded on both the axes is completely subjective, and may be different for

different persons.

Other statistical methods include

Extrapolation method: Binomial expansion method is used in the extrapolation

method to extrapolate the future demand.

Leading indicator or Barometric method: This method is an improvement over

the trend method. It makes use of an indicator variable or a variable other than

demand to indicate the behavior or direction of the movement of the demand

for the given commodity, that is, the behavior of the demand for the given

commodity is not directly observed but indirectly through a proxy variable.

Indicator variables may be of three types: (i) Leading indicators are those

variables which always lead the demand for given commodity,(ii) Lagging

indicators are those variables that always lag behind the demand variable, and

(iii) Coincidental indicators are those variables that occur along with the

demand variable at the same time along the time scale. According to this

technique the present events can be used to predict the directions of change in

the future. Certain economic and statistical indicators from the selected time

series are used to project future demand. Some of the commonly used

indicators are personal income, gross national income, prices of industrial

materials, wholesale commodity prices, industrial production, bank deposits

etc.

The qualitative or the statistical methods, in general are scientific and relatively less

expensive and relatively more reliable. However, on the flip side, these methods involve

complicated calculations and hence require more of personal skill and experience, the

absence of which may not lead to trustworthy results.

Activity A

A firm uses simple exponential smoothing with 01. to forecast demand. The forecast for the

week of January 1 was 500 units whereas the actual demand turned out to be 450 units. Calculate

the demand forecast for the week of January 8.

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5.10 Methods of Demand Forecasting in case of New Products

The methods of demand forecasting mentioned above appear to be more effective,

reliable and trustworthy in case of projecting future demand for the existing products.

However, in case of new products the results may not be perfectly dependable. The

forecasting of demand of new product is more difficult than for an existing product as no past

data are available in this case. In these conditions consumer behavior has to be studied very

carefully and proper thorough research needs to be conducted. It is difficult for the consumer

to give appropriate response for new product as it is not yet available and the consumer has

not yet seen it. Prof. Joel Dean has suggested the following methods for forecasting demand

of new products:

1. Evolutionary approach: This method is based on the assumption that the new product is

actually just an improvement over the old product. The old product has evolved into the new

product gradually. So the demand of the old product is used to forecast the demand for the

new product. For example, the demand for LCDs and now LEDs are viewed as an

improvement over the coloured television.

2. Substitute approach: In the substitute approach, the new product is considered to be

simply a substitute of the existing one. For example, the polythene bags may be considered as

a substitute for the cloth bags.

3. Growth curve approach: The growth rate of the demand of a commodity is used in this

method instead of the quantity demanded of the commodity. Under this method the growth

rate of demand of a new product is estimated on the basis of the growth rate of demand of an

existing product. For example, suppose vim liquid wash for cleaning utensils is in use and a

new product for cleaning utensils is to be introduced in the market. In this case the average

sale of vim liquid wash for cleaning utensils will give an idea as to how the new product for

cleaning utensils will be accepted by the consumers.

4. Opinion poll approach: Under this method the demand for a new product is estimated on

the basis of information collected from the direct interviews (survey) with consumers ( either

all or a sample of consumers may be directly interviewed).

5. Sales Experience approach: Under this method, the new product is offered for sale in a

sample market, i.e. by direct mail or through multiple shop or departmental stores. The total

demand is estimated for the whole market may be estimated from sales experience of this

starter project.

6. Vicarious approach: This method consists of surveying consumers' reactions through the

specialised dealers who are in direct touch with consumers. The dealers are thus able to judge

the reaction of the consumers on the launch and acceptability of the new product and hence,

total future demand can be estimated.

All these methods particularly apply to the case of new products but are quite similar

to the techniques of demand forecasting used usually for the old products. However, these

methods for new products are not mutually exclusive. We can expect better results from these

methods by using a combination of two or more methods based on the given situation and the

nature of study.

Activity B

Exponential smoothing is used to forecast automobile battery sales. Two value of are examined,

08. and 05. . Evaluate the accuracy of each smoothing constant. Which is preferable?

(Assume the forecast for January was 22 batteries.) Actual sales are given below:

Month Actual

Battery

Sales

Forecast

January 20 22

February 21

March 15

April 14

May 13

June 16

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1. There are only two methods of demand forecasting.

2. The qualitative or subjective methods are basically same as the econometric methods.

3. Survey Methods are used for long term forecasting of demand.

4. In the complete enumeration method only a selected group of consumers may be

interviewed to collect information on demand.

5. Trend projection method is an improvement over the leading indicator or the barometric

method.

6. Under the experts opinion method the demand is estimated on the basis of opinions of

skilled and experienced experts rather than salesmen and consumers.

7. Under the growth curve approach, the growth rate of demand of a new product is

estimated on the basis of the growth rate of demand of an existing product.

8. Graphical method makes use of the binomial expansion method to forecast demand.

9. End use method is a quantitative method of forecasting of demand.

10. Vicarious approach consists of surveying consumers' reactions through the specialised

dealers who are in direct touch with consumers.

5.12 Summary

There is a lot of uncertainty associated with demand in the present dynamic uncertain

business environment. This uncertainty in demand further generates uncertainty in the

concepts of production, cost, revenue, profit etc. and it is actually possible to reduce these

uncertainties with the help of demand forecasting. Demand forecasting simply refers to

estimating or anticipating future demand on the basis of past data. Demand forecasting is

extremely important for every business firm involved in the process of production. Every

producer must know the present level of demand along with the expected increase in the

demand for his product over time. Demand forecasts are generally useful by the policy

makers and planners; for estimating financial requirements; for determination of sales target

and incentive; for facilitating regular supply of labour and raw material; for production

planning; and also for society researchers and social workers having a futuristic approach.

The objectives of demand forecasting can be studied under two categories: short term

objectives and the long term objectives. Various factors influence the process of demand

forecasting and hence, govern a good forecast. A few important ones include existing

business conditions; conditions within the industryas well as within the firm; factors affecting

exports; market behavior and sociological as well as psychological factors. There are

numerous methods of demand forecasting which may be broadly classified into quantitative

and qualitative methods. The quantitative or the objective methods make use of statistical

methods on the past historical data of the business firm to get an estimate of future demand in

the forecast period. Important quantitative methods include trend method, regression and

correlation method, simultaneous equations method and the graphical method .On the other

hand, the qualitative methods are the subjective methods or the judgementbased methods and

include expert opinion method, survey methods, end use method, to name a few. A separate

list of methods is available for new products.

5.13 Glossary

Demand forecasting: It refers to estimating the value of future demand on the basis of past

data. In fact it is the art of predicting demand for a given commodity or a service at some

future date based on present as well as past behaviour patterns of some related events.

Qualitative Methods for demand forecasting: The qualitative or subjective methods are

judgement based methods used to forecast demand keeping in mind determinants of demand.

Expert Opinion Method: This method gives a subjective forecast of demand based on the

opinion of experts and not the consumers. It may be of two types: reasoned expert survey the

simple expert opinion poll.

Survey Methods: These methods are used for short term forecasting and are based on

information collected from a few consumers or the the potential consumers about their plans

regarding future purchases.

Test market method: The given product is simply introduced in to a test market; and its

demand is observed. This observed behavior of the consumers is then logically extended to

study the behaviour of total demand in the market

Barometric Method: A method used for demand forecasting by analyzing the behavior of

demand indirectly with the help of a proxy or an indicator variable.

Coincidental indicators: Those variables that occur along with the demand variable at the

same time along the time scale and indirectly help to study the behavior of demand.

Growth curve approach: Under this method the growth rate of demand of a new product is

estimated on the basis of the growth rate of demand of an existing product.



1. risk and uncertainty

2. past data, present

3. minimize

4. commodity or service, international level

5. requirements, long period

6. Internal factors

7. purpose of forecasts

8. Rival

9. psychological factors

10. quality of the demand forecasts


1. False

2. False

3. False

4. False

5. False

6. True

7. True

8. False

9. False

10. True

5.15 References

Spencer and Siegeman’s “Managerial Economics.

Sankaran, Business Economics.

Mithani D.M., and Murthy, V.S.R., “Fundamentals of Business Economics.

Mote, V.L., Samule Paula nd G.S. Gupta, Managerial Economics , Concepts

and Cases, Tata McGraw Hill, New Delhi.


Mathur N.D., Managerial Economics, Shivam book House (P.) Limited, Jaipur Mithani, D.M.

: Managerial Economics, Himalaya Publishing House, Mumbai


1. What do you mean by demand forecasting?

2. Explain the scope and importance of demand forecasting.

3. Give the factors influencing demand forecasting.

4. What are the various methods of demand forecasting?

5. Discuss the qualitative and quantitative methods of demand forecasting.

6. Explain the objectives of demand forecasting.

7. Discuss the regression method and graphic method of demand forecasting.

8. Explain the trend method of demand forecasting.

LESSON – 6

Theory of Production

6.0 Objectives

6.1 Introduction

6.2 Production

6.3 Production Function

6.3.1 Short run production function

6.3.2 Law of Variable Proportions

6.3.3 Long run production function

6.3.4 Check Your Progress 1

6.3.5 Isoquants

6.3.6 Properties of Isoquants

6.3.7 Isoquant Map

6.3.8 Isocost Lines

6.3.9 Producer’s Equilibrium

6.3.10 Expansion Path

6.3.11 Returns to Scale

6.4 Check Your Progress 2

6.5 Summary

6.6 Glossary


6.8 References



6.0 OBJECTIVES


To understand the basic concept of production and production function

To bring out the difference between short run production function and long run

production function

To comprehend the law of variable proportions and returns to scale

To know the concept of isoquants in detail

6.1 Introduction

In simple words, production is a process resulting in the creation of goods and

services. However, in economics production refers to the transformation of inputs or the

factors of production, into outputs. Inputs refer to the raw materials or other productive

resources used to produce final product or the output. A producer has to combine the different

inputs such as land, labour, capital and enterprise to turn out the flow of goods and services.

The theory of production is concerned with the ways in which the factor inputs are combined

to secure the maximum return at the least possible cost. The basic knowledge of the theory of

production is very significant for the managers of the business firms.

6.2 Production

The theory of production is defined as follows:

The theory of production consists of how the producer, given the state of technology,

combines various inputs to produce a definite amount of output in an economically efficient

manner. ---- Ferguson

Therefore, production is the process of converting inputs into output. Production of

any commodity or service requires certain quantities of different factors of production, when

the technique of production is given. All inputs used in the process of production are

collectively known as the factors of production. Broadly the factors of production may be

classified as land, labour, capital and organization. Land is a free gift of nature and also

includes all the available natural resources; its remuneration is called rent. Labour indicates

all the physical and mental efforts made by human beings in the process of production; the

reward for labour is called wages. As regards capital, it refers to capital goods, plant

machinery, etc. Apart from the wealth used in the process of production, capital also includes

the human capital, that is, knowledge and skills attained by individuals through specialized

trainings. The capital gets its reward as interest. Finally organization or enterprise bears the

ability to undertake the risk and uncertainty involved in the process of production; its

remuneration is in the form of profit.

On the basis of their variability, these factor inputs can be categorized into two types

– fixed inputs and variable inputs. This classification is based on the two time frames relevant

for the process of production – short run and long run. Short run or the short period is a time

period in which some factors of production remain fixed while others can be varied. On the

other hand, long run or long period refers to a sufficiently large time period in which all the

factors of production can be changed as per the requirement. Hence, the fixed inputs and

variable inputs can be explained on the basis of the distinction between short run and long

run. Thus, fixed inputs are the those which cannot be altered in the short run, for instance,

land, plant and machinery, technique of production, etc. On the other hand, variable inputs

refer to those inputs which may be altered in the short run, for instance, labour, raw material,

etc. Of course in the long run all inputs tend to become variable.

Almost any business decision can be analyzed with managerial economics techniques,

but it is most commonly applied to production analysis - microeconomic techniques are used

to analyze production efficiency, optimum factor allocation costs, and to estimate the firm's

cost function.

6.3 Production Function

Production function expresses the technical relationship between physical inputs and physical

output. It is the relationship between the quantities of inputs and the quantities produced. A

production function may be defined as:

The production function is the 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. ---Stigler

The production function is a purely technical relation which connects factor inputs and

output. --- Koutsoyiannis

The term production function refers to the physical relation between a firm’s inputs of

resources and its output of goods and services per unit of time, leaving prices aside.

--- Leftwitch

Therefore, the production function is a mathematical function showing the output that can be

produced per unit of time for alternative sets of inputs, using the best possible available

technology. A production function for a given commodity can be expressed as follows:

Q = f (a, b, c, d…)

where Q represents the quantity of output produced,

a, b, c, d…. stand for the productive resources or factor inputs, such as land, labour, capital,

raw materials, time, and technology, used in the production process. Thus, a production

function indicates the maximum quantity of output which may be produced from the given

inputs with the given technology.

This leads us to two important types of production functions studied in the theory of

production: short run production function and the long run production function.

6.3.1 Short run production function

Short run or the short period is a time period in which some factors of production

remain fixed while others can be varied. Hence, a production function in which the quantities

of some inputs are kept fixed and the quantity of at least one (or may be a few) input is

variable is called the short run production function. The time period is very small and not

sufficient enough to bring about changes in the factor inputs like plants, equipment,

machinery or the technique of production. Such a production function is also referred to as a

production function with one variable input or even a single variable production function. For

instance, if labour is the only variable factor of production (all other factors remain fixed) in a

given firm producing some commodity, then its production function can be written as:

Q = f (L)

Where Q stands for the level of output and L shows the number of labourers hired by the firm

in the process of production.

Short run production function or a production function with one variable input is governed by

the law of variable proportions. It is also called variable proportion production function as it

indicates a short run production function in which the output of a given commodity is

produced with a single variable input.

6.3.2 Law of Variable Proportions

A short run production function involves the use of some fixed factors along with some

variable factors. If it is supposed that the input of one factor is varied and the inputs of other

factors remain constant, then the output will change in the variable proportions. The

disproportionate changes in the output, when one factor is increased and other inputs remain

constant, indicate that the production is governed by the law of variable proportions. The law

of variable proportions occupies an important place in the economic theory. It examines the

short run production function, that is, a production function with one factor variable, keeping

the quantities of other factors fixed. Eminent economists have defined this law of variable

proportions as follows:

As equal increments of one input are added; the inputs of other productive services being

held constant, beyond a certain point the resulting increments of product will decrease, i.e.,

the marginal products will diminish. --- Stigler

If the input of one resource is increased by equal increments per unit of time while the

inputs of other resources are held constant, total output will increase, but beyond some point,

the resulting output will become smaller and smaller.

--- Leftwitch

The law states that an increase in some inputs relative to other fixed inputs will, in a given

state of technology, cause total output to increase : but after a point, the extra output resulting

from the same additions of extra inputs is likely to become less and less.

---- Samuelson

Thus, according to the law of variable proportions, an increase in the quantities of a variable

factor to a fixed factor results in an increase in the output to a point beyond which it

eventually declines.

Suppose that a farmer employs 15 hectares of land and 4 machines in the production of rice.

These will be the fixed inputs and labour alone is the variable input which is increased one by

one. The effect of increase in labour input keeping other inputs constant on total, average and

marginal products can be explained with the help of the following table:

Units of Labour

Total Product

TP (in quintals)

Average Product

AP(in quintals)

Marginal

Product

MP(in quintals)

1

2

3

4

10

24

45

60

10

12

15

15

10

14

21

15

Stage I

5

6

7

8

9

10

70

78

84

88

90

90

14

13

12

11

10

9

10

8

6

4

2

0

Stage II

11 88 8 -2

Stage III

Law of Variable Proportions

The above table shows that given the fixed quantities of land and capital, the producer

increases the doses of labour (variable factor) in equal amounts. Columns 2, 3 and 4

respectively show total product (TP), average product (AP) and marginal product (MP). TP is

the total quantity produced by the producer with a given combination of factors. AP is the

quantity produced per unit of labour and is calculated by dividing the total product with the

number of workers. MP is the addition made to the total product by employing one more unit

of labour.

It is clear from the above diagram (showing the law of variable proportions) that as the

producer increases the number of workers, initially the TP increases at an increasing rate

when AP also expands. Thus, in the first stage, AP rises and MP first rises, reaches a

maximum value and then begins to fall. The first stage of the law of variable proportions is

called the Stage of Increasing Average Returns. In the second stage, as more units of labour

are employed, TP increases but at a diminishing rate. It reaches the peak level at the end of

this stage. As regards MP, it continues to decline as also the AP which goes on decreasing in

this stage. The second stage of the law is called the Stage of Decreasing Average Returns. If

the number of workers is still increased beyond this stage, there is a fall in TP. TP continues

to fall along with AP. However, a striking feature about MP is that in the third stage it

becomes negative. So the third stage of the law is called the Stage of Negative Marginal

Returns. The three stages of the law of variable proportions are also known as Increasing

Returns to the Variable Factor, Decreasing Returns to the Variable Factor and Negative

Returns to the Variable Factor respectively because only the variable factor changes and the

returns obtained are actually the returns to the variable factor only.

The main causes of the operation of this law are:

- Indivisibility of the fixed factors: Initially the ratio of the fixed factors to the

variable factors is high as the fixed factors are indivisible. As more units of the

variable factor, labour, are employed, there is better use of indivisible factors.

Thus, AP rises in the first stage. After a point, when the indivisible factor is fully

utilized, the increase in the ratio of variable factors to the fixed factors cause a fall

in AP and MP.

- Scarcity of variable factor: Initially a producer employs the most efficient and

skilled workers who have a higher productivity. As a result the first stage of the

law comes into operation. After a point, the most efficient and skilled workers

become scarce and relatively less efficient and skilled workers have to be

employed which leads to a fall in AP and MP, and TP increases at a diminishing

rate. Ultimately even TP starts falling and MP becomes negative.

- Limited extent of substitution: When only labour units are increased keeping other

factors constant, there is substitution of labour in place of other factors. Upto a

point, the substitution of labour improves the efficiency of the factor combination

leading to more than proportionate increase in total product. But this substitution

is possible only upto a limited extent. After a point, the increased use of the

variable factor makes the factor combination faulty which causes eventual fall in

TP.

- Optimum productive capacity: Each factor of production has a given maximum

productive capacity. If different factor inputs are combined in such a way that

productive capacity of each factor increases, the TP increases more than

proportionately. However, if a factor input is stretched beyond its optimum

productive capacity, the factor combination becomes faulty leading to the second

and third stages of the law of variable proportions.

It is important to note that a typical business firm actually operates only in the second

stage of the law variable proportions. A business firm does not operate in the first stage as in

this stage the increase in the input of the variable factor causes more than proportionate

increase in TP and a consistent rise in AP. Hence, the average cost goes on decreasing and

the producer will continue to expand output by employing more units of the variable factor.

Moreover, the firm does not operate even in the third stage as employing more units of the

variable factor leads to a fall in TP and a negative MP. Hence, a business firm actually

operates only in the second stage of the law variable proportions.

Therefore, it can be said that the law variable proportions is a universal law of

production as production in every sector passes through the different phases of this law.

6.3.3 Long run production function

Long run or the long period is a time period in which all the factors of production can be

varied. Hence, a production function in which the quantities of all inputs are variable is called

the long run production function. The time period is very large and sufficient enough to bring

about changes in those factor inputs also which were fixed in the short period, like plants,

equipment, machinery or the technique of production.

So in the long run all inputs become variable and production may be increased by changing

one or more of the inputs. The firm can make changes in its plant size or the scale of

production.

A long run production function may be represented as follows:

Q = f (L, K)

Where, Q shows the level of output, L represents units of labour and K indicates the units of

capital. Thus, output is a function of both labour and capital which are variable in the long

run. Such a production function is also referred to as a production function with two variable

inputs or even a two variable production function. Given the level of technology, a

combination of the quantities of labour and capital produces a specified level of output. Thus,

a long run production function explains the behavior of output, when all the factor inputs

undergo changes in the same proportion. The law of returns to scale (the technological

relationship between changing scale of inputs and output) helps to describe a long run

production function. Usually in the long run we consider a case where the firm has only two

factors of production, labor and capital, both of which are variable. These two factors inputs

are substitutable with each other to some extent. The isoquants or equal product curves

describe the production function of this type.

Activity A

What do you understand by “cost efficiency”? Draw a long run cost diagram and explain.

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1. Fixed inputs are the ones which can be changed in the short run.

2. Production function is the relationship between the quantities of inputs and costs of

production.

3. Short run production function is governed by the law of variable proportions.

4. In the second stage of the law of variable proportions, as more units of labour are employed,

TP increases at an increasing rate.

5. A typical business firm actually operates only in the second stage of the law variable

proportions.

6.3.5 Isoquants

An isoquant is a curve showing the locus of all the points showing various combinations of

two factor inputs – labour and capital, generating the same level of output. Therefore, an

isoquant is also known as Equal Product Curve or Production Indifference Curve. It is similar

to the concept of indifference curve which assumed a combination of two commodities

(isoquant assumes two factor inputs) yielding same level of satisfaction (isoquant assumes

same level of production or output).

Isoquants

A typical isoquant Q0 is shown in the figure above. It represents different combinations A, B,

C of the two inputs labour and capital which produce the same level of output, given the state

of technology. Q1 shows another isoquant, higher than Q0 indicating different combinations

of the two inputs labour and capital which produce the same level of output, but higher than

Q0, given the state of technology. The movement from point A to point C on isoquant Q0

indicates increasing units of labour and decreasing quantities of capital, output remaining

same.

An isoquant is drawn on the basis of following assumptions:

1. Only two inputs – labour and capital are used in the production of a given

commodity.

2. Both the factor inputs are completely divisible.

3. Labour and capital are imperfect substitutes of each other.

4. The state of technology is given.

Given these assumptions, different combinations of labour and capital can be used to produce

a given quantity of the output, as represented by an isoquant.

6.3.6 Properties of Isoquants

The properties of isoquants are similar to those of indifference curves. Various properties of

isoquants are mentioned below:

1. Isoquants always slope downwards from left to right as shown in the figure above.

Technological efficiency requires that an isoquant must have a negative slope. In

order to produce the same level of output, if more quantity of one output is used, it

definitely means a decrease in the quantity of the other input.

2. Isoquants are always convex to the origin. It implies that the marginal rate of

technical substitution (MRTS) between labour and capital is diminishing. MRTS or

the slope of isoquant is the rate at which an additional unit of labour can substitute an

additional unit of capital, provided the output remains same.

As shown above marginal rate of technical substitution (MRTS) between labour and

capital indicates how many units of capital will be given up (K1K2) to employ additional

unit of labour (L1L2) so that output remains same. This is indicated by:

MRTS = ∆K / ∆L = slope of isoquant

When L2L3 units of labour are employed, K2K3 units of capital are given up, output

remaining same (1500 units). Similarly when the producer hires L3L4 units of labour, he

gives up K3K4 units of capital. Only then the output can remain unchanged. This is what

is meant by diminishing marginal rate of technical substitution between labour and

capital. In other words, the producer is ready to give up lesser and lesser units of capital

(K1K2 › K2K3 › K3K4) to get the same additional amount of labour. The fall in marginal

rate of technical substitution is attributed to the fact that labour and capital are imperfect

substitutes of each other, and factor inputs are subject to diminishing marginal returns.

However, it is important to note that under special circumstances, the shape of the

isoquant may be different depending on the degree of substitutability between the two

inputs, labour and capital. The two exceptional cases are shown below:

(a) Linear Isoquant

(b) Right-angled Isoquant

The figure in part (a) shows a linear isoquant. A linear isoquant is formed when the two

inputs are perfect substitutes of each other. In this case, the marginal rate of technical

substitution (MRTS) between labour and capital remains constant, hence, the isoquant is a

straight line.

The other exception to a normal isoquant is shown in part (b) where the isoquant is right

angled or L-shaped. In this case there is zero substitutability between labour and capital. The

two inputs are perfect complements of each other and cannot be used as substitutes at all.

Both the inputs are used in a fixed proportion and the output can be increased only by

increasing both the inputs proportionately.

3. Higher levels of isoquants indicate higher levels of output. A higher isoquant

represents a factor combination with larger quantities of factor inputs. Larger

quantities of factor inputs will definitely generate higher levels of output. This can be

shown with the help of the following figure:

The factor combination B indicates greater quantities of labour (OL1) and capital (OK1)

as compared to factor combination A (OL and OK). So, factor combination B, which lies

on a higher isoquant, shows higher level of output.

4. Two isoquants never intersect each other. If two isoquants intersect each other, it will

mean that the factor combination at the point of intersection will correspond to two

levels of output indicated by the two isoquants. This, however, is highly inconsistent

with theory. This property may be illustrated as follows:

As the diagram shows, factor combination A corresponds to both the isoquants indicating two

different levels of output (1500 units and 2000 units) which is not possible. Therefore, two

isoquants never intersect each other.

6.3.7 Isoquant map

An isoquant map represents a group of isoquants where each isoquant shows different

factor combinations producing the same level of output, and a higher isoquant shows a higher

level of output. An isoquant map can be shown as below:

I1, I2, I3, I4 and I5 are the five different isoquants shown in the above isoquant map. The

highest isoquant I5 represents the highest possible level of output. An economic region may

be located in an isoquant map which represents a region in which substitution between labour

and capital is technically feasible or the region where MRTS is zero (that is further

substitution between labour and capital is technically not feasible).

As shown above two ridge lines OM and ON may be drawn within which lies the economic

region. First tangents are drawn to the isoquants parallel to x-axis and y-axis. These points of

tangency are then joined to obtain the two ridge lines. The ridge lines are the locus of points

on the isoquants showing zero marginal product of labour and capital. The area between the

two ridge lines is the economic region or technically efficient region and the area outside the

two ridge lines inefficient as in that area larger quantities of both labour and capital are

required to produce the same level of output.

6.3.8 Isocost Lines

An isocost line shows all the different combinations of the two factor inputs, labour and

capital that a firm can purchase, given the total funds with the firm and prices of the factor

inputs. The concept of an isocost line is similar to that of price line or budget line in

indifference curve analysis. A typical isocost line can be shown as below:

Thus, the above isocost line shows all the different factor combinations which a firm can

employ, given the total cost of the firm and prices of the two inputs. The firm will not be able

to afford any factor combination lying outside the isocost line. The isocost line is a straight

line and its slope is measured as the ratio of the prices of the two factor inputs.

Slope of isocost line = PL/PK

where PL refers to the price of labour and PK stands for the price of capital.

There may be changes in the isocost lines if there is a change in either total cost of the firm

or one or both of the factor prices as shown below

Part (a) of the diagram shows that given the factor prices, as the total cost rises the

isocost lines shift outwards to the right. On the other hand, part (b) of the diagram shows that

given the total cost of the firm, isocost line may shift due to change in the prices of either or

both of the factor inputs. (PL,PK) represents the original isocost lines given the total cost of

the firm. The new isocost line in the figure shows a fall in the price of capital ( as the new

isocost line shifts outwards from y-axis, indicating that the firm can now afford to buy more

units of capital) and a rise in the price of labour (as the new isocost line shifts inwards to the

left from x-axis, indicating that the firm can now afford to hire lesser units of labour).

6.3.9 Producer’s Equilibrium

A profit maximizing firm will be in equilibrium when the output is maximized for a given

total outlay or alternatively when total cost is minimized for a given output. The concept of

producer’s equilibrium is completely analogous to the concept of consumer equilibrium with

indifference curve analysis discussed earlier. Producer’s equilibrium can be located by super

imposing an isoquant map on an isocost line. An isoquant map represents a group of

isoquants showing different factor combinations which can lead to the production of different

possible levels of output. However, all the combinations do not minimize the total cost for a

given output. On the contrary, an isocost line shows all those factor combinations which can

be actually attained given the total funds with the firm and prices of the factor inputs.

Combining the isoquant map and the isocost line helps the firm locate that single factor

combination which is minimizes the total cost or is in accordance with the least cost criterion.

The above diagram shows the optimal combination of inputs or the least cost combination of

inputs. The producer’s equilibrium is attained when a profit maximizing firm tries to use that

combination of inputs which minimizes the total cost of producing a given level of output.

For this an isoquant map is superimposed on the isocost line and the least cost combination of

inputs is achieved only if the following two conditions are satisfied:

1. The isoquant should be tangent to an isocost line such that the slope of isoquant

becomes equal to the slope of isocost line, that is,

At equilibrium, MPL/MPK = PL/PK.

2. The above condition of tangency between isoquant and isocost line should be fulfilled

at the highest possible isoquant.

It is clear from the above figure that when the isoquant map is superimposed on the isocost

line, it is found that IQ3 is tangent to the isocost line and the optimal combination of inputs or

the least cost combination of inputs comprises of OL2 units of labour and OK2 units of

capital.

Activity B

How does least cost combination arrived at with the help of isoquant curve. Explain the

significance of tangenital point?

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6.3.10 Expansion Path

Given the factor prices, if a firm changes its total cost, there will be set of parallel isocost

lines for the firm, each of which will indicate given level of total cost. These different

isocosts lines will be tangent to different highest attainable isoquants, showing different

points of equilibrium for the producer. If these points of producer’s equilibrium are joined,

the firm’s expansion path is obtained as shown below:

Expansion Path

It is clear that points E, E’, E” show the points of tangency between various isocost lines and

the corresponding highest attainable isoquants, showing different points of equilibrium for

the producer. These points may be joined to get the firm’s expansion path. The expansion

path may be linear or non linear depending on the ratio of the factor prices of the two inputs –

labour and capital.

6.3.11 Returns to Scale

In the case of short run production function, some factors are assumed to be fixed while

others are variable. However, in the long run all inputs become variable and production may

be increased by changing all the factors of production. Thus, output is a function of both

labour and capital which are variable in the long run. Such a production function is also

referred to as a production function with two variable inputs. In the long run production

function, the returns are varied in the same proportion. For instance, suppose a farmer

employs 20 hectares of land, 8 workers and 4 machines to attain a certain level of output. If

the factor inputs are doubled, say, how will the output increase? This question is answered

by the law of returns to scale. Returns to Scalehas been defined as follows:

The term returns to scale refers to the changes in output as all factors change by the same

proportion. --- Koutsoyiannis

Returns to Scale relates to the behavior of total output as all inputs are varied and is a long

run concept. --- Liebhafasky

The long run production function or returns to scale may be stated as

Q = f (L, K)

Where Q is output, L is labour and K is capital. If the inputs L and K both increase in the

same proportion, say, a, the output may increase to Q1

Q1 = f (aL, aK)

If a is equal to ten percent, say, there can be three different possibilities regarding the change

in the output. The output may increase by more than ten percent (increasing returns to scale),

less than ten percent (decreasing returns to scale), or by exactly ten percent (constant returns

to scale).

Increasing returns to scale : Given the state of technology, when all factors are increased by

a given proportion, the output in response increases by a greater proportion. For example, if

labour and capital are increased by say, 15%, then the increase in output by more than 15% is

known as increasing returns to scale. This may happen due to economies of scale like greater

division of labour and specialization, increase in labor productivity and the like which are

enjoyed by a firm on increasing the scale of production. It can be shown as below:

Increasing Returns to Scale

As the figure shows, when the inputs are doubled from point a to b, the output rises by more

than double the quantity (from Q = 10 to Q = 25). From b to c, the inputs are raised by fifty

percent, and the output rises by more than fifty percent (from Q = 25 to Q = 50). Such a rise

in output represents increasing returns to scale.

Decreasing returns to scale: Given the state of technology, when all factors are increased by

a given proportion, the output in response increases by a lesser proportion. For example, if

labour and capital are increased by say, 15%, then the increase in output by less than 15% is

known as decreasing returns to scale. This may happen when internal and external

diseconomies are more than internal and external economies. It can be shown as below:

Decreasing Returns to Scale

As the figure shows when the inputs are doubled from point a to b, the output rises less than

proportionately (from Q = 10 to Q = 18). From b to c, the inputs are raised by fifty percent,

and the output again rises by less than fifty percent (from Q = 18 to Q = 24). Such a rise in

output represents decreasing returns to scale.

Constant returns to scale: Given the state of technology, when all factors are increased by a

given proportion, the output in response increases by exactly the same proportion proportion.

For example, if labour and capital are increased by say, 15%, then the increase in output by

15% is known as constant returns to scale. This happens because initially economies of scale

accrue when the scale of production is expanded. But there is a limit to the extent to which

economies of scale can rise and after a point internal and external economies get fully

matched with internal and external diseconomies. This is where constant returns to scale

come into operation. It can be shown as below:

Constant Returns to Scale

As the figure shows when the inputs are doubled from point a to b, the output rises in

proportion (from Q = 10 to Q = 20). From b to c, the inputs are raised by fifty percent, and

the output again rises by same proportion (from Q = 20 to Q = 30). Such a rise in output

represents constant returns to scale.

Therefore, a production function may change differently with the change in inputs in

the long run and differently in the short run. However, a change in the production function

may also take place due to technical progress. Technical progress means innovation, research

and development undertaken to improve the technical know-how and eventually reduce the

cost of production by helping to produce a higher output with same quantity of inputs. For

example a new and more efficient machinery or research and knowledge may lead to a higher

output with same quantity of inputs. Technical progress shifts the production function

upwards and the isoquant downwards indicating the same level of output but lesser amount of

inputs.


1. An isoquant is a curve showing the locus of all the points showing various combinations of

labour and capital producing the same level of …………..

2. Isoquants are always ………… to the origin.

3. A long run production function explains the behavior of output when all the factor inputs

undergo changes in the …………………..

4. A linear isoquant is formed when the two inputs are ……………. of each other.

5. Given the state of technology, when all factors are increased by a given proportion, the output

in response increases by a lesser proportion. This is known as ……………….. returns to scale.

6.5 Summary

The concept of production function is useful in explaining the input output relationship for a

given commodity. It describes the technical quantitative relationship between inputs and

output produced for a given commodity. There are two important types of production

function - short run production function (in which some factors of production remain fixed

and at least one factor input is variable) and the long run production function (in which all the

factors of production become variable). Short run production function is governed by the law

of variable proportions, which states that if the input of one factor is varied and the inputs of

other factors remain constant, then the output will change in the variable proportions. It is a

universal law of production as production in every sector passes through the different phases

of this law. On the other hand, a long run production function explains the behavior of output,

when all the factor inputs undergo changes in the same proportion. It can be explained with

the help of the concept of isoquants. An isoquant is a curve showing the locus of all the

points showing various combinations of two factor inputs – labour and capital, generating the

same level of output. The properties of isoquants are similar to those of indifference curves.

An isoquant map represents a group of isoquants where each isoquant shows different factor

combinations producing the same level of output. The economic region may be located in an

isoquant map which represents a region in which substitution between labour and capital is

technically feasible and it is a technically efficient region. An isocost line shows all the

different combinations of the two factor inputs, labour and capital that a firm can purchase,

given the total funds with the firm and prices of the factor inputs. These two concepts help

locate the producer’s equilibrium or the least cost combination of inputs. Different points of

producer’s equilibrium may be joined to get the firm’s expansion path. In the long run

production function, the returns are varied in the same proportion. The term returns to scale

refers to the changes in output as all factors change by the same proportion in the long run.

The returns to scale may be increasing, constant or decreasing, depending on how the

output changes in response to a proportionate change in the inputs.

6.6 Glossary

Production Function: The technical quantitative relationship between inputs and output

produced for a given commodity.

Short Period:A time period in which some factors of production remain fixed while others

can be varied.

Long Period: A time period in which all the factors of production can be varied.

Law of Variable Proportions: The disproportionate changes in the output, when in the short

run one factor is increased (variable factor) and other inputs remain constant (fixed factors).

Isoquant: A curve showing the locus of various combinations of two factor inputs producing

the same level of output.

Isocost Line: A line showing all the combinations of labour and capital that a firm can

purchase, given the total funds with the firm and prices of the factor inputs.

Producer’s Equilibrium: It is attained when a profit maximizing firm tries to use that

combination of inputs which minimizes the total cost of producing a given level of output.

Expansion Path: A path obtained by the joining the points of tangency between various

isocost lines and the corresponding highest attainable isoquants, showing different points of

equilibrium for the producer.

Returns to Scale:The changes in output when all factors change by the same proportion in

the long run.



1. False

2. False

3. True

4. False

5. True


1. Output

2. Convex

3. Same proportion

4. Perfect substitutes

5. decreasing

6.8 References

Salvatore, Domonick, Managerial Economics, Thompson South-Western.

Ferguson, C. E., Microeconomic Theory, Richard D. Irwin, Homewood.

Douglas, Evan J., Managerial Economics: Theory, Practice and Problems, Prentice Hall Inc.,

NJ.



.



Mathur N.D., Managerial Economics, Shivam book House (P.) Limited, Jaipur

Mishra &Puri : Managerial Economics, Himalaya Publishing House, Mumbai




1. What do you mean by production?

2. Explain the law of variable proportions.

3. Define production function.

4. Discuss the producer’s equilibrium.

5. Give the difference between fixed and variable inputs.

6. Explain ridge lines.

7. What is expansion path?

8. Give the properties of isoquants.

9. What is an isocost line?

10. Mention exceptional shapes of isoquants .

LESSON – 7

Theory of Costs

7.0 Objectives

7.1 Introduction

7.2 Meaning of Costs

7.3 Kinds of Costs

7.4 Short run Costs

7.4.1 Total Costs

7.4.2 Average and Marginal Costs


7.5 Long run Costs

7.6 Economies of Scale

7.7 Diseconomies of Scale

7.8 Economies of Scope

7.9 Learning Curves


7.11 Summary

7.12 Glossary


7.14 References



7.0 OBJECTIVES


To understand the meaning and importance of cost in managerial decision

making

To explain the different concepts of cost.

To comprehend cost behavior in the short run and the long run.

To introduce the concepts of economies of scale and learning curve.

7.1 Introduction

All productive activities of the business firms are guided by the consideration

of maximum profits. The objective of profit maximization can be achieved if the said

firm is able to produce maximum possible output at minimum possible cost. The cost

analysis plays a vital role in every organisation, and hence, in managerial

economics, within the decision making process. The information on costs is of

extreme importance for any business firm because it helps to monitor the other

control systems of the firm like production control, quality control, stock control, etc.

Hence, the business managers must have a complete knowledge of cost concepts

and their role in business, to maximize the value of the firm. The concept of cost is of

great significance in microeconomics as it helps the business managers in making

appropriate business decisions (aiming at reduction of costs) aimed at maximization

of profit. Business firms are responsible for providing the consumers in the market

with a flow of goods and services, in accordance with their tastes and preferences.

The process of production involves various inputs or the factors of production such

as land, labour, capital, raw materials, etc. The factor prices of these inputs, in turn,

affect the price of the final goods and services. All the explicit and implicit payments

made by a firm in the process of production, form the production costs of the firm.

The importance of the relevant time frame is all the more realized in the

context of cost analysis. The major concerns of the business managers of a firm in

the short run are different from those in the long run. In the short run the production

has to be planned keeping in mind that only one factor input is variable while others

are fixed. Hence, the optimum level of output has to be worked out in terms of the

optimal input of the variable factor. However, in the long run all the factor inputs

become variable and the firm is basically concerned with the scale of production, that

is, the pursuit for optimal combination of inputs or the least-cost combination of

inputs. The decision regarding which kind of cost concept should be used in a

specific situation, in turn is influenced by the business decision made by the

manager of a firm. Owing to various definitions and concepts of cost, the cost

analysis has in itself become a complex one. It requires an in depth study of the cost

analysis to decide about the usage of different concepts of cost. This is so because

the cost of production is an important element in almost all the processes of

business decision making. Also, costs can make or break any strategic move in

important decisions involving crucial issues (like expansion or integration or maybe

diversification), which need to be justified on the basis of profitability. Hence, cost

analysis forms the very basis of the economic rationale behind the process of

business decision-making.

7.2 Meaning of Costs

The term cost has different meanings to different users of the term. In economics

the definition of cost is based on the concept of opportunity cost. Every business firm

has to employ different factors of production for producing goods and services for the

consumers in the market. The owners of the factors of production are made

payments in return for the use of their services. In addition to these costs, the

producer also has to give up his time, comfort and opportunity of other sources of

income. Hence, cost also involves sacrifice on the part of the producer as cost leads

to a current or future decrease in cash or other assets. According to Marshall, the

real cost of production includes the real cost of efforts of various qualities and real

cost of waiting. It is also known as alternative sacrificed cost, or transfer cost.

Opportunity cost of a commodity is the alternative sacrificed in order to obtain it.

There are various factors which influence the level of costs, some of which

are uncontrollable while others can be controlled (partially or completely). Out of

these factors, the most significant factor is the factor prices or the prices of the factor

inputs, which largely constitute the total production cost, and which are usually

outside the control of the business firm. Further, the factor costs are related to the

marginal productivity or the efficiency of these factors of production. Other things

remaining the same, a higher level of marginal productivity or efficiency of the factor

inputs leads to a lower factor cost and vice-versa. The other important determinants

of cost are technology (an improvement in technology lowers the cost by increasing

the efficiency, other things remaining the same) and the level of output.

The expenses on production or costs vary directly with the level of output.

Higher the level of output, higher is the cost and vice-versa. The functional

relationship between costs and the level of output is called the cost function. Hence,

the cost function is derived from the production function and is defined as:

Cost functions are derived functions. They are derived from the production function.

--- Koutsoyiannis

Cost is a function of a number of factors- the expenses incurred on all inputs of

production (both factor inputs – land, labour, capital and organisation; and non-factor

inputs - raw materials, fuel, machinery equipment, tools, etc.) form the cost of

production. The cost function can be expressed as:

C = f (Q, T, Pf)

where C is the total cost of production, Q is the level of output; T stands for

technology, and Pf is the prices of factors of production.

7.3 Kinds of Costs

There are various concepts of cost relevant to business operations and the process

of business decision making.Different types of costs are relevant for various kinds of

management decisions.Some important concepts of costs of production are

explained as follows:

Accounting Costs: These costs are the nominal or money costs, that is, costs

expressed in money terms. Accounting costs are so called because these can be

recorded in the books of accounts. Those costs which can be identified and

measured are included in this category, for example, wages and salary, cost of raw

material, interest on capital, electricity expenses, etc.

Real Costs: Real cost of producing a commodity is the exertion, inconvenience, pain

or sacrifice involved in producing it. In the words of Marshall, “Real cost is the

exertion of all the different kinds of labour that are directly or indirectly involved in

making it together with the abstinence or rather waiting required for saving the

capital used in making it.” The producers compensate the owners of factors of

production through the amount of money considered equivalent to exertion,

inconvenience, pain or sacrifice involved in production. However, exertion,

inconvenience, pain or sacrifice are psychological concepts which cannot be exactly

measured in money terms. Hence, real costs are not of much significance for the

accountants but the business decision makers cannot ignore them.

Opportunity Costs: Opportunity cost of a decision is the cost of next best

alternative sacrificed in order to take the current decision. Thus, it is the value of the

next best alternative or opportunity forgone. It is defined as:

The opportunity cost of anything is the next best alternative that could be produced

instead by the same factors or by an equivalent group factors, costing the same

amount of money. --- Benham

The alternative or opportunity cost of producing one unit of commodity X is the

amount of commodity Y that must be sacrificed in order to use resources to produce

X rather than Y. --- Ferguson

Thus, opportunity cost of a particular product is the value of the foregone alternative

products that resources used in its production, could have produced. The concept of

opportunity cost is of special significance for determining the prices of the factors of

production.

Explicit Costs: Explicit costs are the payments made by the producer to the owners

of the factors of production (which do not belong to the employer himself) on account

of the supply of factor services by them.

Explicit costs are those cash payments which firms make to outsiders for their

services and goods. --- Leftwitch

These costs fall under the category of business costs or accounting costs as these

involve cash payments and are entered in the books of accounts. Explicit costs are

also called expenditure costs or out-of-pocket costs, and include payments for raw

materials, fuel, interest on borrowed funds, rent on hired land, wages and salaries,

insurance premium, depreciation charges and taxes paid to the government.

Implicit Costs: Implicit costs of production are the costs of self-owned and self-

employed resources. These costs that do not involve cash payments and hence, are

not entered in the books of accounts. Non-expenditure or implicit costs arise

because of the fact that the entrepreneur himself provides certain services to

production like his own land or capital or managerial services. However, these costs

are not taken into consideration while calculating the loss or gains of the business,

though they form an important consideration in managerial decisions about the

usage of a factor in business operations. Non-expenditure costs are implicit or

internal in character, and hence, they are the imputed costs. Implicit costs are non-

cash costs, like the salary that could have been earned, leisure time foregone and

interest foregone on assets which have to be used in production. These include the

rewards for the entrepreneur’s self-owned land, labour and capital. Expenditure

costs are explicit as they are paid to factors outside the firm while non-expenditure

costs are implicit, hence they are imputed costs. The sum total of the explicit and

implicit costs formseconomic costsor the total cost of production.

Private, External and Social Costs: External costs are not borne by the firm, but

are incurred by others in society. In order to know the social cost or true cost to the

society, we need to know all costs no matter who bears them.

Private costs include the total costs (economic costs) of a firm in involved in the

production of a commodity. For example, the purchase price (offered to the

consumer) of a bike includes the private cost borne by the producer. On the other

hand, the air pollution (and/or other types of pollution) generated in the process of

production of the bike is called an external cost (as these fall not on the firm

producing the bike but on other people in the society). The air pollution from driving

an automobile is also an externality or third party effect. . On the contrary, social cost

is a wider term which is the total of all the costs associated with an economic activity.

It, hence, includes the costs undertaken by the producer as well as the costs on the

society as a whole. Thus, social costs are the sum total of private costs and the

external costs. Therefore, if social costs are greater than private costs, it implies the

presence of a negative externality for example, environmental pollution. However, if

private costs are greater than social costs, this indicates the presence of a positive

externality, for example, education which benefits the society as a whole.

Replacement Costs or Current Costs: Current costs refer to the current price of

buying or replacing any input t under present market conditions. Replacement cost is

the relevant cost for decision-making as it involves the expenditure on replacing an

old machine with a new one on the expiry of its economic life.

Historic Costs and Future Costs: Historical costs are the costs incurred at the time

of the purchase of assets and represent actual cash outlay which is recorded by the

accountants. Historic costs or past costs are the actual costs incurred by a producer

in the past. On the other hand, future costs are those costs which may have to be

incurred in the near future. As this is only a sight into future business actions, future

costs are very important for planning and evaluating of managerial decisions.

However, there is no scope for managerial decision in historic or past costs which

have already been incurred. Relevant feasible action may be taken if the future costs

are high.

Incremental Costs and Sunk Costs: Incremental costs are the changes in costs

caused by a particular decision. This concept is quite similar to the concept of

marginal cost. Incremental cost refers to the total additional cost caused by a change

in the level of production or the nature of activity. It may be associated with the

decision to expand output or to add a new variety of product. Incremental costs may

also arise by adding a new product or changing distribution channel, or adding new

machinery, or replacing worn out plant and machinery, replacing old technique of

production with a new one, etc. Incremental costs are the relevant costs for decision-

making.

Sunk costs are the costs that do not vary according to different decisions.

These costs have already been incurred and cannot be altered in any way.

Investment on machinery, or costs incurred in building a factory, etc. are examples of

sunk cost. All preceding costs are considered to be the sunk costs as they relate to

the prior commitment. It is not possible to reverse or recover these costs when there

is a change in market conditions or a change in business decisions.

The distinction between the sunk cost and the incremental cost is very important in

evaluating different business alternatives. Incremental cost will be different in each

case while sunk cost will remain same. Hence incremental cost is relevant for the

management in decision making.

Controllable Costs and Non-Controllable costs

Controllable costs are those costs that can be controlled by some executive action

on the part of the business management in a firm. These can, hence, improve the

efficiency of the factor inputs. For example, fringe benefits to employees. On the

other hand, non-controllable costs are those that cannot be controlled by way of any

action on the part of the business administration. These costs may lead to wastage

of resources and encourage inefficiency. The factor prices may be regarded as non-

controllable costs as they reflect the external environment and are not in the control

of the producer.

Activity A

Identify types of cost in each case

a)Payment for office stationary

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b)Interest cost of owner’s capital----------------------------------------------

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c)Salary of the owner of the company

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7.4 Short run Costs

Short run is a period of time in which some factors are fixed and some are variable.

So in the short period a firm can change its output by changing only the quantity of

the variable factors, such as labour and raw materials etc. The fixed factors like land,

machinery etc, cannot be changed. Hence, based on the fixed factors and variable

factors in the short run, short run costs may be divided into two categories: fixed

costs and variable costs. The concepts related to short run costsare discussed

below:

7.4.1 Total Costs

Total cost is the sum of all the expenses of production that a producer incurs through

the process of production. It is defined as:

The sum of all expenditures incurred in producing a given volume of output.

--- Dooley

Hence, total cost refers to the total expense on the production of goods and services

and it includes both explicit and implicit costs. The explicit costs further comprise of

fixed and variable costs. In the short period, the total cost (TC) is made up of total

fixed cost (TFC) and the total variable costs (TVC).

TC = TFC + TVC

Total Fixed Costs: In the short period, certain factors of production like land,

building, etc. remain fixed. Thus, the expenses incurred by the producer on the fixed

factors also remain constant. So the total fixed costs are related to the fixed factors

and do not vary with output in the short run. For example rent, insurance, interest

payments, depreciation, cost of construction of a building, payment to permanent

staff, expenditure on machinery, property tax, etc.

Fixed costs are those costs which in total do not vary with changes in output.

---- McConnel

Thus, the fixed costs are independent of the level of output and are the costs that

continue even if the firm is temporarily shut down, producing nothing. Fixed costs

have to be paid even if output is zero for any period. Total fixed cost can be shown

with the help of the following figure

It is clear that the TFC curve is a straight line parallel to x-axis indicating that total

fixed costs remain constant at all levels of output. The fixed costs are also called

indirect costs, supplementary costs or the overhead costs.

Total Variable Costs: In the short period, some factors of production are variable

and the expenses incurred by the producer on the variable factors comprise the

variable cost.Total variable costs are those costs which vary with a change in the

level of output. Total variable costs increase with the increase in the level of output

and vice-versa. If the output falls to zero, the variable costs also become zero.

The variable costs are those that vary with the volume of output.

--- Watson

The variable costs include cost of raw materials, wages to the workers, expenditure

on electricity, repairs and transportation, excise duty, sales tax, depreciation, etc.

Total variable cost can be shown with the help of the following figure

It is clear that the TVC curve has an inverse-S shape indicating that total variable

costs vary with the level of output. The variable costs are also called direct costs, or

the prime costs.

As mentioned earlier, total cost for the various levels of output is the sum of total

fixed costs and total variable costs,

TC = TFC+TVC

This can be shown as follows:

Given the above relation that total cost is the sum of fixed costs and total variable

costs, fixed cost is equal to the difference between total costs and variable costs.

7.4.2 Average and Marginal Costs

Average cost (AC) is the cost per unit of output and is computed by dividing total

costs by output. The concept of AC can be used to find average fixed cost (AFC) and

average variable cost (AVC).

Average Fixed Costs(AFC): AFC is the fixed cost per unit of output and is

computed by dividing total fixed cost (TFC) by total output as shown below:

where TQ is total output.

The above diagram shows AFC curve. The shape of AFC curve is a rectangular

hyperbola, indicating that TFC remains constant throughout.

Average Variable Costs(AVC): AVC is the variable cost per unit of output and is

computed by dividing total variable cost (TVC) by total output as shown below:

where TQ is total output.

It is clear from the above diagram that AVC curve is U-shaped. AVC falls initially,

reaches a minimum when the plant is operated optimally and then starts rising

thereafter showing that AVC is per unit cost of the variable inputs and changes as

the level of output changes.

Average Total Costs or Average Costs(ATC or AC): Average cost (AC) is equal to

total costs divided by the total output. Hence, ATC is per unit cost of both fixed and

variable inputs. Average total cost of production can be calculated by dividing total

cost by the level of output. Moreover, AC is also equals to the sum of AFC and AVC.

This is shown as follows:

The average cost (AC) curve can be shown in the following figure:

Hence, the average cost (AC) curve is U-shaped and its shape is same as that of the

AVC curve.

Marginal Costs

Marginal cost (MC) is the addition to the total cost when the producer produces one

more unit of any commodity. It can be expressed:

MC(N) = TC(N) – TC(N–1)

where, N is any given number of units of output. Alternatively, marginal cost can also

be expressed as follows:

Where, ΔTC and ΔTQ stand for the change in total cost total output respectively.

The MC curve can be diagrammatically shown as above. MC curve represents the

slope of the TC curve, as MC shows the change in TC due to unit change in output.

It is a U-shaped curve. Initially it slopes downwards from left to right because of

negative relation between output and MC. Later the MC curve slopes upwards from

left to right because of positive relation between output and MC. In this connection it

should be noted that MC is independent of fixed cost as the amount of fixed cost has

no impact on the marginal cost. It can be explained as:

MC(N) = TC(N) – TC(N–1)

MC(N) = [FC(N)+VC(N)] – [FC(N–1)+VC(N–1)]

Since FC(N) = FC(N–1)

Hence, MC(N) = VC(N) –VC(N–1)

where, FC and VC are the fixed and variable cost respectively, N is the number of

units of the output.

The relationship among fixed, variable costs, total, average and marginal costs can

be explained with the following table

Thus, total costs are calculated by adding the columns of fixed cost and variable

cost, average fixed cost by dividing fixed costs by output (column 1), average

variable cost by dividing variable costs by output. Average total cost is the sum of

average fixed cost and average variable cost, or alternatively, ratio of total costs to

output. Finally, marginal cost measures the change in total costs as discussed

above. All the cost curves in the short run can be shown as below

The level of output is measured on x-axis and the costs on y-axis. The vertical

distance between AC or ATC and AFC goes on decreasing with rise in output.

However, AC and AFC will never meet as AFC can never be zero. Also, MC cuts the

AC at its minimum point and also cuts the AVC at its minimum point.

The U-shape of short run average cost can be explained as follows:

Initial negative slope of AC curve is attributed to

(i) Rapid fall in AFC

(ii) Fall in AVC

(iii) Better use of indivisible factors with increase in variable factor

(iv) First stage of the law of variable proportions which causes a more than

proportionate increase in total product and rise in average and marginal

product.

Positive slope of AC curve after a point, with rise in output, is attributed to

(i) Slow decline in AFC

(ii) Rapid increase in AVC

(iii) Faulty combination of inputs with continuous rise in variable factor

(optimum factorcombination is at the minimum point of AC).

(v) Second stage of the law of variable proportions which causes total product

to increase at a diminishing rate and there is a fall in the average and

marginal product.

Hence, the initial negative slope of AC curve and the subsequent positive slope of

AC curve in the short run, explains that the short run average costcurve is U-shaped.

Similarly, the U-shape of short run marginal cost curve can be explained on the basis

of different stages of the law of variable proportions.


1. Cost functions are derived from the …………….

2. ………….. costs involve psychological concepts which cannot be exactly

measured in money terms.

3. ……………costs are the cash payments made by the producer to the owners

of the factors of production.

4. In the short run, the …………………. are those that vary with the volume of

output.

5. Total cost is the sum of total ………. costs and total ………… costs.

6. The shape of AFC curve is a ………….., indicating that TFC remains constant

throughout.

7. Marginal cost (MC) is independent of ……..cost.

7.5 Long run Costs

The long run is the time period which is long enough to enable the firm to change all

the factor inputs. Thus, in the long run there are no fixed factors and hence, no fixed

costs. The firm can adjust the resources to take advantage of more efficient means

of production. For example, a firm can change the amount of all inputs used, alter

the building size, or even change the machinery capabilities. Hence, improvements

in technology, which are possible only in the long run, make production costs

cheaper in the long run.Hence, the most important decision to be made by the

business managers of the firm is to determine the optimal plant size or scale of the

firm, when a certain target level of output is given. In the long run, the firm can build

any size or scale of plant as it can change all its inputs. Consequently, all the costs

in the long run are variable. As soon as the decision regarding the optimal

combination of inputs is made, some of these inputs, like plant and equipment, again

become fixed (or given) in the short run.In this context, we study long run average

cost and long run marginal cost.

Long run Average Costs (LAC): The long run average cost represents per unit cost

of producing a given commodity in the long run. It is not possible for the producer in

the short period to bring about changes in the plant. However, the producer can

make any necessary change in the plant, in the long run, at the minimum per unit

cost. Hence, the long run average cost curve is defined as a curve on which each

point indicates the least per unit cost corresponding to each level of output. In other

words, LAC shows the lowest AC of producing output when all inputs can be varied

freely. Since the objective of the firm is to produce at the least per unit costs, there

will be continuous changes in plant and organization of production. It means there

will be a large series of SAC (short run AC) curves or plant curves each

corresponding to different levels of output. The LAC curve can be derived from that

series ofplant curves as shown below:

In the figure below, SRAC1, SRAC2, SRAC3, SRAC4, SRAC5 are the short run AC

curves or plant curves. LRAC is the long run average cost curve. It is a curve which

contains or envelopes a series of short run average cost curves or plant curves.

Thus, LAC is also called as an Envelope curve. It is also called as the Planning

curve as it enables a producer to plan which plant size is the most appropriate for a

given level of output. When minimum point of SAC coincides with the minimum point

of LAC, then LAC curve is tangent to the minimum point of SAC. Such a plant is

regarded as the optimum plant.

Like the short run average cost curve, the long run average cost curve is also U-

shaped but it is relatively flatter. Initially the LAC slowly decreases but later as the

output is increased, it goes on rising and slopes positively. Here too it is less steep

than the short run average cost curve. The main reasons of the U-shape of the long

run average cost curve lies in the economies of scale and diseconomies of scale

discussed later. Economies of scale can result from improvement in technology and

specialization and the diseconomies of scale may occur due to coordination and

communication problems resulting from the firm’s growth. The initial fall in the LAC is

attributed to the economies of scale and the subsequent rise in LAC is explained by

the diseconomies of scale.

Long run Marginal Costs (LMC): The long run marginal cost (LMC) is also U-

shaped. It is the addition made to total cost by the production of one more unit of

output, when all the factor inputs can be varied. When the output takes place in the

long run with the optimum plant, SMC and LMC become exactly equal. However, if

the output is less than optimum, the LMC is greater than SMC and vice-versa.

7.6 Economies of Scale

When all the factor inputs are increased in the same proportion in the long run, it

signifies an increase in the scale of production. The expansion in the scale of

production brings out certain advantages in production or costs. These advantages

are called the economies of scale. An increase in the scale of production leads to

reduction in the long run average cost of production over a range of output which

signifies an improvement in productive efficiency. Moreover, it is important for a firm

to specialise as it expands, as it will improve the possibility of reaping the economies

of scale. Economies of scale may result even from the use of larger and more

efficient machines as they provide more output per unit of input. However, the

improved efficiency associated with increased size requires the need of skilled

managers. Hence, in the long run, a firm can achieve economies of scale by

increasing quantities of output while keeping costs at a minimum level. The long

period is a planning horizon for the firm as it has all options available to it regarding

the quantity of resources, since no factor input is fixed anymore.

The economies of scale are broadly of two types:

(i) Internal economies

(ii) External Economies

(i) Internal Economies arise from the growth of the firm itself, that is, from the

expansion of the plant size of the firm and are exclusively available to the expanding

firm. These are the advantages resulting from the internal and organization of the

firm. Hence, the internal economies are controllable and under the influence of

business managers. Internal economies are further classified into the following

types:

Technical Economies: The technical economies arise mainly from increased

specialization and indivisibilities. Larger firms are in a position to use more

specialized machinery, equipment and skilled labour in the process of production.

Indivisibilities may also occur in the form of use of more expensive but often more

effective advertising media, and greater expenditure on research and development

activities that small firms cannot afford. Specialisation of the workforce within larger

firms is possible as they split complex production processes into separate tasks. The

division of labour in mass production leads to technical economies of scale.

Other technical economies relate to increased dimensions. The dimensional

economies arise when there is enlargement of plant, machinery or some other

equipment. As the size increases, volume increases more rapidly than surface area.

The unit costs fall as size increases, as volume often determines the output while

surface area determines cost. This is particularly relevant in the transportation and

storage industries. For example, the cost of constructing a double-decker bus is less

than two times the cost of constructing a single-decker bus but its capacity is two

times the capacity of a single-decker bus.

Another type of technical economy relates to economies of linked processes.

Production processes can be linked together with one integrated plant. It is

specifically important in mass production which requires complex manufacturing

processes. Larger firms find it easier to combine equipment or facilities with different

capacities more efficiently. For example, a steel mill having its own iron mines,

transport arrangements and other units involved in different stages of production of

steel, can manufacture steel at a much lesser cost than a small firm not having these

linked processes under its control. These economies are sometimes called multi

plant economies. These technical economies tend to be the most important source

of economies of scale for most of the firms.

Managerial economies: Large scale firms attract and use more specialized, skilled

managers, who are trained and efficient in managerial functions and decision

making. This leads to savings in administrative costs by splitting up jobs (like

specialist buyers, production management). A large firm can afford to employ various

specialist managers to supervise production systems. Hence, better management,

more investment in human resources and use of specialist equipment, all work

towards raising the productivity and reducing unit costs.

Marketing economies: These economies arise from large scale purchase of raw

materials and other inputs, along with large-scale selling of the firm’s own products.

When the firm buys in bulk, larger firms get bulk discounts (if it has monopsony

(buying) power in the market). Economies in marketing the firm’s own product are

associated with the economies in advertisement cost. Expensive advertising

expenditure can be spread over huge volumes of sales which thereby reduces the

marketing costs per unit.

Economies in Transport and Storage costs: These economies arise from full,

efficient and optimum utilisation of the available transport and storage facilities.

Financial economies: Large firms can usually borrow at a lower interest rate due to

higher credit worthiness in the market. So the firms operating at a bigger scale have

access to cheaper sources of finance. Also they have more sources of finance as

compared to smaller firms. They can even use the capital markets to borrow cheaply

through the issue of equities.

Learning Economies: These economies relate to the efficiencies due to the length

of experience in a market and are readily available in high-knowledge industries

which have an edge as they get to learn the tricks of the trade.

Network economies of scale: Some networks and services have huge potential for

economies of scale as they become more valuable to the business that provides

them. For example, networks economies are enjoyed in online auctions, air transport

networks, new phone connections, etc. The marginal cost of adding one more user

to the network is almost negligible but the resulting benefits are huge as each new

user in the network can then interact with all of the existing members.

(ii) External Economies: External economies arise from the growth of the

industry and are independent of the size of the firm. These economies occur outside

of a firm, within an industry. For example, creation of a better transportation network

may increase the scope of expansion of an industry and result in a decrease in cost

for a firm operating within that industry. External economies are also called

economies of concentration because they arise when firms in the same industry are

located close to each other. Development of research and development facilities in

local universitiesmay benefit several business firms in that area. Trade magazines

help firms to advertise cheaply and spread information (economies of information).

Also the relocation of component suppliersand other supporting business firms near

the main centre of production may generate external economies by reducing

transportation costs. Further, external economies of scale exist when the long-term

expansion of an industry leads to the development of ancillary services which benefit

all or the majority of firms in the industry (economies of disintegration).Thus, external

economies justify the tendency for firms to cluster geographically.

Thus, as the internal and external economies create the conditions for

expansion in output and sale along with economy in costs, the profitability of the firm

increases by a large measure.

7.7 Diseconomies of Scale

With the expansion of the scale of production, a firm may eventually experience a

rise in long run average costs caused by diseconomies of scale. Diseconomies of

scale are the disadvantages that arise due to the expansion of scale of production,

thereby leading to a rise in production cost. Diseconomies of scale may be internal

or external.

Internal Diseconomies of Scale: These are the disadvantages that originate within

the firm.Economies of scale reach a limit, when the optimum combination of inputs is

achieved for a given level of output. Then diseconomies appear when the

advantages of division of labour and managerial staff have been fully exploited. For

example, workers doing repetitive jobs may lose motivation to work, which reduces

productivity. It may increase the chance of industrial unrest. Also workers in large

firms may feel a sense of alienation and thus loss of morale. Large firms are more

difficult to manage; monitoring the productivity and the quality of output from

thousands of employees in big corporations could be imperfect and costly. The

suppliers of factor and non factor inputs may start demanding higher prices, raising

the costs. Beyond a point, serious financial difficulties can arise disrupting the whole

process of production.

External Diseconomies of Scale: These are the disadvantages that originate

outside the firm by virtue of being a part of the industry. The diseconomies of scale

lead to rising long-run average costs when the firms expand beyond their optimum

scale. They are often caused by the complex nature of managing large-scale firms.

Increasing demand for inputs also puts pressure on input markets leading to

increase in input prices or even creating serious shortages of raw materials,

machinery, trained labour, power, finance, etc. This further increases production

costs. The expansion of an industry results in an increased intensity of competition

among the firms causing a rise in the cost of material and labour, and also a price-

cut strategy. This in turn leads to a steady erosion of profits for all the firms.

7.8 Economies of Scope

Economies of scope refer to a situation where it is cheaper to produce a range of

products than to produce each individual product on its own.

Economies of scope occur when the total cost of producing two types of outputs

together is less than the total cost of producing each type of output separately.

--- Baye

Economies of scale relate to an increased production of the same commodity being

produced by firm. On the other hand, economies of scope relate to making different

but compatible products. For example, making mango pickle would probably use a

lot of the same equipment as for making lemon pickle, so the firm can save money

per unit because the scope (range of products) is being increased within similar

categories. Economies of scope are relevant to firms that produce more than one

product and obtain production or cost advantages. This concept is a relatively new

business strategy based on high technology. When a firm produces multiple or joint

products, economies of scope can be measured as the ratio of average costs to

marginal costs.

Economies of scope occur when changing the mix of operations leads to cost

benefits as the products may use common processing facilities, especially when

there are joint products or by-products, for example petrochemicals. Thus, the cost

of a set of resources or skills is spread over two or more products or enterprises. It

can be explained with the following figure:

It is clear that the cost for an enterprise is reduced when the resources are used in

two or more enterprises rather than just one. However, it is important to note that the

economies of size and economies of scope are not mutually exclusive and can

coexist in a single firm. On one hand, economies of scope allow costs to be spread

over several enterprises, and on the other, the size of each enterprise can be

increased in order to achieve economies of scale as well.

7.9 Learning Curves

Rapid changes take place in in the dynamic business environment of the present

times. The firms gain experience with products and processes in the organization

and try to achieve improvement in productivity with better work methods, tools,

product design, or supervision. These improvements mean that the producers learn

from experience (learning by doing). Further, experience with a given production

process, workforce, supplier(s), managers, etc. lead to an improvement in technical

efficiency. The concept of learning curve is used to show the extent of fall in average

cost due to rise in output. A learning curve represents the learning effect which

shows the relationship between the total direct labour per unit and the cumulative

quantity of a product produced. It relates to a repetitive task and represents the

relationship between experience and productivity. It is observed that individuals who

perform repetitive tasks show an improvement in their performance, that is, the time

required to produce a unit decreases as more units are produced.

The learning curve was first developed in the aircraft industry before World War

II. It was found that the direct labour input per airplane declined with an increase in

the cumulative number of planes produced. For any given product and company, the

rate of learning may be different. Learning curves enable managers to project the

manufacturing cost per unit for any cumulative production quantity.

Although learning curves can be useful tools for managers, several things should

be kept in mind when using them. An estimate of the time required to produce a unit

of output is required for learning curve. This estimate may have to be developed by

management using past experiences with similar products. Also, learning curves

provide their greatest advantage in the early stages of new product production.

Moreover learning curves are dynamic because they are affected by various factors.

Finally, learning curves are only approximations of actual experience and not the

actual experience.

Activity B

A automobile company recently expanded its annual production from 100 to 150 units and also

diversified its activity. Highlights the economies and diseconomies during expansion.

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1. The long run average cost represents the lowest average cost of producing output

when all inputs can be varied freely.

2. Economies of scale are the cost advantages that a business firm enjoys by

expanding its scale of production in the short run.

3. External economies arise from the growth of the firm itself and depend on the size

of the firm.

4. Economies of scope refer to a situation where it is cheaper to produce an

individual product rather than a range of products.

5. The external diseconomies of scale originate outside the firm by virtue of being a

part of the industry.

7.12 Summary

The cost analysis plays a vital role in the decision making process. Cost is influenced

by many factors, like factor prices, productivity of the factor, technology and the level

of output. Cost functions are derived from the production function. A firm incurs

different types of costs under different situations. Accounting costs are the costs

which go to the book of accounts. Real costs involve psychological concepts which

cannot be exactly measured in money terms. Opportunity cost of is the cost of the

next best alternative which is foregone.Explicit costs are the payments made by the

producer to the owners of the factors of production (outsiders) on account of the

supply of factor services.Incremental costs are the changes in costs caused by a

particular decision while sunk costs are the costs that do not vary according to

different decisions. Similarly, controllable costs and non-controllable costs reflect the

extent of control of the firm on the costs. Managers must be very careful in using

cost information prepared by the accountants, as it is collected and categorised for

different purposes. On the basis of time frame, costs may be divided into short run

costs and long run costs. Short run costs may be divided into two categories: fixed

costs and variable costs; fixed costs do not vary with output while the variable costs

vary with the volume of output. Average and marginal costs may be derived from the

total costs. The short run average cost and marginal cost curves are U-shaped. In

the long run there are no fixed factors and hence, no fixed costs. The long run

average cost represents per unit cost of producing a given commodity in the long

run.The long run marginal cost is the addition made to total cost by the production of

one more unit of output, in the long run. The economies of scale are the cost

advantages that a business firm enjoys by expanding its scale of production in the

long run. With the expansion of the scale of production, a firm may eventually

experience a rise in long run average costs causing diseconomies of scale. The

concept of learning curve is used to show the extent of fall in average cost due to

rise in output.

7.13 Glossary

Accounting Costs: These costs are the nominal or money costs.

Explicit Costs: The payments made by the producer to the owners of the factors of

production.

Implicit Costs: The costs of self-owned and self-employed resources.

Sunk costs: The costs which do not vary in response to different decisions as they

relate to the prior commitment.

Short run Costs: These costs comprise of fixed costs (of fixed factors) and variable

costs (of variable factors).

Long run Average Costs: The long run average cost represents per unit cost of

producing a given commodity in the long run.

Economies of Scale: The cost advantages that a business firm enjoys by

expanding its scale of production in the long run.

Diseconomies of scale: The disadvantages that arise due to the expansion of

scale of production in the long run.

Learning curve is used to show the extent of fall in average cost due to rise in

output.



1. Production function

2. Real

3. Explicit

4. Variable costs

5. Fixed, variable

6. Rectangular hyperbola

7. fixed


1. true

2. false

3. false

4. false

5. true

7.15 References


Ferguson, C. E., Microeconomic Theory, Richard D. Irwin, Homewood.

Douglas, Evan J., Managerial Economics: Theory, Practice and Problems, Prentice

Hall Inc., NJ.



.








1. What is opportunity cost?

2. Explain incremental and sunk costs.

3. Distinguish between fixed and variable costs.

4. Explain various short run cost curves with the help of a diagram.

5. Discuss economies of scope.

6. Why is short run average cost curve U-shaped?

7. What is learning curve?

8. What are internal and external economies of scale?

LESSON – 8

Revenue and Revenue Curves

8.0 Objectives

8.1 Introduction

8.2 Revenue Concepts

8.2.1 Total Revenue

8.2.2 Average Revenue

8.2.3 Marginal Revenue

8.2.4 Relationship between Total Revenue, Average Revenue and Marginal

Revenue

8.3 Revenue Curves under Different Market Situations

8.4 Break even Analysis

8.4.1 Algebraic Method

8.4.2 Graphic Method

8.4.3 Limitations of Break Even Analysis

8.4.4 Examples of Break Even Analysis

8.5 Summary

8.6 Glossary


8.8 References



8.0 OBJECTIVES


To understand the meaning and importance of revenue for a firm

To explain the different concepts of revenue

To explain the revenue curves under different market situations

To comprehend break even analysis

8.1 Introduction

The functions, strategies and managerial decisions of a business firm are basically

determined by the objective of the firm. The traditional theory regarding the objective of the

firm states that the single most important objective of a business firm is maximization of

profits. This idea of profit maximization is justified on the ground that profit is the

remuneration which an entrepreneur expects to get in return for putting on risk his time and

capital. Moreover, profit is extremely essential for the long term survival of a firm. The profit

earned by any business firm is computed as the difference between total revenue and total

cost. However, later several scholars came up with an alternative objective of a business firm

– sales maximization. In this context, Baumol’s theory of sales revenue maximization asserts

that sales play a greater role in market leadership as compared to profits and hence, the firms

constantly try to maximize their total revenue instead of maximizing profits. Still other

objectives of firms have emerged eventually. However, there is no denying the fact that no

matter what is the basic objective of the firm, profits continue to be the main guiding force in

determining the short term and long term perspective of the firm. An in depth study in to the

different concepts of revenue is a pre requisite to ascertain the profits associated with a firm.

8.2 Revenue Concepts

The primary objective of any business firm, by and large, is to secure maximum

profits. The fulfillment of this objective requires production at the least possible cost and the

sale of output bringing in the maximum revenues. In this context, an attempt is made to study

in detail the different concepts of revenue and their inter relationships.

There are three main concepts related to revenues. These are total revenue, average

revenue and marginal revenue.

8.2.1 Total Revenue

Total revenue (TR) is the total amount of money income that a firm receives through

the sale of a specified quantity of its product in the market. Suppose a producer sells 1000

metres of pipes at the price of Rs. 75 per metre, the total money received by him through this

sale in the market is Rs. 75,000. This amount is total revenue. It may be defined as follows

Total revenue is the sum of all sales, receipts or income of a firm. --- Dooley

Total revenue is money received from selling a quantity of a product. --- Holland

Total revenue at any output is equal to price per unit multiplied by quantity sold.

--- Stonier and Hague

If the firm practices single pricing rather than price discrimination, then according to

the above given definition,

TR = total expenditure of the consumer = P x Q

where P stands for the price per unit, and

Q stands for the quantity of the output sold.

Total revenue is the direct function of price of the commodity (P) and the quantity of the

output sold (Q).

TR = f (P, Q)

Given the price, the TR increases with an increases in the quantity of the output sold (Q) and

vice versa. Similarly, if the quantity of the output sold (Q) remains the same but price (P)

rises, the TR will also rise and vice versa. Also, if there is a rise in both P and Q, the TR will

again rise and vice versa.

8.2.2 Average Revenue

Average revenue is the revenue per unit of output. In other words, average revenue

(AR) is the total amount of money income that a firm receives from the sale divided by the

number of units of the commodity sold.

Average revenue is the ratio of the total revenue to the quantity sold of the product.

--- Holland

Average revenue is the per unit revenue received from the sale of one unit of a commodity.

--- Mc Connel

Average revenue (AR) = TR/Q

Since for single pricing practice TR=P x Q, therefore AR = P x Q/Q = P. It signifies that

average revenue (AR) is the technical name for price. This concept of average revenue is very

significant in pricing theory as average revenue along with average cost helps to determine

whether a firm will get normal profits or super normal profits or losses. If average revenue is

more than with average cost, it indicates per unit profit and on the other hand if average

revenue is less than with average cost, it indicates per unit loss. Still another case is possible

where average revenue is just equal to average cost then the firm gets normal profits. Hence,

the study of average revenue is crucial for a firm to ascertain its profits or losses, if any.

8.2.3 Marginal Revenue

Marginal revenue (MR) is the change in total revenue resulting from selling an extra

unit of the commodity. In other words, when a firm sells one more unit of a commodity, the

resultant increase in total revenue is known as marginal revenue.

Marginal revenue, at any level of a firm’s output is the revenue which would be earned from

selling another (marginal) unit of the firm’s product.

--- Stonier and Hague

Marginal revenue is the addition to total revenue, that is, the extra revenue which results from

the sale of one more unit of output. --- Mc Connel

The marginal revenue of nth unit of output is given as

MRn = TRn – TRn-1

Where MR is the marginal revenue, TR is the total revenue and n stands for any given

number of units of output sold.

Alternatively, the marginal revenue may also be expressed as

MR = TR/Q

where TR is the change in TR due to change in Q, and Q is the change in Q.

This concept of marginal revenue finds immense significance in the determination of the

equilibrium of a firm. The basic condition required for the equilibrium of a firm is the

equality between the firm’s marginal revenue and marginal cost. However, if marginal

revenue is more than the marginal cost, the firm tends to expand its output and on the other

hand if marginal revenue is less than the marginal cost, the firm tends to decrease its output.

8.2.4 Relationship between Total Revenue, Average Revenue and Marginal Revenue

The relationship between total revenue, average revenue and marginal revenue can be

explained with the help of the following table and diagram

Total Revenue, Average Revenue and Marginal Revenue

The first column of the above table shows the units of the output sold (Q). The second

column shows the average revenue or the price which is calculated by dividing the total

revenue (shown in the third column) by the units of the output sold (Q). Marginal Revenue is

shown in the last column. It is calculated by finding the difference between two consecutive

values of the total revenue using the formula mentioned above. It is clear that the total

revenue increases with an increase in the sale of output. The total revenue is maximum at Rs.

30 when six units of the output are sold. When seven units of the output are sold, total

revenue falls to Rs. 28 and goes on falling henceforth as the quantity sold increases. The

marginal revenue also witnesses a fall with a rise in the units of output sold. When the total

revenue is maximum, the marginal revenue falls to zero and beyond this point, the marginal

revenue becomes negative.

A diagrammatic representation of the above data can be shown as follows:

The above figure shows that the total revenue curve (TR) starts from the origin and has a

positive slope. It attains a maximum value when six units of the output are sold and after that

there is a fall in the total revenue and the total revenue curve slopes negatively. The AR and

MR curves both slope downwards from left to right. It can be observed from the above

diagram that when AR falls, MR curve lies below it. This signifies that MR falls at a much

faster rate as compared to AR. Thus, the gap between AR and MR curves goes on increasing

with an increase in the units of output sold. When six units of the output are sold, the MR

curve touches the x-axis indicating that it has fallen to zero. After this point the MR curve

shows that the value of marginal revenue becomes negative. Hence, MR may be positive,

negative or zero, but AR is always positive.

Here it is important to take note of the fact that the falling MR curve divides the distance

between y-axis and the AR curve in to two equal parts. However, this relationship holds true

only if the AR curve is a straight line that slopes downward as shown below

In the above figure MR divides the perpendicular from AR to y-axis (CA) into two equal

parts, that is, AB= BC.

However, when AR is convex to the origin as shown in the figure below

In this case the MR curve is also a falling convex curve, passing at a less than half the

distance between y-axis and the AR curve, that is, AB < BC.

On the other hand, when AR is concave to the origin as shown in the figure below

In this case the MR curve is also a falling concave curve to the origin, passing at a more than

half the distance between y-axis and the AR curve, that is, AB > BC.


1. The traditional theory about the objective of a firm states that the most important objective of a

business firm is ……………..

2. When AR is concave to the origin, the MR curve passes at a ………..…… the distance

between y-axis and the AR curve.

3. Total revenue at any level of output is equal to the ………… multiplied by the ……………….

4. Average revenue (AR) of a firm is the technical name for …………. of the commodity being

produced and sold.

5. With an increase in the price of the commodity, total revenue …………….

6. When the total revenue attains its maximum value, the marginal revenue falls to

………………. level.

7. The gap between AR and MR curves goes on ………….. with an increase in the units of

output sold.

8. When AR and MR curves are straight lines, the MR curve divides the distance between y-axis

and the AR curve in to ……………

8.3 Revenue Curves under Different Market Situations

The problem of product pricing in different market situations is closely connected to the

shape of the revenue curves. The different possible shapes of the revenue curves in different

market situations are discussed below:

1. Revenue Curves under Perfect Competition: In perfect competition there are large

number of buyers and sellers and the product is homogeneous. Each individual firm

cannot influence the supply or price and the price is given for a firm. As the price

remains constant, the AR curve is perfectly elastic or a straight line parallel to x-axis.

Correspondingly, the MR curve is also a straight line coinciding with the AR curve as

shown below

2. Revenue Curves under Imperfect Competition: Under imperfect competition, the

shape of the revenue curves is considered for the following prominent market

situations:

(i) Revenue Curves under Monopoly: In monopoly there is a single seller having

complete control over the price. There is an inverse relation between price and

quantity sold as the monopolist can reduce the price to increase the quantity

sold. Thus, the AR and MR curves slope downwards from left to right and MR

lies below the AR curve as shown below.

The figure clearly shows that both the AR and MR curves slope downwards

from left to right and both are relatively less elastic in this market.

(ii) Revenue Curves under Oligopoly: In oligopoly there are a few sellers selling

identical or differentiated product, and having a major control over the market.

The demand curve or the AR curve has a kink in the oligopoly market.

Beyond a specific price, if one firm raises the price, the rival firm will not do

so. The firm which raises the price, loses buyers to other firms, that is, even a

small rise in price in this situation leads to a big fall in the sale. So beyond a

specific price, the demand curve or the AR curve is more elastic. On the other

hand, if the price is reduced below a specific price, other firms will also do so

and here the demand curve or the AR curve is less elastic. The upper part of

the demand curve is more elastic and the lower part is less elastic and such a

demand curve is called a kinky demand curve as shown below

The kink in the demand curve occurs at point P, the part above P is more

elastic and the part below P is less elastic. Corresponding to the more elastic

part of the demand curve, the MR curve is also more elastic, and

corresponding to the less elastic part of the demand curve, the MR curve is

also less elastic. RT portion shows the discontinuity in the MR curve.

(iii) Revenue Curves under Monopolistic Competition: In this market situation

there are a large number of sellers and the product is differentiated but closely

related. If a firm slightly cuts down its price, it is able to attract the buyers of

the rival firm also, because the products are of substitutable nature. Hence, the

demand curve or the AR curve is relatively more elastic than in monopoly.

Correspondingly the MR curve also slopes downwards from left to right and is

relatively more elastic as shown below

Both the AR and MR curves slope downwards from left to right and both are relatively more

elastic in this market as a small cut in the price leads to a substantial increase in the sale of

output.

8.4 Break Even Analysis

The concept of break even analysis is one of the simplest analytical tools in

management available to the business manager to help in the process of decision making. An

appropriate financial decision making and profit planning are very important for every firm

pursuing the goal of profit maximization. The profit planning involves the study of profit

function which shows the different quantities of output at which the concerned firm makes

profits. For an economist the term profit could refer to two different meanings – normal profit

or super normal profit. The term normal profit indicates the amount of return which an

entrepreneur must definitely earn, only then the entrepreneur will continue that business. The

additional income earned over and above the normal profit is referred to as super normal

profit. In other words, normal profit can be considered to be a part of the total cost while

super normal profit is the excess of total revenue over total cost. The basic condition for the

equilibrium of a profit maximizing firm is the equality between marginal revenue and

marginal cost. A rational firm enjoys maximum profits, and hence, stops further production

when the marginal revenue becomes equal to the marginal cost. However, if marginal

revenue is more than the marginal cost, a rational firm continues with more production and if

marginal revenue is less than the marginal cost, the firm will stop any further production.

Thus, a comparative analysis of cost and revenue of a firm helps the manager to pursue the

objective of profit maximization.

In this context, the break even analysis helps to study the relationship between the

amount of output produced, its cost of production and the revenue generated from the sale of

this output (also known as Volume Cost Profit Analysis). The break even analysis helps a

firm to identify the break even point by determining the levels of profit associated with

different levels of projected sales of the output. A business firm can only make profit when

its total revenue is greater than the total costs. If it is not so, that is, total revenue is less than

the total costs, the firm will run into losses. The break even point is simply the point where

the total revenue becomes equal to the total costs and there is a no profit no loss situation.

The concept of break even analysis is a simple but very useful forecasting technique which

can help a firm to estimate the level of output to be produced and sold keeping in mind the

capital, resources and time that have been put to risk; and to assess the impact of changes in

costs and price on the profits.

In order to use the technique of break even analysis, all the costs incurred by a

business firm need to be further classified as fixes costs and variable costs (see the lesson on

costs). Fixed costs are the costs which do not vary with the level of output. These are the

expenses incurred by the producer on the fixed factors of production (which cannot be

changed in the short run) and hence, remain constant. Such costs include rent of land, cost of

construction, expenditure on machinery, payment to permanent staff, etc. which remain fixed.

On the other hand, the variable costs are the costs which vary along with changes in the level

of output. If the total output rises, variable costs also rise and vice versa. If the total output

falls to zero, the variable costs also become zero. These costs are the expenses incurred on the

variable factors of production, that is, the factors which can be varied in the short run. The

variable costs include the wages, cost of raw material, electricity expenses, repairs,

transportation, etc. Hence,

Total Costs = Fixed Costs + Variable Costs

The calculation of break even point is based on a few concepts which may be listed as

follows:

Average Contribution Margin: It refers to the difference between the sale price (P) and the

average variable cost (AVC). It is so called because it represents that portion of selling price

that contributes towards paying the fixed costs. So

Average Contribution Margin = P – AVC

On the same lines, Total Contribution Margin = (P – AVC)Q = TR – TVC, where Q is the

quantity sold, TR is total revenue and TVC is the total variable cost.

PV Ratio: PV ratio or the profit volume ratio is also known as the contribution to sales (C/S)

ratio. It shows how much contribution a product would earn for every rupee of sales

generated. For example, 25% PV ratio means that 40 paise of contribution is earned for every

rupee of sales generated.

PV Ratio = Contribution / Sales

Break Even Revenue: It is the revenue earned by the sale of the output which would give

neither any profit nor any loss. Break even revenue can be calculated using the following

formula

Break even revenue = Fixed Costs / PV Ratio

Margin of Safety: It is the difference between the planned or budgeted volume of sales and

the break even volume of sales. Margin of safety measures the sensitivity of the planned sales

in comparison to the break even volume of sales.

Margin of safety = Planned sales – Break even sales

The break even analysis is based on the assumption that sale price, fixed cost and the variable

cost remain constant. On the basis of this assumption, the break even analysis can be

explained using the algebraic method and the graphic method as follows.

8.4.1 Algebraic Method: This method may be explained using the following notations: Let

Q be the quantity of a given commodity being produced and sold; P its price; TFC the total

fixed cost; TVC the total variable cost; AFC the average fixed cost; and AVC the average

variable cost. Let Q’ be the break even volume of sales where total revenue becomes equal to

total cost. It follows that

Total Revenue = P.Q

Total Cost = TFC + TVC = TFC + AVC.Q

Thus, P.Q = TFC + AVC.Q

At break even level, P.Q’ = TFC + AVC.Q’

Or, (P – AVC)Q’ = TFC

Q’ = TFC / (P – AVC)

The above formula for the break even output can be generalised to deal with the situation

where the business firm has determined in advance a target profit. The output volume Q’ that

will yield this target profit is implicitly given by

P.Q’ = Target Profit + TFC + AVC.Q’

Hence, Q’ = (Target Profit + TFC) / (P – AVC)

It is clear from the above formula that changes in TFC, AVC and P affect the break even

output (Q’). If there is a rise in TFC (say cost of equipment, etc.) break even output also rises

and vice versa. Similarly there is a direct relation between AVC (say cost of raw material,

etc.) and the break even output. On the other hand, there is inverse relation between price, P

and Q’. If P increases, Q’ falls and vice versa. It is relatively easy for the firms to calculate

the break even output using the above formula as the data on TFC and AVC are readily

available with the business firms.

8.4.2 Graphic Method: In the graphic method to explain the break even analysis, a typical

break even diagram or a break even chart is as shown below

The quantity of output is measured on the x-axis and total costs and the total revenue on the

y-axis. The total revenue and total cost curves are straight lines because price and AVC are

assumed to be constant. The difference between TC and TFC measures the variable costs as

shown in the figure. The break even point is achieved where TR curve intersects the TC

curve and the corresponding level of output is the break even output (Q’). The firm will get

profits only when TR exceeds TC and if TR is less than TC, the firm will experience losses as

shown in the diagram. Such a break even diagram can prove very helpful for any business

firm as it helps the firm to assess the volume of sale to reach the break even point and thus

helps in future planning.

8.4.3 Limitations of Break Even Analysis

Some limitations of the break even analysis are as follows:

It involves estimated projections of expected sales, fixed costs, variable costs, and the

costs and not the actual true values.

Break even analysis is useful only over a limited range of sales volume which remains

quite close to the expected level of sales. If this range has to be extended further, it will

require more of capital expenditure (on machinery, etc.) which, in turn, will affect the other

estimates of fixed costs and variable costs.

Break even analysis does not focus on the opportunity cost of the money invested and

does not take into consideration the possible alternative uses for funds in comparison to the

present use. In other words, break even analysis considers every project in isolation and also

does not permit proper examination of cash flows.

Moreover, the break even analysis assumes that the total revenue and total cost curves

are straight lines because price and AVC are assumed to be constant. However, such

restrictive assumptions may not be applicable for every business firm. There is no provision

for the change in price or change in the market conditions or even the changes in the costs

over the time period under consideration.

However, despite its limitations, break even analysis continues to be a very useful tool

in the hand of business managers for appropriate decision making regarding issues like the

costs of expansion, evaluation of sales or profit performance, estimation of the impact of

various expenses on profit, etc. It can even serve as a substitute to estimate an unknown

factor in making project decisions. However, it can not be considered a panacea for all

problems in the financial decision making. Break even analysis is only one of the many tools

available to the business decision maker. The best possible results may be achieved if the

break even analysis is used in combination with the other techniques of financial analysis.

Above all it is very essential for every business firm to be familiar with the break-even

analysis.

8.4.4 Examples of Break Even Analysis: The practical application of the break even

analysis for a business firm can be judged from the following numerical examples.

Example 1:Calculate the break-even output for TFC = Rs. 20,000, P = Rs. 70, and AVC = Rs.

50

Answer: Break even output, Q’ = TFC / (P – AVC)

So Q’ = 20000 / 70 – 50 = 20000 / 20 = 1000

Example 2: Suppose TFC = Rs. 10,000, P = Rs. 50, AVC = Rs. 20. What volume of output is

necessary in order to earn a total profit of Rs. 5000? Also find the average contribution

margin?

Answer:

Q’ = (Target Profit + TFC) / (P – AVC)

So Q’ = (5000 + 10000) / (50 – 20) = 15000 / 30 = 500

Further, Average Contribution Margin = ACM = P – AVC

So ACM = 50 – 20 = 30

Therefore, break even analysis is primarily a planning tool which may be used to examine the

expansion feasibility and other important business decisions.

Activity:

The ABC Credit company incurs the following monthly expenses: Salaries and benefits 3,400

Administration expenses 1,620 Rent and utilities 1,440 Other fixed expenses 800 Interest on debt

@ 12% annual rate per 1,000 10 Interest paid on deposits @ 6% annual rate per 1,000 5 Travel and

transportation per 1,000 loans outstanding 4.5 The ABC Credit company earns a 20% yield on their

loans. Calculate the portfolio size required to break even in a month.

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1. Revenue Curves under monopoly are straight line parallel to x-axis.

2. Break even revenue is the revenue earned by the sale of the output which would give

the target profit.

3. In oligopoly market the demand curve is a kinky demand curve.

4. In the break-even analysis the price and AVC are assumed to be constant.

5. Both the AR and MR curves slope downwards from left to right and both are relatively

more elastic in case of monopolistic competition.

6. Break even analysis involves estimated projections of expected sales, fixed costs, and

the variable costs.

7. In perfect competition each individual firm can influence the supply or price in the

market.

8. The break even point is the point where the total revenue becomes equal to the total

costs and there is a no profit no loss situation.

8.5 Summary

The traditional theory regarding the objective of the firm states that the single most important

objective of a business firm is maximization of profits. Whatever be the basic objective of a

firm, profits continue to be the main guiding force in determining the functions, strategies and

managerial decisions of a business firm. In order to assess the level of profits earned by a

business firm, it is very essential to have an in depth knowledge of the meaning and usage of

the different concepts of revenue. In this context, total revenue (TR) is the total amount of

money income that a firm receives through the sale of a specified quantity of its product in

the market. Average revenue (AR) is the revenue per unit of output sold. Marginal revenue

(MR) is the change in total revenue resulting from selling an extra unit of the commodity. A

study of the relationship between total revenue, average revenue and marginal revenue shows

that total revenue curve (TR) starts from the origin and has a positive slope. On the other

hand, both AR and MR curves both slope downwards from left to right. When TR becomes

maximum, MR becomes zero and when with further increase in sale of output TR starts

falling, then MR becomes negative. However, although AR is also falling all the time with

rise in sale of output but it always remains positive. The revenue curves have different shapes

under different market situations.Break even analysis is an important application of the cost

analysis which is used in business decision making. This concept studies the relation between

total revenue, total costs and total profits of a firm at different levels of output. A break even

point is a point where there are no profits and no losses, that is, where total revenue is just

equal to the total costs. Break even analysis may be explained with the help of algebraic

method as well as the graphic method. Despite its limitations, the study of break even

analysis is very essential for every business firm.

8.6 Glossary

Total revenue: It is the total amount of money income that a firm receives by the sale of a

given quantity of its output in the market.

Average Revenue: It is the revenue per unit of output.

Marginal Revenue: It is the change in total revenue resulting from the sale of an extra unit

of the commodity.

Monopoly: A market situation in which there is a single seller having complete control over

the price.

Perfect Competition: A market situation in which there are large number of buyers and

sellers, the product is and the price remains constant.

Break Even Point: The point where the total revenue becomes just equal to the total costs

and there is a no profit no loss situation.



1. Maximization of profits

2. More than half

3. Price per unit, quantity sold

4. Price

5. Also rises

6. Zero

7. Increasing

8. Two equal parts


1. False

2. False

3. True

4. True

5. True

6. True

7. False

8. True

8.8 References

Blank, L. T., and Tarquin, A.J., Engineering Economy, 5th Edition, McGraw-Hill, USA.

Chandra P., Appraisal Implementation, Tata-McGraw Hill Publishing Company Limited,

New Delhi.

Hampton J.J., Financial Decision Making (4th

edition), Prentice Hall of India Private Limited

Khan M.Y. and Jain P.K., Financial Management (4th

edition), Tata-McGraw Hill Publishing

Company Limited.


Douglas, Evan J., Managerial Economics: Theory, Practice and Problems, Prentice Hall Inc.,

NJ.


.




Mishra & Puri : Managerial Economics, Himalaya Publishing House, Mumbai



Swarup K., Gupta P.K. and Mohan M., Operations Research, Sultan Chand and Sons, Delhi.


1. Explain the different concepts related to revenue.

2. Explain the relationship between TR, AR and MR.

3. Discuss the shape of the revenue curves under different market situations.

4. What is break even analysis? Discuss its importance for a business firm in decision

making.

5. What do you mean by average contribution margin?

6. How can you calculate break even output using the break even analysis?

7. Explain break even analysis using the graphical method.

LESSON – 9

Market Structure and Pricing

9.0 Objectives

9.1 Introduction

9.2 Meaning of Market

9.3 Market Structure and Pricing Decisions

9.3.1 Price Determination under Perfect Competition

9.3.1.1 Features of Perfect Competition

9.3.1.2 Price and Output under Perfect Competition

9.3.1.3 Price in Market Period

9.3.1.4 Price in Short Period

9.3.1.5 Price in Long Period

9.3.2 Check Your Progress A

9.3.3 Price Determination under Monopoly



9.3.4 Price Discrimination under Monopoly

9.3.5 Price Determination under Oligopoly

9.3.5.1 Features of Oligopoly

9.3.5.2 Price Determination

9.3.6 Price Determination under Monopolistic Competition

9.3.6.1 Features of Monopolistic Competition



9.4 Check Your Progress B

9.5 Summary

9.6 Glossary


9.8 References



9.0 OBJECTIVES


To understand the meaning of market and its different types

To explain price determination under different market situations

To know the relevance of short run and long run in determination of

equilibrium price and output

9.1 Introduction

In a modern economic system all exchange of goods and services takes place

in the market. Whether the producer will be able to charge a higher or lower price

from the buyers, is determined in an important way by the nature of the market. So

far we have studied that, by and large, maximization of profits remains the primary

objective of any business firm. Besides maximizing output, minimizing cost and

optimizing resource allocation, another important aspect of profit maximization is to

determine the relevant price which is commensurate with the objective of profit

maximization. This profit maximizing price may not always correspond to minimum

cost. Also the level of profit maximizing price is different in different kinds of markets

based on the degree of competition among the sellers in the markets. Hence, it

becomes essential for a firm to give due consideration to the nature of the market

while determining the price of its product.

The market structure plays an important role in determining the ability of a firm

in make pricing decisions, or in other words, the structure of the market helps to find

the extent of freedom (freedom here refers to independence from the rival firm in

determining the product prices) enjoyed by a firm in the determination of product

prices. More is the degree of competition in the market, the firm will enjoy lesser

independence in making decisions about the prices of its products and vice-versa.

Hence, the information about different market forms is very essential for pricing

decisions made by a firm. In simple words, a market is an area over which buyers

and sellers come in close contact with one another and indulge in the process of

buying and selling. However, this is a restricted meaning of market and in economic

sense the word market has a much deeper and elaborate meaning as explained

ahead.

9.2 Meaning of Market

In economics, the word market refers to an effective institutional arrangement which

brings buyers and sellers into contact with one another at a mutually agreed upon

price. In broader sense it is not necessary for the buyers and sellers to be in a face

to face or a direct physical contact with each other. This contact can be through

different means of communication like letters, agents, newspapers, telegraphs,

telephone, e-mail, etc. Thus, the terms market refers to an entire area where buyers

and sellers of a commodity are in such close contact with each other that the price of

the same commodity tends to be the same throughout that area. This can be better

understood with the help of the following definitions of market.

Economists understand by the term market not any particular market place in

which things are bought and sold but the whole of any region in which buyers and

sellers are in such free intercourse with each other that the price of the same goods

tends to uniformity, easily and quickly. ---- Cournot

A market is that mechanism by which buyers and sellers are brought together.

It is not necessarily a fixed place. ---- J.C. Edwards

The term market refers not necessarily to place but always to a commodity

and the buyers and sellers who are in direct competition with one another.

--- Chapman

The structure of the market influences not only the pricing behavior of a firm, but also

its behavior with regard to supply, barrier of entry, efficiency, and competition. It also

enables a firm to control its market plan, to adjust to the changed environment, and

to facilitate the process of strategic decision making.

Hence, it is clear that the term market does not confine to a particular place

but the whole area wherein buyers and sellers of a commodity are spread. For the

existence of the market there must be one commodity like rice, sugar, tea, fruits,

furniture, and utensils, etc. Also there must be healthy and free competition among

the buyers and sellers without any restrictions on them. Generally one price prevails

in a market which is the main feature of a market.

There can be different classifications of markets, on the basis of competition,

commodities transacted (wheat market, rice market, etc.) area or region (local

market, international market, etc.) time period (very short period market, short period

market, long period market, etc.), quantum of transactions (retail market, wholesale

market, etc.), legality of transaction (open market, black market) and so on. We will

basically focus on different market forms based on the degree of competition among

the buyers and sellers. According to this classification of markets, there are three

main types of markets – perfect competition, imperfect competition, and monopolistic

competition. Perfect competition is a market situation in which there are a large

number of buyers and sellers dealing in homogeneous goods such that same price

prevails for a given commodity throughout the market. On the other hand, imperfect

competition is a market situation in which there is some limitation on the number of

buyers and sellers. The goods may be identical or differentiated. The individual firms

may have some degree of control over supply or price of the commodity. The

different forms of market found in imperfect competition are monopoly, duopoly,

oligopoly, monopsony and bilateral monopoly. Monopolistic competition is a market

situation in which there are a large number of buyers and sellers dealing in

differentiated products and is a market situation much close to reality.

9.3 Market Structure and Pricing Decisions

The price level and the level of production of a commodity by a firm depend

upon the market structure in which the firm is operating. The structure of market

tends to influence the possible outcomes of sales, revenues, profits and prices. Also

the demand curve of the firms and the industry (of which the firm is a part) depends

on the number of sellers in the market and the similarity of their products. The

market demand also depends on nature of the commodity (homogeneous or

heterogeneous), number of buyers and sellers of the product in the market and their

mutual inter-dependence. These characteristics of the market structures are likely to

influence the behaviour and performance of a firm. Additional aspects of market

structure that may influence the behaviour and performance of a firm include the

ease with which a firm may enter the industry, nature and size of the buyers of the

firm's products, and the ability of the firm to influence demand by advertising. Broadly

speaking, we will focus on the effect of market structure on a firm’s ability to

determine the price of its product. This power of a firm to fix the price of its product

depends largely on the degree of freedom enjoyed by a firm or its independence

from the rival firms in price fixation. The degree of freedom enjoyed by a firm in turn

depends on the degree of competition among the sellers and buyers in the market.

Higher the degree of competition in the market, lesser is the firm’s control over the

price of its own product. The most important theoretical market structures include

perfect competition, monopoly, oligopoly and monopolistic competition. Each of

these are discussed one by one as follows.

9.3.1 Price Determination under Perfect Competition

Perfect competition is a market situation in which there is an infinitely large number

of buyers and sellers dealing in homogeneous products. The competition among the

buyers and sellers results in the same price of a given commodity throughout the

market. Since each firm contributes a negligible quantity to the total supply, no

individual firm can influence the price of the commodity, it has to accept the given

price and sell its product at the given price only. Perfect competition may be defined

as follows.

Perfect competition is a market in which there are many firms selling identical

product with no firm being large enough relative to the entire market so as to be able

to influence market price. ---- Leftwitch

The perfect competition is characterised by the presence of many firms. They

all sell identical products. The seller is a price taker, not a price maker. ---- Bilas

9.3.1.1 Features of Perfect Competition

Perfect competition is a market structure with the following features

(i) Large number of buyers and sellers: The number of buyers and sellers is

so large that no individual buyer or seller’s independent action can

influence the market price and output. This is so because every buyer and

seller purchases or sells a very negligible amount of the total output.

(ii) Homogeneous products: Perfectly competitive firms produce an identical

or homogeneous product, so consumers will have no preferences for a

particular product or a firm. Perfectly competitive firms do not differentiate

their products or compete in any other manner because same

priceprevails in the market.

The assumptions of large numbers of sellers and buyers and

homogeneous products indicate that a single firm is a price taker. Demand

curve or average revenue curve is infinitely elastic, or demand curve is

horizontal straight line parallel to x-axis as shown below.

(iii) Uniform price: Single price prevails in the market for all the buyers and

sellers. At a particular time uniform price of a commodity prevails all over

the market as shown below.

(iv) Free entry and exit of the firms: This means there are no barriers to entry

or exit of firms. Every firm is free to join or leave the industry. If the

industry is making profits new firms can enter the market to share these

profits. Similarly, if the industry suffers losses the individual firms can quit

the market.

(v) Perfect knowledge: All the firms and the buyers possess all relevant market

information regarding the product and its price.

(vi) No government regulation: There is no government interference in the market in

the form of taxes, subsidies, etc.

(vii) Zero transportation costs: It does not cost anything to the firms to bring products

to the market or for the buyers to go to the market.

(viii) There is perfect mobility of resources.

(ix) There is absence of non-price competition as the firms are satisfied with the

prices and quantities offered.

The above mentioned features make perfect competition a market situation

rarely found in the real business world.

9.3.1.2 Price and Output under Perfect Competition

In perfect competition the prices are determined by the market forces of

demand and supply, that is, by the market demand and market supply. Market

demand is the industry demand or the sum of quantity demanded by each individual

buyer in the market at different prices. Similarly, market supply is the sum of quantity

supplied by individual firms in the industry. The price existing in the market is

determined for the industry and is given for individual firms and buyers. Hence, a firm

is a price taker and not a price maker in perfect competition.

The price determination of commodity under perfectly competition is studied

under three different time periods:

(i) the market period or very short period

(ii) short period and,

(iii) long period.

9.3.1.3 Price in Market Period

The market period, or very short period is the time period in which the market supply

of the commodity remains fixed. In case of perishable commodities in the market

period, costs of production become irrelevant in market price determination the entire

supply of the commodity sold at whatever price it can get.As the supply is fixed, the

supply curve is perfectly inelastic, as shown below and the price is determined solely

by demand. Supply is an inactive agent of price determination as it is fixed at some

level of output,Q.

Even if the demand increases to D2, supply cannot be increased and hence, the

price rises to P2.


Short period is a time period in which firms cannot change their size or leave

the market. New firms cannot enter the industry. In the market period, supply is

inelastic, but in the short run, supply may be changed by increasing or decreasing

the variable inputs. Hence, in the short run the supply curve is elastic as shown

below

A firm is in equilibrium in short period where marginal cost (MC) is equal to marginal

revenue (MR) and the curve MC cuts MR from below (point E in the figure). The

output corresponding to this point shows the equilibrium or optimum level of output,

q*. Given the industry price, P* (price=AR=MR in perfect competition), the firm’s

profit is maximised where P* equals MC at equilibrium point E. A firm may even

make losses in the short run due to fall in price. However, it may not be desirable for

a firm to shut down in the short run, because if a firm shuts down, the entire amount

of fixed cost will get converted into loss. So it tries to minimise losses by adjusting its

output where it covers atleast some part of AFC. If price falls to such a level that no

part of AFC is covered, there is no further scope of loss minimization and the firm

will decide to close down. So when price becomes equal to minimum AVC in the

short run it is the condition of shut down point. Another possible situation is when

total revenue of a firm is just equal to total cost, in this case the firm gets normal

profits.


In the long run, all factors of production and all costs are variable and a firm

can adjust its size or leave the industry; new firms are also free to enter the industry.

Thus, in the long run every firm enjoys normal profit. If in long run the firms make

super normal profits then new firms enter the industry which increases the supply

and lowers the price. Hence, there will be normal profits. On the other hand if the

firms are incurring losses then some firms leave the industry, supply decreases,

price increases and the losses disappear. So, normal profits exist in perfect

competition in the long run.

The above figure shows how price and output are determined in the long run in

perfect competition.DL represents long-run demand curve, when short-run supply is

S1, price is determined at P1 (equilibrium point is M as P1 = AR1= MR1 = LMC).

The firms get super-normal profit of MS per unit of output which attracts new firms

into the industry. So, the industry supply curve shifts rightward to S2, and price falls

to P2. At this price, firms cover only the long-run marginal cost (LMC), and will make

losses because AR < LAC. Firms incurring losses will quit the industry decreasing

total industry production causing a leftward shift in the supply curve to S0 with the

corresponding market price P0. The firms adjust their output to q0 and make only

normal profit, where P0 = AR = MR = LMC = LAC. Hence, in the industry equilibrium

position no firm either makes supernormal profit, or losses but only normal profit in

the long run.

9.3.2 Check Your Progress A


1. For a market to exist, it is necessary for the buyers and sellers to be in a face to

face or a direct physical contact with each other.

2. The structure of the market does not influence the pricing behavior of a firm.

3. Perfect Competition is a market situation in which there is only a single seller and

a large number of buyers.

4. In perfect competition there are no barriers to entry or exit of firms.

5. Supply of the commodity remains fixed in the very short period.

6. In the short period the supply curve is elastic.

7. At shut down point price equals average fixed cost, AFC.

8. In the long run, under perfect competition all firms enjoy normal profits.

9.3.3 Price Determination under Monopoly

A monopolyis said to exist when a single seller is the market and has no close

substitutes. Pure monopoly is a market structure in which there is a single firm

selling a commodity which has no close substitutes. The cross-elasticity of demand

for a monopolist’s product is either zero or negative. Thus, the firm itself is the

industry facing negatively sloped industry demand curve for the commodity. Hence,

to sell more of the commodity, the monopolist must lower its price of the commodity

being sold. The main features of monopoly are as follows:

(i) There is only one firm in a monopoly. The firm is the single supplier of the

product and it is a case of single-firm industry.

(ii) There are no close substitutes of the product being produced by the

monopolist.

(iii) Monopolist has complete control the prices and the quantity supplied in the

market. So a monopolist is a price maker not a price taker.

(iv) A monopoly firm earns abnormal profits in the long run. (v) Selling costs are negligible. (vi) A monopolist firm is capable of following price discrimination, which means

charging different prices for its products from different buyers. (vii) There are strong barriers to entry into the industry.

Thus, monopoly is a market structure in which a single firm controls the total supply

of a commodity having no close substitutes.

Strong barriers to entry are the main feature of monopoly that allow monopoly

firms to earn supernormal profits in the long run by making it unprofitable for new

firms to enter the industry. These barriers may be of two main types - structural and

strategic. Structural barriers or natural barriers occur due to factors outside the firm’s

control and are of the following types:

(i) Control of essential resources: This may occur due to concentration of

such resources in certain areas. For example, oil, gas, etc. are only found

in limited supplies and locations; certain areas are very advantageous for

the production of quality wines or even the expertise of resource owners

may be included like skilled surgeons or scientists.

(ii) Economies of scale play an important role in a monopoly. A monopolist

may experience economies of scale in the long run due to lack of

competition and hence, can produce more at low costs.

(iii) Brand awareness and image are very important in many industries which

can take time and a heavy cost to develop.

(iv) New firms find it difficult to raise money because of the greater risk they

impose on the lender.

(v) Government regulations like patent laws play a role in preventing entry of

new firms. Many governments deliberately create monopolies through a

licensing system, like public utilities and postal services are legally

protected monopolies in many countries. Foreign trade barriers may also

be imposed by the government to prevent a foreign company to enter the

industry.

Strategic barriers, on the other hand, occur due to deliberate restrictive practices or

strategies to deter entry of new firms. Such strategies include

(i) Limit pricing. It is the practice to discourage entry by charging a low price

before any new firm enters.

(ii) Predatory pricing. It is the practice wherein a firm tries to encourage exit,

by charging a low price after any new firms enter.

(iii) Excess capacity. Firms tend to have extra capacity which poses a threat to

potential entrants. This is because it is easy for incumbents to expand

output with little extra cost, thus forcing down the market price and post-

entry profits

(iv) Heavy advertising. This forces the potential entrant to respond by itself

spending more on advertising, thereby increasing its fixed costs, thus

increasing the minimum efficient scale in the industry.

Therefore, there is very little possibility to enter into a monopoly market. No

immediate competitors exist due to the above mentioned barriers.

9.3.3.1 Price in the Short Period

The equilibrium price and output of a monopoly firm, like perfect competition,

are based on revenue and cost conditions.The AC and MC curves here are same as

in perfect competition while the revenue conditions are different. A monopoly firm

faces a downward-sloping demand curve as discussed in revenue analysis.

The short-run equilibrium level for the monopolist is attained where MR equals

SMC and the slope of the MR curve is smaller than the slope of the SMC curve.

Further, a monopolist in short period cannot charge price less than the average

variable cost (AVC). If he does so then he will have to shut down his firm. Thus, at

equilibrium level, MC equals MR and monopolist enjoys maximum profits.

The above diagram shows that given the cost and revenue curves, equilibrium is at

point E where MR = SMC, and the profit-maximising level of output is Q*. Given the

demand curve, AR = D, this output can be sold in a given time at only one price, P*.

Hence, determination of output simultaneously determines the price for a monopoly

firm. Also, for any given price, the total profits are also simultaneously determined.

9.3.3.2 Price in the Long Period

In the long run, monopolist gets enough time to adjust the supply according to

the demand of the product. The monopoly firm can expand its size to increase long-

run profits. It remains in business only if it can make profits by producing the

optimum level of output with most appropriate scale of plant. This level of output is

given by the point where the LMC intersects the MR curve from below. In

equilibrium, the most appropriate scale of plant is the one whose SAC curve is

tangent to the LAC curve at the optimum output. The monopolist adjusts the long run

output by adjusting the size of plant depending upon the level and slope of the AR

and MR curves. It is obvious from the diagram given below that in the long run a

monopoly firm always makes super normal profits shown by the shaded area. LMC

and MR intersect at point P, where the equilibrium output is represented as Q* which

is profit-maximising level of output. Given the AR curve, the corresponding

equilibrium price is P*. This output-price combination maximises the long run profit.

9.3.4 Price Discrimination under Monopoly

Price discrimination occurs when a monopolist charges different prices for the same

product from different buyers, different markets or for different uses of the same

product. Price discrimination can take place only when certain conditions are met:

(i) A monopolist must have monopoly power, that is, control over output and

price.

(ii) Separation of market must be attainable. The buyers must be dependent

on monopoly firm’s product even if the elasticities of consumers vary.

(iii) When buyers purchase the product from a monopolist, they must not be

able to resell it.

Monopolists can increase their total revenue and profits for a given level of output

by price discrimination, or, by charging different prices for the same commodity in

different markets in such a way that the last unit of the commodity sold in each

market gives the same MR. The figure below shows that monopolist charges a

higher price and supplies a smaller quantity in the market for consumers X where

elasticity of demand is less and conversely, a lower price and supplies a larger

quantity in the market for consumers Y where elasticity of demand is more.

.

Price discrimination could be personal (eg, a doctor charging lower fee from poor

patient and higher from rich); geographical (eg, a producer charging lower price in

Punjab and higher in Maharashtra); or according to use (eg, railways charges

different rates for carrying goods and passengers).

Activity A

In long run only normal prices will exists comment…….

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.

9.3.5 Price Determination under Oligopoly

Oligopoly is the market structure in which a few firms dominate the industry.

These firms are interdependent, that is, a firm cannot take independent action

without thinking of in what way its opponent firms will react.Strategic decisions made

by one firm affect other firms, who react to them in ways that affect the original firm.

Thus, firms have to consider these reactions in determining their own strategies.

9.3.5.1 Features of Oligopoly

Interdependence among firms is the most important feature of oligopoly.Price

and output decisions of one oligopoly firm have considerable effect on the price and

output decision of the rival firms. Another feature is that an oligopoly firm can never

be certain about the nature and position of its demand curve. Any change in price or

output by one firm leads to a series of reactions by the rival firms. Hence, the

demand curve of an oligopoly firm is indeterminate. According to Sweezy, an

oligopolistic firm faces a kinked demand curve at the existing price as shown below.

If a firm reduces its prices other firms will also follow as demand curve is less elastic

in its lower part BC and the firm which has lowered the price will not gain anything. If

it raises its price above the prevailing price, other firms will not follow this time as

demand curve above the prevailing price (upper part) AB is more elastic. Thus, the

firm will lose due to his action. Therefore, price will remain more or less stable under

oligopoly situation. The demand curve in oligopoly is kinked at B.

Further, advertisement, publicity and other sales techniques play an important role in

oligopoly pricing. Oligopoly firm generally sticks to a price, which is determined after

a lot of planning and negotiations, with the competing firms. Interdependence among

firms compels them to maximize their profits through collusive action. Oligopoly firms

prefer group decisions that will protect the interest of all the firms instead of

independent price output strategy.

9.3.5.2 Price Determination

The price and output equilibrium of a firm under oligopoly may be explained

with the help of the following figure.

The above figure explains that the firm is starting at a point P with the corresponding

current price OP1 and output OQ. KPD is the kinked demand curve. MR is the

discontinuous Marginal Revenue curve, the portion AB shows its discontinuity. MC is

the marginal cost curve faced by oligopolist. Starting from point P with price OP1,

any increase in the price will reduce sales for the firm and rival may or may not follow

the same, profit will be limited because KP part of the kinked demand curve is more

elastic. The corresponding portion KA of MR curve is positive. Thus, any increase in

price is will reduce sales and revenue. On the contrary, if the firm reduces its price

below OP1, rival firm will also reduce its price, sales may increase but the profit

would be less than before as PD portion of kinked demand curve is less elastic and

the corresponding part of MR curve below B is negative. Thus, in both situations

whether price increases or decreases, oligopolist remains loser. Thus, he would stick

to the prevailing market price OP1 which remains rigid. Hence the rigidity is

maintained at kinky point P of the kinked demand curve in oligopoly.

9.3.6 Price Determination under Monopolistic Competition

Monopolistic competition is market structure in which there are many firms

selling closely related but not identical products. For example, many different brands

of soaps are available in the market (e.g., Lux, Vivel, Santoor, Hamam, Nirma, etc.).

Due to this product differentiation, sellers have some degree of control over their

prices and thus, face a negatively sloped demand curve. However, the existence of

many close substitutes severely limits the sellers monopoly power and results in a

highly elastic demand curve. The revenue curves in this case are downward sloping

just as in monopoly but are relatively more elastic.

9.3.6.1 Features of Monopolistic Competition

The main features of monopolistic competition are:

(i) The number of firms which constitutes an industry is fairly large.

(ii) Under monopolistic competition each firm produces a differentiated

product, differentiated by using different kinds of raw materials, ,colour,

packing, design, etc. For example, different firms produce biscuits like

parle-g, tiger, sunfeast, Horlicks, etc. (though the ingredients are same,

brand name may be different).

(iii) Under monopolistic competition firms are free to enter and leave the

industry at any time.

(iv) Every individual producer has own independent price policy.

(v) Every firm tries to promote its sales through expenditure on advertisement

and other promotional activities.

(vi) Under monopolistic competition, both price and non-price competition

prevails.


In short run the equilibrium of the firm in monopolistic competition is

determined where MC=MR (same as monopoly). The main difference from monopoly

is that here the demand curve (and MR curve) is flatter than the demand curve in

monopoly due to the greater availability of substitutes. The figure below shows price

and output determination under monopolistic competition in the short run. The

difference between equilibrium price and AC determines super normal profit per unit.


However, in the long run, lured by the super normal profits, new firms will

enter the industry, shifting the demand curve downwards for existing firms. This shift

will continue until the demand curve becomes tangent to the LAC curve. Hence, at

this point of equilibrium all supernormal profit gets washed away and the firms get

only normal profits as shown below.

At the equilibrium price, LAC is tangent to AR curve and the corresponding output

level is such that the firm gets only normal profits. Hence, monopolistic competition

combines the features of monopoly and perfect competition.

Activity B

Compare the long run equilibrium condition under monopoly and perfect competition

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1. Pure monopoly is a market structure in which there is a ………… firm selling a

commodity which has no ………………….

2. ………………barriers or ………………barriers occur due to factors outside the control

of monopoly firm.

3. In the short period a monopolist cannot charge price less than the …………………

4. In the long run a monopoly firm always makes ……………….. profits.

5. Price discrimination occurs when a monopolist charges ………… prices for the ………

product from different buyers.

6.The demand curve of an oligopoly firm is ……………..

7. Oligopoly firms prefer …………… that will protect the interest of all the firms.

8. Under monopolistic competition firms are free to ……………the industry at any time.

9. In long run a firm under monopolistic competition gets only ……………..

10. In …………………. every firm has its own independent price policy.

9.5 Summary

The word market refers to an effective institutional arrangement which brings

buyers and sellers into contact with one another at a mutually agreed upon price. A

market may be a place (area or region), or a function, or even a process. There can

be different classifications of markets on different basis. However, on the basis of the

degree of competition among the buyers and sellers there are three main types of

markets – perfect competition, imperfect competition, and monopolistic competition.

The market structure plays a crucial role in the pricing decisions made by a firm and

control of a firm over the price of its own product. Perfect competition is a market

situation in which there is an infinitely large number of buyers and sellers dealing in

homogeneous products and single price prevails in the market. The price

determination under perfectly competition is studied under three different time

periods - market period or very short period, short period and, long period. Monopoly

is a market structure in which there is a single firm selling a product which has no

close substitutes.There is virtually no way into a monopoly’s market and no

immediate competitors exist. Strong barriers to entry could be structural and

strategic barriers.Price discrimination occurs when a monopolist charges different

prices for the same product from different buyers, different markets or for different

uses of the same product. Oligopoly is the market structure in which a few firms

dominate the industry. On the other hand, monopolistic competition is market

structure in which there are many firms selling closely related but not identical

products.

9.6 Glossary

Market: An effective institutional arrangement which brings buyers and sellers into

contact with one another at a mutually agreed upon price.

Perfect Competition: A market situation in which there are a large number of

buyers and sellers dealing in homogeneous products and same price prevails in the

market.

Market Period: Market period or very short period is the time period in which the

market supply of the commodity remains fixed.

Monopoly: A market structure in which there is a single firm selling a product which

has no close substitutes.

Oligopoly: A market structure in which a few firms (which are interdependent)

dominate the industry.

Monopolistic Competition: A market structure in which there are many firms selling

closely related but not identical products.


Check Your Progress A

1. False

2. False

3. False

4. True

5. True

6. True

7. False

8. True

Check Your Progress B

1. Single, close substitutes

2. Structural, natural

3. Average variable cost (AVC).

4. super normal

5. different, same

6. kinked

7. group decisions

8. enter and leave

9. normal profits.

10. monopolistic competition

9.8 References


Mehta P.L. : Managerial Economics-Analysis Problems and Cases: Sultan Chand,

New Delhi.


Douglas, Evan J., Managerial Economics: Theory, Practice and Problems, Prentice

Hall Inc., NJ.



Gupta, E.S: Managerial Economics, Tata MC Grow Hill, New Delhi

Dholakiya R.H. and A.H. Ojha: Micro Economics for Management students, Oxford

University Press, Delhi.



Mithani D.M.: Managerial Economics, Himalaya Publishing House, Mumbai

Dwivedi, D.N: Managerial Economics, Vikas Publishing House Pvt. Ltd, New Delhi


1. What do mean by the term market?

2. Explain the meaning of perfect competition.

3. How is price determined under perfect competition?

4. Why is the demand curve kinky in oligopoly?

5. Discuss in detail price discrimination under monopoly?

6. Give the features of monopolistic competition.

7. How is equilibrium price determined in the long run under monopoly?

8. Why is the study of market structure important?

Chapter 10

Pricing Methods and Approaches

Structure

10.1 Objectives

10.2 Introduction

10.3 Meaning of Price

10.4 Pricing Methods and Approaches

10.5 Pricing Objectives

10.6 Price Discrimination

10.7 Product Line Pricing

10.8 Cost Control

10.9 Conclusion

10.10 Check your Progress

10.11 Glossary

10.12 References


10.14 Model Questions

10.1 Objectives

To study the Pricing Objectives and methods

To study the different types of price discrimination

To understand the concept of product line pricing

To study the ways of cost control.

10.2 Introduction

Given the cost and demand curves, price and output are so determined

that profit is maximized. There are no cut and direct rules for pricing as every

firm has different market situation and are having distinctive features. Thus

every firm follows a variety of pricing rules and methods depending on its

objectives and conditions faced by them.

10.3 Meaning of price

Price can be defined as the exchange of goods or services in terms of

money. Without money, there is no exchange of goods, but without price; there

is no exchange value of a product or service agreed upon in a market

transaction. Thus, What you pay is the price for what you get. Price is the

exchange value of goods or services in terms of money.

10.4 Pricing Methods and Approaches

The method of pricing can be classified into three broad categories. These are:

1. Cost oriented pricing:

(a) Cost plus pricing

(b) Marginal (or incremental pricing)

(c) Target pricing

(d) Programme pricing

2. Competition oriented pricing:

(a) Going rate pricing

(b) loss leaders

(c) Trade association pricing

(d) Customary pricing

(e) Price leadership

(f) Cyclical pricing

(g) Initiative pricing & suggested pricing

h) Multi-Product Pricing

3. Pricing based on other economic considerations:

(a) Administrated pricing

(b) Dual pricing

(c) Price discrimination or differentiated pricing

1. Cost oriented pricing:

a) Cost plus pricing: Cost plus pricing is a most commonly adopted method.

The theory of full cost pricing has been developed by Hall and Mitch.

According to them, under the conditions of oligopoly and monopolistic

competitive markets, business firms do not determine price and output with

the help of the principle of MC = MR.

Price is determined on the basis of full average cost of production AVC +

AFC margin of normal profit.

Under the method, the price is estimated by adding a certain margin to

the cost of the product per unit. Under this method, cost includes production

cost (both variable and fixed) and administrative and selling and distribution

cost (both variable and fixed). This method is also known as margin pricing or

average cost pricing or full cost pricing or mark-up pricing.

Cost-plus Pricing = Cost + Fair Profit.

Advantages

• It is the most easy and convenient method

• It fulfills the objective of profit maximization

• Reduce cost of decision making

• Price considered are fair from point of view of consumers

• More popular and suitable in industries where price leadership prevails

Limitations

• Only consider cost not demand

• It does not accurately take account of competitive forces

• This method cannot provide suitable basis for fixing price

• This method cannot be applied to industries dealing with perishable goods

b) Marginal Cost Pricing: Under the marginal cost pricing, the price is

determined on the basis of marginal or variable cost. In this, fixed cost is

totally excluded and price of product is based on incremental cost of

production. The firm uses those costs that are directly attributed to the output

of a specific product. Pricing decision is basically for the future and as such, it

should be dealt solely with the estimated revenues, expenses and capital

outlays. All type of past outlays, i.e. : historical cost and sunk cost belongs to

the full cost.

Advantages

• It is the most suitable method of short run pricing

• It is useful for pricing over the life cycle of product

• In case of multi-product, multi-process and multi-market firms, marginal

cost pricing seems satisfactory

It is useful at the time of introducing a new product.

Limitations

•It is help only in short period pricing so applied only on a temporary basis

•It does not give guarantee that firm will operate at break even point.

This method leads to cut-throat competition.

c) Target (or Rate of Return) Pricing: It is updated version of cost plus

pricing. When firm revised price, it need to ensure that prices so revised will

allow it to maintain:

Fixed percentage mark up over cost

Profit as a percentage of total sales

Fixed return on existing investment

ROR Price = Full cost + Mark up

FullCost

Earnings

investedCapital

Earnings

tFull

invertedCapitalupMark

cos

d) Programmed pricing: In Programmed pricing, price is related to supply

price. In order to cover own cost and profit margin, a mark-up is put over the

supply price. This supply price may be the wholesale price or that of the goods

at godown. Such practice is popular in wholesale and retail trade.

2) Competition oriented pricing

a) Going rate pricing: It is the price where firm examines the general price

structure prevalling in the industry and accordingly fixes its own price. It is

adopted by those industries which have price leadership characteristic. This

price is the safest policy as it saves the firm from the hazards of price wars.

Moreover, calculations in such pricing are less costly and troublesome for the

business.

b) Loss leader: A loss leader Is an item which produces a less than customary

contribution or a negative contribution to overhead but expected to create

profit on increased future sales or sales of other items. Sometimes, the firms

which deals in multiple products, charge relatively low on some popular

product with the hope that that customer, who come for this product, will also

buy some other products produced and sold by the firm. Such a product is the

firm‟s loss leader. The basic idea of loss leader product is that the profits thus

sacrificed will be made by selling other goods at profit.

c) Trade association pricing: It is used to avoid uncertainties of pricing

decisions and downward pressure on prices which competition exerts. For this,

firms frequently come to express or implied agreements to maintain prices at

similar level.

d) Customary pricing: In case of some commodities prices get fixed because

they have been prevailed over a long period of time. Any change in cost for such

products reflected in its quality and quantity of product rather than its price.

For example: Price of cup of tea in market is customary fixed.

e) Price leadership: When there is one or many big firms in an industry whose

cost of production is low, they dominate the industries. In such a situation,

small firms do not want to enter into the price war and as a result small firms

follow the price fixed by leader.

f) Cylindrical pricing: It is used when pricing by firm is based on assessment

of general economic environment. Such firm has to reduce price in case of

depression and rise price in boom period and ignoring the fact that cost of

production remain unchanged. Price adjustment may be based on:

(1) Cost changes

(2) Price of substitutes

(3) Change in general price level

(4) Market share

(5) Industry‟s other price determinants

g) Suggested prices: It is one in which wholesaler or manufacturer has found

feasible, given the market conditions. It suggests to retailer to charge this price

from customers. This helps the management of retail trade from undertaking

its own assessment of market and cost conditions.

h) Multi-product pricing:

The price theory of price discrimination is based on the assumption that

a firm produces a single, homogenous product. But in actual practice, there is

not a single firm which produces a single homogenous product. Usually, all

firms produce a number of related products at the same time. These are multi

product firms.

For example, the various models of the refrigerators, TV sets, radio are

produced by the same company and set different prices for different products.

Each product has different AR and MR curves and thus firm charging different

prices for all products and this is known as multiproduct pricing strategy. In

multiproduct pricing strategy, the firm considers that the demands for the

various goods are inter-related and thus enjoy a greater cost economy in the

sense that production costs tend to be lower when the goods are produced in a

joint operation. Due to the joint operation, the firm has to look into the cross

— elasticity of demand for the multi-product. Thus, Multi goods produced by

the firm may be in two categories :

• Substitutes/competitive

• Complementary

Complementary products will have negative price Cross-elasticity demand

coefficient where as Substitutes products will have a positive price-cross-

elasticity demand coefficient.

In multiple products, firm considers demand elasticity while deciding

about pricing strategy. The product will be high priced when they are having

inelastic demand While, the product having more elastic demand will be low

priced. In the same way, cost functions will be taken into account. Products

which cost high, will be high priced, with high margin for the make-up.

The multi-product pricing strategy helps in manipulating the

combination of prices for different items, until an optimum or profit

maximising price structure is determined.

3) Prices based on other economic consideration

a) Administrative prices: these are those prices which are statutorily fixed by

government, taking into account cost and stipulated profit per unit. The basic

purpose is to control prices of essential goods and input. This helps weaker

section to have goods at economic prices. Public distribution system, fair price

shops are based on this approach.

b) Dual pricing: A dual market is a market where a commodity is

simultaneously under administrative prices as well as market prices. In such

market, half part of output is subjected to administrative price, while rest is

sold in free market. For example: sugar in India

c) Price discrimination or differentiated pricing: In this, market is

subdivided on some systematic basis, such that it is impossible for buyer to

whom high price is charged to take advantage by shifting to group to which a

low price is quoted.

10.5 Pricing Objectives

Pricing goals or objectives gives direction to the whole pricing process.

The first step in pricing is determining your objectives. For this, one must

consider 1) overall financial, marketing and strategic objectives of the company;

2) the objectives of your product or brand; 3) the availability of resources; and

4) consumer price strategy. After considering the above, one can determine its

pricing objectives.

The basic objective of every pricing strategy is capturing consumer

surplus and converting it into additional profit for the business firm. In figure

11.1, Suppose the firm sold all its output at a single price. To maximize profit,

it would sell at P* and corresponding output at Q*where MC=MR.

Now the managers know that some customers (in region A of the demand

curve) would pay more than P*. But if the firm raises price then it means losing

some customers and hence earning less profits. Similarly, there are other

customers (in region B of the demand curve) who will not pay a price as high as

P*. many of them, however, would pay prices higher than the firm‟s marginal

cost. But by lowering profits, the firm could sell to some of its customers but it

would then lead to earning less revenue from its existing customers and again

profits would shrink.

Now the problem is how can the firm capture the consumer surplus from its

customers in region A and also sell profitably to some of its potential customers

in region B? The solution is price discrimination in which firm might charge

Y

P*

A MC

B

M

D

MR

E

AR

MR

0 Q* x

Output

Co

st/

Rev

enu

e/P

rice

Figure 11.1: Capturing Consumer Surplus

different prices to different customers, according to where the customers are

along the demand curve. The concept of price discrimination is discussed in

the next section. Before this, let us discuss some of the common pricing

objectives are:

1. Pricing for Target Return (on investment) (ROI): Every business needs

capital investment either in the form of various types of assets or working

capital. When a businessman invests capital in a business, he calculates the

expected return on his investment. He aimed to earn a certain rate of return on

investment and accordingly, the price is fixed. This price is seller oriented and

thus includes the predetermined average return.

2. Market Share: The expected volume of sales and the target share of the

market are the most important consideration in pricing the products. Some

firms adopt it as the main pricing objective with a view to maintain or to

improve the market share towards the product. A good market share

symbolizes an indicator of progress. By comparing the present market share

with the past market share, manager can know well whether the market share

is increasing or decreasing. When the market share is decreasing, then firm

can fix low price which discouraged the competitions from entering the market

and hence market share increases.

3. To Meet or Prevent Competition: Another objective of pricing is to meet or

prevent competition. While fixing the price, the price of all products produced

by other firms in the same industry, will have to be considered. At the time of

introduction of products to the market, a low price policy is likely to attract

customers, and can establish a good market share. The low price policy

discourages the competitors.

4. Profit Maximization: All business aims to earn maximum profit and the

situation of profit maximization can be enjoyed where monopolistic situation

exists. The ultimate objective should be to maximize profits on total output,

rather than on every item. Thus every firm fixes the price which generates

maximum profits. But there are government regulations and price control

which check that the price so charged will not exploit the consumers.

5. Stabilize Price: It is a long-time objective and aims at preventing frequent

and violent fluctuations in price. When price remains stable, then price war

amongst the competitors also reduces. The prices are formulated in such a way

that during the depression, the prices are not allowed to fall below a certain

level and in the period of boom, the prices are not allowed to rise beyond a

certain level and hence price remains stable.

6. Customer Ability to Pay: The prices that are charged are according to the

person‟s capacity to pay and hence differ from person to person. For instance,

in government hospitals, doctors charge fees for their services according to the

paying capacity of the patient.

7. Resource Mobilization: This is a pricing objective in which the products are

priced in such a way that sufficient resources are made available to the firms

for their expansion, developmental investment etc.

8. Survival and growth: Another important objective of pricing is survival and

achieving the expected rate of growth. According to P. Drucker, avoidance of

loss and ensuring survival are more important than maximization of profit.

9. Prestige and goodwill: Pricing also aims in maintaining the prestige and

enhancing the goodwill of the firm.

10.6 Price Discrimination

According to Barron's Educational Series (2000), “Price Discrimination is

charging a different price for a different product or to a different buyer without

any true cost differential to justify the different price".

10.6.1 Types/ Methods of price discrimination :

There are various types or methods of price discrimination which are

determined on the basis of the strategy or the policy adopted by the firms.

Following are the main methods or types.

1. Discrimination according to markets: The firm may discriminate between

the whole sale and retail market. Thus a commodity may be sold at a lower

price in the wholesale market and at a higher price in the retail market.

2. Discrimination according to income: Discrimination can also be made on

the basis of incomes of various customers. The financial consultant may charge

higher fees from a big businessman while lower fees from a small

businessman.

3. Discrimination according to time: The time when a commodity or service

is bought may also constitute the basis for price discrimination. The rickshaw

service hired during the night hours costs more fare. Doctors may charge

higher fees for the night visits.

4. Discrimination according to national boundaries: A monopolist may

charge higher price in the protected domestic market but a lower price across

the national boundary. This in other words called as „dumping‟.

5. Discrimination according to utility: Sometimes, different prices are

charged from different customers according to the utilities conferred on them.

Discrimination in first class and second class fares by railways is an example

of this kind. The passenger travelling by first class gets more comforts for

which he pays more.

6. Discrimination according to places: The place where the commodity is

sold is also responsible for price discrimination. The set of „playing cards‟ sold

at railway station shop may cost more than elsewhere.

7. Discrimination according to uses: Sometimes the monopolist may charge

different price for the same service or commodity if used for different purposes.

The electricity charges for example, are more for domestic use than for

industrial use.

10.6.2 Degrees of Price Discrimination

Price discrimination can be divided into three broad forms:

1. 1st Degree Price Discrimination: It refers to charging a different price

based on the customer.

2. 2nd Degree Price Discrimination: It implies charging a different price

based on quantity sold.

3. 3rd Degree Price Discrimination: It refers to charging a different price

based on location of customer segment.

1. First – Degree Price Discrimination: This type of discrimination is also

known as perfect price discrimination. Ideally, a firm would like to charge a

different price to each of its customers. If it could, it would charge each

consumer the maximum price that individual is willing to pay for each unit

bought. This maximum price is the customer„s reservation price. The practice

of charging each customer his or her own reservation price is called first-

degree price discrimination.

This takes out the entire consumer surplus and earns the firms the

maximum possible profits. This method of discrimintation is the most difficult

to adopt as it requires that the company knows each of its customers perfectly

at each level of consumption (Baye, 2006).

2. Second- Degree Price Discrimination: Practice of charging different prices per

unit for diffeeent quantities of the same goods or services is called second-

degree of price discrimination. In this, firm charges separate prices for

different blocks or quantities of the same commodity from the buyers. For

example, Rs 50 per unit for first 10 units, Rs40 per unit for next 10 units and

Rs 30 per unit for another 10 units and so on. This type of discrimination is

usually followed in electricity department.

3. Third- Degree Price Discrimination: Practice of dividing consumers into

two or more sub-markets with separate demand curves and charging

different prices for each group is known as third-degree price

discrimination. For this form of discrimination, it is necessary that the firm

must be able to predict the elasticity of demand in various consumers.

Third degree price discrimination based upon the firm‟s ability to separate

the segments. If separation of segments is not possible then the product

can be transferred from one segment to another.

The firm will be able to charge higher price and will bring less number of

units in the market where the demand for his product is more inelastic but

he will charge lower price and bring more units in the market where the

demand is less inelastic. This will be clear from the following diagram.

Figure 11.2: Third-Degree Price Discrimation

In the above diagram fig. 11.2 represent market (1) with more inelastic

demand, market (2) with less inelastic demand and the combined situation

for the firm in fig. (3). It can be seen that OP1 price is charged in market „1‟

while OP2 price is charged in market „2‟. The CMR is combined marginal

revenue curve of the two markets derived by adding the MR curves in the

two markets sideways. Thus, by maintaining the same level of MR in two

markets, the firm distributes the total output (OQ) in the two markets as

OQ1 and OQ2. It can be seen that, he brings less output where the price is

higher and more output is brought where the price is lower. By doing so, he

can maximize his profits. The total profits earned by him are shown by the

shaded area ARB.

Thus, by dividing the consumers into different sub-markets, the firm can

maximize its profit with the condition that the demand elasticity in both

markets are different and consumers are not able to transfer goods from

one market to another.

10.7 Product Line Pricing

Product line means a group of product items related to each other as

substitutes or compliments. The key economic feature with respect to pricing a

company‟s product line is the cross elasticity of demand.

Pricing of substitute goods: A firm produces substitute goods with a view to

segregate market sectors that have different demand elasticities. Although each

product in the product line competes with similar products of other companies,

they also compete with each other. Pricing policies that push the sales of one

product may consequently hurt the sales of another product of the firm as well

as other firms‟ competing products.

In practice, there are two common methods of product line pricing for

substitute goods. Many producers use mark-up method of pricing on the entire

line of products, with the same margin for all similar products in the line. The

second approach of pricing is to price the product by varying the size of margin

with the level of costs. Thus, more costly the product, higher the product and

vice-versa.

Both of these methods suffer from the defect that they do not considered

the differences in demand, competitive conditions and degree of market

maturity of each product in the line. Moreover, the accounting methods used to

divide joint costs among products of the same firm are whole arbitrary, thus

resulting in prices that reflect the arbitrary allocation of common costs.

Ideally, the optimum price is the one that yields the largest total

contribution margin. The objective of the product-line structure should be that

of exploiting the differences in demand elasticities between market sectors.

Pricing of complimentary goods: The degree of complimentarity can take two

forms:

i) Fixed proportions, like meat and hides; or

ii) Variable proportions, like passenger and freight railway services.

In case of complimentary goods, cross elasticity is negative, i.e, decrease in the

price of one goods leads to an increase in demand for the other goods. The

practical implication is that the sellers may often find it profitable to price an

item low or even sell at loss, in hoping of selling the complementary item at an

above-margin price. But the problem is in the allocation of cost to each

individual output.

1) Fixed Proportion Case: In such case, allocation of cost is not necessary

rather determination of separate price for each product is essential in

order to maximize profits.

2) Varying Proportions Case: In this, the total cost has to be apportioned to

each product because a single MC curve no longer suffices. In such a

case, the optimal price-output combination for the joint products would

require the simultaneous cost and revenue relationships. Linear

Programming approach helps in solving such pricing cases.

10.8 Cost Control

Cost control is defined as the regulation by execution action of the costs

of operating an undertaking. There are the various tools through which

one can execute the technique of cost control. It involves the following

procedure.

1. First of all, plan is set in the form of budgets, standards or estimates,

which serve as a basis for comparing the actual performance with the

planned objectives.

2. After this, communicating the plan to those who is responsible for

execution of this plan.

3. Once the plan executed, evaluation of the performance starts.

4. Comparison is made of the actual performance with the

predetermined targets. Deviations or variances are found out and

reported to the higher officials for further actions.

5. Lastly, the reported variances are reviewed. Either the corrective

actions and remedial measures are taken or the set of the targets is

revised depending upon the management‟s understanding of the

problem.

Thus cost control is a procedure which involves setting standards,

finding deviations which are analysed and reported and hence take the

corrective action. Next area is to know about the major areas in which

cost can be controlled.

10.8.1 Areas of Cost Control

Cost control is essential in following areas:

a) Material Cost: Material cost forms a major part of the total cost of

production. Thus the control and reduction of material cost is extremely

important. Ways of material cost control:

Bulk Buying

Research and Development efforts

Availability of cheaper substitutes

Better utilization of material and inventory control

b) Labour Cost: Reducing labour cost is a very difficult task. Due to the

existence of trade unions and minimum wage legislations, it is not

possible to reduce wage rates. Some other ways of labour cost control

are:

Proper recruitment and training policy

Proper work environment and motivation

Improved methods of production

Proper scheduling of work and materials

c) Overheads Cost: Once the capacity is established, overhead cost is fixed.

A proper selection of capacity, proper layout of plant, a right choice of

equipment and its proper maintenance are likely to keep overheads

down. Some other ways of overheads cost control:

Effective utilization of space and equipment

Reduction in the cost of transportation

Reduction in the cost of energy, i.e. power fuel

Reduction in pilferage, wastage and spoilage

These are the major areas through which cost can be controlled but now the

problem is how one can control these costs. In next section, we will discuss

tools of cost control.

10.8.2 Tools of cost Control

a) Standard cost and budgets: These are those costs that can be obtained

under efficient operations. They are predetermined costs and represent

targets that are considered important for cost control. When comparing

standard performance with the actual performance, one can know about

the area of divergence and the focus area of cost control.

b) Budgetary control: It is a system which used budget as a means of

planning and controlling. It involves the continuous checking and

evaluation of actual performance with the budget goals and hence

helping in taking corrective action.

c) Ratio Analysis: Cost control endeavors can be aided considerably by

using ratio analysis technique. In the ratio analysis, a desirable ratio is

predetermined, the actual performance is compared with this ratio and if

deviation is statistically significant then the corrective action is taken.

d) Value Analysis: It is a method which studies cost in relation to the

product design. It involves the procedure which specifies the functions of

products or components, establishes the appropriate costs, determines

the alternatives and evaluates them.

10.9 Conclusion

There are various methods of pricing. Choosing a particular method of

pricing depends upon the prevailing situations in the economy. Given the lack

of economic training and imperfect knowledge, the business decision makers

decide the simplified pricing method. These methods may be based on cost

considerations, demand conditions or market competitiveness.


1. Price- discrimination is possible and profitable, if two markets have

a) Equal Elasticity of Demand c) Different Elasticity of Demand

b) Inelastic Demand d) Highly Elastic Demand

2. Adding a standard markup to the cost of the product refers to:

a) cost-plus pricing c) break-even analysis

b) target profit pricing d) perceived-value pricing

3. When demand elasticity is hard to measure, and firms tend to price

according to the “collective wisdom” of the industry, the pricing method

most likely to be used is called:

a) cost-plus pricing c) break-even pricing

b) sealed-bid pricing d) going-rate pricing.

(Answers: 1c, 2a and 3d)

10.11 Glossary

Consumer Surplus: An economic measure of consumer satisfaction,

which is calculated by analyzing the difference between what consumers

are willing to pay for a good or service relative to its market price. A

consumer surplus occurs when the consumer is willing to pay more for a

given product than the current market price.

Substitute goods: Substitute goods are two goods that could be used for

the same purpose. If the price of one good increases, then demand for the

substitute is likely to rise. Therefore, substitutes have a positive cross

elasticity of demand.

Complimentary goods: A complementary good is a good whose use is

related to the use of an associated or paired good. Two goods (A and B) are

complementary if using more of good A requires the use of more of good B.

For example, the demand for one good (printers) generates demand for the

other (ink cartridges).

10.12 References

Mehta P.L. (2006), Managerial Economics Analysis, Problems and Cases,

Sultan Chand & Sons, New Delhi.

Ahuja H. L. (2005), Advanced Economic Theory, S Chand and Company,

New Delhi.


Dwivedi, D N. (2003), Micro Economics : Theory and Applications;

Pearson Education (Singapore) Pvt. Ltd, Delhi.

Samuelson P.A. & Nordhaus W. D. (1998), Economics, Tata McGraw

Hill, New Delhi.


1. Explain the method of cost plus pricing. Also state the strength and

weaknesses of this method.

2. Discuss the various pricing objectives.

3. Write short note on

a) Product line pricing

b) Cost Control

Chapter 11

Profit

Structure

11.1Objectives

11.2 Introduction

11.3 Theories of Profit

11.4 Profit Planning

11.5 Break Even Analysis: A technique of profit planning

11.6 Conclusion


11.8 Glossary

11.9 References



11.1 Objectives

To study the various theories of profit

To understand the technique of profit planning

11.2 Introduction

Profits are the fourth factors of production and are the reward for enterprise.

In common language, profit denotes the net income of a businessman. It is

calculated by subtracting total expenditure from the total revenue. In short,

profit is a return to the entrepreneur for the use of his entrepreneurial ability.

There are various hypothesis explaining the emergence and growth of

profits. Thus, there are several theories of profit which explaining the different

views on profit. These theories are discussed in next section.

11.3 Theories of Profit

There are several theories of profit, though none of them is complete in itself to

give a fairly reasonable insight but yet gives partial insight into the process of

emergence of profits. These are:

1. Dynamic Surplus theory of Profit

2. Innovation theory of profit

3. Risk and uncertainty theory of Profit

4. Monopoly Theory of Profit

11.3.1 Dynamic Surplus theory of Profit

This theory is given by the J. B. Clark, who is of the view that there can

be no profit in the static world where size and composition of the population,

the number and variety of human desires and taste, techniques of production,

technical knowledge, commercial organization, etc. remain constant. In a world

like this, everything is certain and is knowable and can be accurately foreseen.

There is no risk, and hence no profit. Costs and selling price remains same,

and hence there can be no profit beyond wages for the routine work of

supervision.

But in the real world, we are not living in a stationary state. Ours is a

dynamic world and some changes are always taking place. The able

entrepreneur foresees these changes and hence makes profits.

Thus According to this theory, profit arises because the world is dynamic

that it is possible for them to keep the lead and reap the profits. In a static

state, there will be no profits, and the entrepreneurs will only earn wages of

management.

Criticism:

Prof. Knight, however, viewed that only those changes which cannot be

foreseen will generate profits and not others. Change may provide a situation

out of which profit will be made, if it brings about ignorance of the future”.

Thus, according to Knight, it is the uncertainty, and not the change, which is

the cause of profit.

11.3.2 Innovation theory of profit

According to the dynamic theory of profits, it is the dynamic changes

which give rise to profits. American economist Joseph Schumpeter viewed that

profit arises because of innovate. As long as entrepreneurs able to hit at one

innovation or another, keeping their business ahead of others and thus making

handsome profits.

According to Schumpeter, the major task of the entrepreneur is to make

innovations and hence profits are a reward for successful innovations.

Schumpeter has given the term „innovation‟ which means that “Discovery of a

new material or a new technique of production”. This innovation helps in

lowering the cost of production or improving the quality of the product.

Innovations may be of two types:

(a) First innovation is changing the production function and hence lowering

the cost of production. This includes the introduction of new machinery, new

production techniques or processes, introduction of a new source of raw

material or a new and better organisational pattern for the firm.

(b) Second innovation is one which stimulate the demand for the product, i.e.,

which change the demand or utility function. This includes introducing a new

product or a new variety of an old product, new and more effective mode of

advertisement, discovery of new markets, etc.

Success of any of these innovations generates a increase in profits.

Profits increase either because of the lowering cost of production or the product

fetches a higher price. It may be noted that profits generated because of

innovations are only temporary and as soon as competitor bring out new

innovation, their profits tend to be competed away.

One must also remember that profits are both the cause and effect of

innovations. Profits serve as a basis for making innovations; hence profits are a

cause of innovations. But since innovations generate profits, thus profits are

the effect of innovations.

Criticism:

Schumpeter‟s innovation theory can be criticised on the following grounds:

(a) Like Clark, Schumpeter also ignores uncertainty as a source of profit.

(b) He also refuses that risk-bearing plays any role in the determination of

profit.

11.3.3 Risk and uncertainty theory of Profit

Risk bearing theory: This theory was developed by the American economist

prof. Hawley in his book Enterprise and productive process published in 1907.

According to this theory profit is a reward for risk bearing. Every

business has some level of risk because all business is more or less

speculative. Thus profit is not reward for differential ability rather it depends

upon the risk taking ability of the entrepreneur. He cannot delegate the

function of risk taking, he alone has to bear the risk and thus profit is the

reward for this risk taking.

The degree of risk affects different business in different way. According

to Prof. Hawley there is a positive relationship between risk and profit - higher

the risk greater is the possibility of profit and vice-versa.

Criticisms:

The risk bearing theory has been criticized on the following grounds.

1) Profit is not the reward for risk bearing but it is the reward for avoiding the

risk.

2) There is never a direct relation between the extent of risk and the amount of

profit.

3) Some risks are 'INSURABLE' and hence shitted over to the insurance

company- the entrepreneur therefore does not bear that risk.

4) The theory overlooks other factors like monopoly, innovation, unexpected,

situation etc which can create profit.

Uncertainty Bearing Theory: Prof. Knignt made a refinement in Hawley‟s risk

bearing theory of profit. According to Prof. knight, pure profit are linked with

uncertainty and risk bearing. For this, he classified risk in the following:

(1) Insurable Risks

(2) Non- Insurable Risks.

Every business has some risk and out of which some risk are predictable while

some are non-predictable. To save business from predictable risk, firms usually

takes insurance. Hence if risk arises, business does not have to bear the risk.

Actual ability of entrepreneur is reflected in bearing non insurable risks. There

risks are uncertain and non-calculable. Such risks being unpredictable, no

insurance company would be willing to cover them. Some examples of non-

insurable risks are fluctuations in demand, depression phase of trade cycle.

Technological changes, changes in degree of competition, changes in govt.

policies etc.

Thus, profit is an exclusive reward for the entrepreneur, for making

business decision under unpredictable and uncertain economic condition. In

short Knight theory implies that uninsurable risks are uncertainty of business

and Profit is the reward for uncertainty bearing.

Criticisms:

The uncertainty bearing theory has been criticized on the following grounds.

1) Uncertainty of business is not only the determinants of profit. There are

other factors also which influence the earning of profit.

2) In fact it is managerial skill rather than uncertainty which leads to higher

profit.

3) The theory dose not focus on the phenomenon of monopoly profit.

11.3.4 Monopoly Theory of Profit

Besides the theories which explain the emergence of profit through dynamic

changes, innovation and uncertainty bearing, there is a strong reason to

believe that monopoly is another source of profit. Monopolistic situation gives

rise to profits both in static and dynamic conditions. Monopolists commands

control over the price of a product and therefore, manages to make profits by

virtue of his monopoly power. He raises price by restricting his level of output

and thereby makes profit.

Criticism:

Monopoly theory of profit is only a partial explanation of the emergence of

profit. If profits had been solely dependent on monopoly power, then a

producer must always create conditions where he can exercise certain

monopoly power to get profits. In real life, this is not always true.

11.4 Profit Planning

Profit planning is a method in which environments affecting an

organisation are analysed, the available resources and internal competence is

identified, agreed objectives are established and plans made to achieve these

objectives. Profit planning is routine job and covers a definite time span.

11.4.1 Need for Profit Planning:

Need for profit planning are as follows:

(i) To improve performance of the management.

(ii) To ensure that the organisation as a whole moves in the right direction.

(iii)To ensure that objectives should be set which will stretch but not overwhelm

managers.

(iv)To encourage strict evaluation of manager‟s performance in monetary terms.

(v) To run a company in a more demanding way.

11.5 Break Even Analysis: A technique of profit planning

The break-even analysis (BEA) has considerable significance for economic

research, business decision-making, company management, investment

analysis and public policy.

The break even analysis is an important technique to explain the relationship

between cost, revenue and profits at the varying levels of output or sales.

The maximization of profit is one of the traditional objectives of a firm.

Maximum profit and minimum cost can not be achieved at the same time.

Similarly, profit maximization output can not be known in advance. If it is

known it can not be achieved at the beginning. Thus often in practice the firms

start their production even experiencing a loss so as to earn the anticipated

profit in the future. In the process of production firm has to incur cost in the

form of fixed cost even before the production starts. Even when output is zero

total fixed cost is there. But when no unit of output is sold then total revenue is

zero. Thus in the initial stage of production cost remains higher than the

revenue. Therefore, a firm has to bear a loss. But as more and more units of

output are sold total revenue starts increasing and it reaches to the point where

total revenue will cover total cost i.e. TR = TC.

Break-even point is the point at which the total revenue is exactly equal to

the total cost. In other words, the Break-even point is defined as, „the point

where the level of output is so reached that TR = TC and hence the net income

is equal to zero. Hence break-even point is no-profit-no-loss zone.

Break-even point may be calculated either in the terms of units of output

which is called as break-even volume or in the terms of total rupee sales. We

can explain the break-even point concept with the help of the following diagram.

Y TR TC Revenue TVC & cost E

A TFC O Q output X

Figure 11.1 Break Even Figure

In the diagram X axis represents level of output and Y axis represent

revenue & cost. TFC is the total fixed cost curve which is an intercept on Y axis

at point „A‟. TVC is the total variable cost, TC is the total cost which is the sum

of TFC & TVC and TR is the total revenue which starts from origin and slopes

positively upward from left to right shows that TR increases with an increase in

sales. Till OQ output the total cost is more than total revenue and therefore the

area AOE indicates the area of losses. But as output increases to OQ level, TR =

TC at point E. If the output is increased beyond the OQ level TR increases much

faster than TC and hence total profit goes on increasing. Thus the point „E‟ is

called as Break-even point.

Assumptions- Break-even analysis is based on the following assumptions.

1. The cost function and revenue function are linear.

2. The total cost is divided into fixed and variable costs.

3. The selling price is fixed.

4. The volume of sales and production are identical.

5. Prices of factors are remaining constant.

6. Productivity and efficiency remains unchanged.

BEP in terms of total number of units of output/ break even volume – Algebraically, the break even volume is measured by the following formula.

tiableice

tFixedevenvolumeBreak

cosvarPr

cos

Let us explain with the help of following example. Suppose the FC of a firm

is 7,000. Variable cost per unit of output is 15/-. Price per unit is 50/- We can find out the break even level of output with the help of above formula.

1550

7000

BEV

7,000 = ---------

35 = 200 units

BEP in terms of total rupee sales- Total sales value or Total Revenue = P × Q

= 50× 200 =10,000. Total Cost = FC + VC

TFC = 7,000 TVC = VC per unit × Total number of units of output.

= 15 × 200 = 3,000 TFC + TVC = TC 7,000 + 3,000 = 10,000

TR - TC = Net income is equal to zero. TR 10,000 – TC 10,000 = 0 Hence, total profit is zero and thus 200 units is the break-even level output.

Limitations- Break-even analysis has following limitations.

1. Break-even analysis is based on certain assumptions which are assumed to be

constant. This implies a static in nature. It is not applicable to the dynamic

situation.

2. Break-even analysis is unrealistic because it is based on many assumptions.

Linear cost and revenue functions are true only for a limited range of output.

3. It fails to explain the impact of technological change, better management,

division of labour, improved productivity and other factors which influence

profits.

4. It assumes horizontal demand curve with the constant price. It is possible only

in case of perfect competition. But it is not true in case of monopoly.

5. The scope of break even analysis is limited to the short run only.

6. The break even analysis does not consider elements of uncertainty due to tax

structure.

Usefulness of BEA-

1. BEA is useful for decision-making in regards to pricing, cost control, product-

mix, channels of distribution etc.

2. It is a useful tool of managerial planning.

3. It can be used for determining the safety margin.

4. It provides a microscopic view of the profit structure of the firm.

5. It is useful for determining the quantity of output and level of sales of a firm.

6. We can compare the profit margin of different firms with the help of BEA.

7. BEA is useful to understand the relationship between firm‟s cost, revenue,

production, loss and profit.

11.6 Conclusion

Several theories have been formulated to explain how profits arise but

unfortunately none of these theories provide a comprehensive explanation of

the profit. The fact is that, in the real world, there are several factors which

give rise to profit, but the principal factor is uncertainty. It is uncertainty

which is the basic reason of profit. This uncertainty is due to the dynamic

changes of the world. And there is not a single entrepreneur who can foresee

all these changes nor all the circumstances are under his control.


1. Which of the following would be considered to be one of the major faults of

break-even analysis and target profit pricing?

a. They do not take into account the price-demand relationship.

b. They are very complicated to calculate.

c. There are serious time lags in the calculations.

d. Most managers do not have confidence in the methods.

2. The following assumptions are made in case of break even analysis, except

a. All fixed costs are fixed

b. All variable costs are fixed

c. The prices of input factors are constant

d. Volume of production and volumes of sales are equal

3. Which theory of profit holds that profit will be higher in industries

characterized by a high degree of variability in their revenues or their costs?

a. Risk-bearing theory

b. Frictional theory

c. Monopoly theory

d. Innovation theory

(Answers: 1a, 2b, 3a)

11.8 Glossary

Fixed Cost: These are defined as expenses that do not change as a

function of the activity of a business, within the relevant period. For

example, a retailer must pay rent and utility bills irrespective of sales.

Variable cost: Variable costs are those costs that vary depending on a

company's production volume; they rise as production increases and fall as

production decreases. Variable costs differ from fixed costs such as rent,

advertising, insurance and office supplies, which tend to remain the same

regardless of production output.

11.9 References

Mehta P.L. (2006), Managerial Economics Analysis, Problems and Cases,

Sultan Chand & Sons, New Delhi.

Dwivedi, D N. (2003), Micro Economics : Theory and Applications;

Pearson Education (Singapore) Pvt. Ltd, Delhi.


Samuelson P.A. & Nordhaus W. D. (1998), Economics, Tata McGraw

Hill, New Delhi.

Ahuja H. L. (2005), Advanced Economic Theory, S Chand and Company,

New Delhi.


1. Explain briefly the various theories of profit.

2. What is profit planning? Explain the tool of profit planning.

LESSON – 12

Business Cycles

12.0 Objectives

12.1 Introduction

12.2 Meaning and Nature of Trade cycles

12.3 Causes of Trade Cycles

12.4 Check Your Progress A

12.5 Phases of Trade Cycles

12.6 Types of trade Cycles

12.7 Theories of Trade Cycles

12.7.1 Hawtrey’s Pure Monetary Theory

12.7.2 Keynes’ Saving and Investment theory

12.7.3 Hicks’ theory of trade cycle

12.7.4 Over Investment Theory

12.7.5 Under Consumption Theory

12.7.6 Psychological Theory of Trade Cycle

12.8 Control of Trade Cycles


12.10 Summary

12.11 Glossary


12.13 References/ Suggested Readings


12.0 OBJECTIVES


To understand the meaning and nature of trade cycles

To know the causes and effects of trade cycles

To understand the different phases of trade cycles

To explain different theories of trade cycles

To comprehend controls of trade cycles

12.1Introduction

A glance at economic history reveals that fluctuations in economic conditions

have existed since time immemorial. A prominent feature of modern market-oriented

economies is the existence of economic cycles or fluctuations in the form of the

alternating expansions and contractions that mark cycles in growth. Economic cycles

or business cycles are the recurring fluctuations that occur in real GDP over time.

The business or trade cycles relate to the volatility of economic growth, and the

different periods that the economy goes through. Trade cycles have been closely

connected with the development surges accompanying the economic progress. No

doubt the phases of business cycles are recurring, but their duration, intensity and

scope vary considerably. They have a strong tendency to synchronize industrial,

commercial, and financial processes in the working of an economy. Business cycle

movements often spread from one country to another and sometimes spread to

almost the entire world. A global economic downturn will tend to affect individual

economies. Foreign trade, commodity prices, stock prices, and interest rates play a

vital role in this process of transmission, both directly and indirectly through their

influence on business psychology. Some economists feel that trade cycles cannot be

avoided and so it is not possible for the government to influence and prevent

recessions. However, other economists (prominent among these are Keynes and his

followers) argue that government intervention can definitely help fight and overcome

recessions.

12.2 Meaning and Nature of Trade Cycles

Trade cycles are a type of fluctuation found in the aggregate economic activity

of nations that organize their work mainly in business enterprises: a cycle consists of

expansions occurring at about the same time in many economic activities, followed

by similarly general recessions, contractions and revivals which merge into the

expansion phase of the next cycle; this sequence of changes is recurrent but not

periodic. In other words, business cycle refers to waves of money and economic

activity that forms a regular pattern, defined in terms of periods of expansion or

recession. During expansion, the economy grows in real terms (measured by

indicators like income, output, employment, sales, etc.), after excluding the effects of

inflation. On the other hand, recession is that period when the economy is shrinking

or contracting.

A trade cycle is composed of periods of good trade, characterized by rising prices

and low unemployment percentages, shifting with periods of bad trade characterized

by falling prices and high unemployment percentages. ---Hawtrey

In other words, trade cycles are wave like movements of the economic activity as a

whole, characterised by successive periods of rise and fall. For some years there is

an upward movement extending followed by the downswing for some years and

again followed by an upswing. Usually there is a considerable uniformity in the length

of the cycle (eight or nine years) unless if there are certain exogenous factors

operating such as a war, etc. which might reduce the length of trade cycle to less

than six years or more than eleven years. However, successive cycles differ in

length from each other. This may be attributed to a number of causes including

harvest conditions, domestic politics, changes in monetary and banking systems,

international relations, the conditions of war or peace, the discovery of new industrial

methods, etc. all of which tend to alter the pace of business. The fact however

remains that movements in economic activity are crucial for progress.

During these wavelike movements employment, prices, consumer’s

expenditure, production and investment rise and fall in a successive manner. The

movements in prices and employment moreover also move to and synchronize with

other countries of the world, because in open economies the demand for the

products of various countries is interlinked. Prosperity in one industry creates a

demand for the products of other industries, which, in turn, become prosperous

creating further demand for one still others’ products (psychological factor playing an

important role). Optimism and pessimism in one industry spread to other industries.

However, all industries may be affected by economic fluctuations (depression or a

boom) differently depending on the type if goods being produced. Similarly, the

international character of the trade cycle is strongly influenced by the demands of the

countries for each other’s goods and the psychology of the business class.

Pessimism or even optimism are all the more infectious at the international level,

once started quickly becomes universal. The fluctuations in the business activity,

depressions or booms get easily transmitted from one nation to the rest of the world

if the extent of the international trade is very high, as is prevalent in modern day

economies.

12.3 Causes of Trade Cycles

Various theories to explain the trade cycles share the view that the main

driving force behind the economic fluctuations in an economy (which is also the

original cause of the cycle) is always some sort of shock or disturbance. In addition,

most of the trade cycle theories rest on a propagation mechanism that amplifies

shocks. There exists a need of some propagation mechanism that translates small,

short-lived shocks into large, persistent economic fluctuations if the disturbances are

not big enough by themselves to cause the fluctuations. Some of the possible

shocks and propagation mechanisms are as follows.

Technology shocks: It is a well-known fact that the real world production

functions exhibit a dynamic character and keep changing over time with the

development and introduction of new and improved technologies and

methods of production. Such technical improvements increase the overall

productivity and the production process gets altogether changed. However, on

the other hand, it may be possible that production facilities might break down

or may not work as expected. This may cause the productivity to fall. Hence,

the technological change may not always be smooth as it often comes in the

form of shocks. Improvements in technology may cause a boost in economic

growth while the opposite may also happen.

Weather shocks and natural disasters: Such shocks are faced by those

industries which are dependent on weather conditions, for example,

agriculture or tourism, etc. Fluctuations in the output and productivity of these

sectors is largely influenced by rainfall and sunshine, and even natural

calamities like earthquakes, landslides, floods, cyclones, tsunami, etc. Hence,

weather conditions may act as a potential source of fluctuations in the

economic activity.

Monetary shocks: Real effects of monetary policy may act as monetary

shocks. Therefore, trade cycles or fluctuations in business activity may even

be caused by random changes in money supply or interest rates as also by

other changes in the monetary sector of the economy.

Political shocks: The government influences the working of the economy in

two possible ways - directly through government or public sector enterprises

and indirectly through government regulations and controls influencing

different sectors of the economy. In this context, potential sources of

economic fluctuations may include changes in tax laws, antitrust regulation,

government expenditure and so on. Some economists suggest that there is a

political business cycle especially when politicians try to have a high

economic growth before an election to help win the election.

Taste shocks: Such type of shocks arise from changes or shifts in consumer

tastes, preferences, habits, fashions, etc. (snob effect and bandwagon effect

may introduce taste shocks in the business activity by influencing the

consumer demand patterns). These fluctuations in economic activity are

primarily witnessed in those industries which are strongly influenced by

fashion, style and high fan following, like apparels, music, or movie industries,

foot wears, accessories, etc.

All the above mentioned shocks are present to some degree in every economy but

these may not be potent enough to directly set in trade cycles. There are some

mechanisms present in the economy which perhaps amplify these shocks and

propagate them through time. These may include the following

Sticky prices: The response of market economies to the stimulus of above

mentioned changes or shocks is in the form of price adjustments (both in the

goods market and factor market). For example, in the factor market a negative

productivity shock will lower the marginal productivity of labour, so that the

real wage would have to go down to the demand and supply labour. But as

mentioned in previous chapter, wage cut policy is not very practical and

desirable and hence, the adjustment cannot take place. This in turn leads to

loss of output and unemployment which is much larger than the direct effect of

the shock. Similarly effects arise if prices are sticky in the goods market.

Intertemporal substitution: In continuation with the above example, shocks

having a negative impact on productivity in turn lower the marginal return to

labour along with other factors of production. Fall in marginal products may

reduce the incentive to work, and workers might prefer more of leisure instead

of work. Hence, supply of labour falls further and lowers the output still further.

On the other side, in response to a shock the workers (as consumers) might

cut down their savings to continue smooth consumption. Overall this leads to

lower investment and a lower capital stock in the future, extending the impact

of a shock far into the future.

Frictions in financial sector: Even small shocks can force the directly hit firms

into bankruptcy. This in turn affects other firms and also the banks which gave

credit to these firms. Many a times even banks fail if bad debts rise

excessively, this adversely affects all the creditors and debtors of the bank,

leading to serious economic crises.

On the basis of these causes of trade cycles, business cycle models can be

broadly divided into two categories. On one hand there are some theories which

consider trade cycles as a failure of the economic system. According to these

theories the economy experiences depressions and fails to achieve the efficient level

of output and employment due to frictions (or imperfections of the market mechanism

for example financial frictions, sticky prices, or other adjustment failures. The

Keynesian model of output determination falls into this category where technology

shocks and monetary shocks are considered to be important sources of business

fluctuations. The Great Depression was closely connected to financial sector

disruptions marked by failure of banks and financial instability.

On the other hand, the other category of models that considers trade cycles

as the optimal reaction of the economy to unavoidable shocks. Even if the market

mechanism efficient, the shocks get propagated through intertemporal substitution.

In this case technology shocks are the main cause of economic fluctuations. Such

models are called real business cycle models which can be explained as the optimal

reaction of an efficient market system to economic shocks.

12.4 Check Your Progress A

State True or False

1. A trade cycle is composed of periods of good trade, shifting with periods of bad

trade.

2. Economic fluctuations are country specific and do not extend to other nations of the

world.

3. Trade cycles cannot be caused by technology shocks.

4. A sudden change in fashion may act as a potential source of fluctuation in economic

activity.

5. Real business cycle models are the optimal reaction of an efficient market system to

economic shocks.

6. Sticky prices amplify the effect of shocks to generate trade cycles.

7. The Keynesian model of output determination considers trade cycles as a failure of

the economic system.

12.5 Phases of Trade Cycles

Trade cycle is a wave of economic activity that forms a regular pattern, defined in

terms of periods of expansion (when the economy grows in real terms) or recession

(when the economy shrinks or contracts). A business or a trade cycle has four

phases: expansion- recession-depression-recovery.

Expansion or Prosperity: This is a phase in which there is expansion of

output, income, employment, prices and profits. The standard of living also

rises in this phase. All the macroeconomic parameters witness a substantial

rise. The main features of prosperity are high levels of output and trade,

effective demand, income and employment, rising interest rates, huge

expansion of bank credit, rising prices, high level of marginal efficiency of

capital and investment. The level of production is maximum possible due to

full employment of resources and there is a rise in income. There is a rise in

profits and prices due to a high level of economic activity. There is general

upswing in the economy as the economic activity reaches its peak. The

expansion or prosperity phase is also called boom period.

Recession: This phase is marked by a significant decline in the overall

economic activity. It begins right after the economy reaches a peak of activity

and marks the turning point from prosperity to depression. Due to a fall in

demand there is a decrease in production and future investment and there is

a steady decline in output, income, employment, prices and profits. The wave

of pessimism in the economy reduces investment and hence, halts the

process of business expansion.

Depression: Due to steady and continuous decline in output, income,

employment, prices and profits, there is a fall in the standard of living which

paves way for depression to exist in the economy. The main features of

depression are low levels of output and trade, effective demand, income and

employment, falling interest rates, contraction of bank credit, falling prices, low

level of marginal efficiency of capital and investment. Fall in national income is

due to underutilization of resources. The level of economic activity is lowest

possible and fall in prices and profits continues till the economy reaches its

lowest point – trough.

Recovery: Recovery is the turning point from depression to expansion and is

also called the revival phase. In this phase there are expansions and rise in

economic activity. Rising demand leads to increase in production which in turn

necessitates increase in investment. A steady rise in output, income,

employment, prices and profits generates a wave of business optimism which

further increases investment. Overall the level of production in the economy

rises and the economy sets on a path of recovery. This process of economic

revival is facilitated by expansion of bank credit which encourages business

expansion and rise in the stock markets.

The recovery phase soon gives way to prosperity as there is considerable

expansion in the output, income, employment, prices and profits. The entire

business cycle then repeats itself in all its four phases periodically. The phases of

trade cycles can be depicted with the help of the following figure

The above diagram clearly shows the phases of prosperity, recession, depression

and recovery. In the expansionary phase the economy witnesses upward trends in

all the major economic activities and reaches a peak as shown in the figure. A peak

marks the end of an expansion and the beginning of a recession. The peak or boom

is followed by recession. A recession is a significant widespread decline in economic

activity which begins just after the economy reaches a peak of activity and ends as

the economy reaches its trough. A trough marks the lowermost point of the phase of

depression after which the economy starts showing signs of revival or recovery. A

trough date will mark the end of the recession. Between trough and peak, the

economy is in an expansion phase.

However the length of business cycles is not similar, some cycles are of long

duration while short duration. No matter what is the length of the trade cycle, every

cycle passes through the above mentioned four phases.

Activity A

What is Trade Cycle and describe its various Stages or Phases

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12.6 Types of trade Cycles

According to Schumpeter there are three types of cycles: the major cycles, the minor

cycles and the long waves.

Major Cycles: These type of cycles of economic fluctuations mostly influence the

activities of the businessmen as these basically involve the curse of unemployment

and the wastage of potential wealth. Usually major cycles average between 8 and 9

years from boom to boom but may vary between 6 and 11 years.

Minor Cycles: Such cycles approximately have a duration of forty months. These

cycles have little effect on the day to day operations of most business activities. The

worst hit industries include the ones which are very sensitive to cyclical movement ,

like heavy industries and certain kinds of consumer durables, etc. On the other hand,

firms selling basic foods and low price clothing etc. may not be affected at all. These

minor cycles are superimposed on the major cycles — when the booms and

depressions of the two cycles fall on one another they get intensified.

Long Waves: These cycles have a duration ranging between forty five and sixty

years. They are sometimes also called ―Kondratieff Cycle‖ after the name of the

economist who studied them. Just as the minor cycle is superimposed on the major

cycle, similarly the ―Kondratieff Cycle‖ is superimposed on the major cycle. Good

times during the rising phase of the ―Kondratieff Cycle‖ and bad times during the

falling phase are more prevalent. Hansen found that in each of the long periods of

good times there developed four major recoveries and three major depresssions. In

the downswing of the ―Kondratieff Cycle‖ there developed two major recoveries and

three depressions.

Special Cycles: Besides the above mentioned types of trade cycles, there are

numerous types of special cycles which can be found in particular kinds of economic

series. An important type is the building cycle which seems to have a duration of

about seventeen years. Other examples include cycles in crops, weather, migration

etc.

12.7 Theories of Trade Cycles

There are various theories of trade cycles given by eminent economists to

explain the complex phenomenon of trade cycles but there is no consensus for a

single universal theory accounting for the trade cycles. A trade cycle is a rhythmic

fluctuation in the level of employment, income and output in an economy. Keynesian

theory of output and employment also gives an explanation of the determination of

income, output and employment in an economy at a particular time so in a way,

Keynes also gives and explanation about the cause of trade cycle. Here we discuss

a few important theories of trade cycles including the one by Keynes.

12.7.1 Hawtrey’s Pure Monetary Theory

According to Hawtrey, trade cycle is a purely monetary phenomenon and is

caused by changes in the flow of monetary demand by businessmen in the

economy. The cyclical fluctuations are caused by expansion and contraction of bank

credit which further causes changes in the monetary demand by producers and

traders. The phase of prosperity of trade cycle starts with increase in credit facilities

(by lowering the interest rates or by purchasing securities) by the banks. Cheaper

credit encourages the businessmen to increase their stocks or inventories. Hence,

there is increase in production, employment, and income; again resulting in more

demand. Hence, a circle of cumulative expansion of productive economic activity

sets up leading to higher prices. In turn, traders still further expand their production.

However, this phase of prosperity ends when the banks stop further credit expansion

(due to depletion of their cash funds) and raise the rates of interest. The business

community has to repay their loans for which they need to sell their stocks; as a

result prices start falling and also there is a fall in productive economic activity.

Hence, unemployment may rise due to fall in the demand for the factors of

production, leading to depression – fall in income, output, employment, prices. When

loans are not repaid, banks further contract credit. However, this phase does not

continue endlessly and gradually recovery sets in as the traders try to repay their

loans; cash flows of banks rise. Although pessimism in the economy prevents

traders from borrowing from the banks, central bank plays a key role in initiating

recovery by introducing a cheap monetary policy. Thus, the economy revives and

slowly again expansion starts.

12.7.2 Keynes’ Saving and Investment theory

Although Keynesian theory is not a theory of trade cycle as such, yet it gives a

general explanation for the level of employment by the cyclical nature of changes in

employment. According to Keynes the main cause of trade cycles is the fluctuations

in the rate of investment, which in turn are caused by the marginal efficiency of

capital. Marginal efficiency of capital is the relation between the prospective yield of

capital and the cost of producing the units of output or the expected rate of profit on

new investment or capital goods. The fluctuations in economic activity are attributed

to the expected rate of interest on new investment. Investment is also influenced by

the rate of interest but it is stable in short period (liquidity preference and the quantity

of money which determine the rate of interest do not change significantly in short

period). Hence, fluctuations in investment are mainly due to changes in the marginal

efficiency of capital (as it rises investment will rise leading to expansion). Eventually

there is a decline in the prospective yield on capital due to growing increase of the

capital goods. Fall in marginal efficiency of capital will later result in falling production

and consequent depression. However, a change from depression to recovery is

again due to the revival of the marginal efficiency of capital which pumps in optimism

in the economy by boosting the confidence of the traders. Hence, an increase in

investment is witnessed which causes the income to rise due to the multiplier effect.

Thus, an upward trend or prosperity sets in and hence, the trade cycle operates in

the economy.

12.7.3 Hicks’ theory of trade cycle

Hicks explains the theory of trade cycles on the basis of combination of the

principles of multiplier and accelerator. Investment could be of two possible types -

autonomous investment, and induced investment. Induced investment depends on

the changes in income, output and consumption, whereas autonomous investment is

not at all influenced by the fluctuations in income, output and consumption.

According to Hicks, autonomous investment causes cyclical fluctuations in the

business activity by multiplier effect and induced investment via accelerator effect.

Suppose, initially there is an increase in autonomous investment in the economy. A

multiplier effect will set in and bring about an increase in income and output. This

expansion in the level of income output and employment will increase the induced

investment via the accelerator. Further increases in income are brought about by

multiplier effect and investment by the accelerator principle. This marks the

expansionary phase of the economy which continues till the economy reaches the

upper limit or ceiling determined by full employment. After this upper limit, rate of

expansion in output and income slows down; reducing the amount of induced

investment as the multiplier and accelerator forces start operating in the reverse

direction. This downswing continues till the lower turning point is reached. The

turning point again causes an expansionary phase to set in.

12.7.4 Over Investment Theory

Over investment theory attributes trade cycle to over investment in investment

industries – basic and heavy industries like iron and steel, engineering, building and

construction, etc. This assertion holds true because it is observed that during boom,

capital good industries grow faster than consumption good industries while during

depression capital good industries suffer more than consumption good industries.

There is difference of opinion about the reason of this statement. Some experts

attribute it to banks giving credit at low rates to encourage investment, causing

withdrawal of resources from consumer goods industries to capital goods industries.

The next phase of trade cycle sets in when the banks raise the interest rates to

check credit creation leading to contraction in the economic activity – depression. On

the other hand, some economists feel that the main cause of trade cycle is the

process of production and not the expansion and contraction of bank credit.

12.7.5 Under Consumption Theory

According to Hobson, the main cause of trade cycles is the mal distribution of

national income. During expansion the businessmen amass income with business

activities become richer. Savings also increase as the entire increase in income is

not consumed. Excessive saving during the boom period ultimately leads to

reduction in the level of consumption, hence a fall the demand for consumer goods

Prices begin to fall due to mismatch between demand and supply of consumer

goods. The wave of pessimism initiates a downswing in the economy and leads to

depression. Depression also does continue forever and leads to revival.

12.7.6 Psychological Theory of Trade Cycle

According to Pigou, trade cycles are basically influenced by the psychology of

the businessmen, their optimism and pessimism causes fluctuations in the business

activity. During boom, businessmen earn high profit and expand the investment,

production and employment. There is a wave of optimism in the economy which

leads to prosperity. However, excessive increase in aggregate supply causes prices

and hence profits to fall. Investment, and hence, output and employment also fall.

The wave of pessimism catches up leading to depression.

Activity B

Describe the shocks which are said to cause trade cycles? How are these shocks amplified

in the economy.

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.12.8 Control of Trade Cycles

Although some economists argue that the business cycle is an essential part

of an economy. Even downturns have their role to play in weeding out the inefficient

firms. However, this view is controversial and majority of the economists argue that a

volatile trade cycle may be harmful for the economy. The main measures which have

been suggested for the effective control of trade cycles are as follows:

Monetary Policy: Many economists opine that trade cycle is purely a monetary

phenomenon and hence an effective monetary policy (measures to control the

supply of money and credit). During inflation the central bank can reduce the quantity

of money in circulation by increasing the bank rate, selling of securities in the market,

increasing the reserve ratio of the member banks, by moral persuasion, etc. On the

other hand during depression the quantity of money in circulation can be increased

by appropriate measures. However, monetary policy alone cannot achieve the

desired results (as was seen during Great Depression). The modern economists are

of the opinion that monetary policy can be successful tool to control trade cycles if it

works in coordination with the fiscal policy.

Fiscal Policy: Fiscal policy involves the use of fiscal tools – taxation, government

expenditure, public debt, etc. – to control trade cycles. During inflation, the

government may cut down its own public works programmes, levy heavy taxes,

reduces purchasing power by public debt, etc. On the other hand, during depression,

public works programmes may be increased to increase income, investment and

employment. Fiscal policy is a very sensitive counter cyclical instrument in but needs

to be used in tandem with the monetary policy.

Control of Private Investment: By proper control of private investment in the

economy, the government can help achieve economic stabilization. However, this in

no way means discouraging private investment rather managing it to check

fluctuations.

International Measures: Some economists have suggested the use of measures on

an international scale to check trade cycles as in modern dynamic world business is

an international phenomenon. So business fluctuations should be tackled on an

international level. Important measures in this direction include international

production control, international bill stock control, international investment control,

etc.


1. The phase of …………. is marked by a significant decline in the overall economic

activity.

2. Hicks theory of trade cycles is based on the combination of the principles

of………………..

3. The best possible way to control trade cycles is to apply ……………. policy in

coordination with the ………….. policy.

4. According to ……….. trade cycle is a purely monetary phenomenon and is

caused by changes in the flow of ……… by businessmen in the economy.

5. The main features of ……. are low levels of output and trade, effective demand,

income and employment, falling interest rates, contraction of bank credit, falling

prices, low level of marginal efficiency of capital and investment.

6. …………. have a duration ranging between forty five and sixty years.

7. Between trough and peak, the economy is in an ……… phase.

8. According to Pigou, trade cycles are basically influenced by ……….. the

businessmen.

12.10 Summary

Trade cycles are wave like movements of the economic activity as a whole,

characterised by successive periods of rise and fall. For some years there is an

upward movement extending followed by the downswing for some years and again

followed by an upswing. The four phases of a trade cycle are expansion, recession,

depression, and recovery and any cycle of whatever duration can be described as

going through these four phases. There is always some sort of shock or disturbance

which causes trade cycle and it is often amplified by some propagation mechanism.

Important ones are technology shocks, monetary shocks, natural shocks or political

shocks. According to Schumpeter there are three types of cycles: the major cycles,

the minor cycles and the long waves. There are various theories of trade cycles

given by eminent economists to explain the complex phenomenon of trade cycles

but there is no consensus for a single universal theory accounting for the trade

cycles. Pure monetary theory by Hawtrey, saving and investment theory by Keynes

are the prominent among these. Other theories by Hicks, Pigou and Hobson are also

important. Trade cycles can be effectively controlled through the judicious and

coordinated use of monetary policy, fiscal policy as well as international measures.

12.11 Glossary

Trade Cycles: Wave like movements of the economic activity as a whole,

characterised by successive periods of rise and fall.

Shocks: Small short-lived disturbances which cause trade cycles.

Expansion or Prosperity: Phase of trade cycle marked by high levels of output and

trade, effective demand, income and employment, rising interest rates, huge

expansion of bank credit, rising prices, and investment.

Depression: When the level of economic activity is lowest possible.

Recovery:Turning point from depression to expansion, also called the revival phase.

Over Investment Theory: Attributes trade cycle to over investment in investment

industries

Pure Monetary Theory: Given by Hawtrey, attributes trade cycles purely to changes

in monetary demand.

Long Waves: Trade cycles having a duration ranging between forty five and sixty

years. They are sometimes also called ―Kondratieff Cycle‖.


Check Your Progress A

1. True

2. False

3. False

4. True

5. True

6. True

7. True

Check Your Progress B

1. recession

2. multiplier and accelerator

3. monetary, fiscal

4. Hawtrey, monetary demand

5. Depression

6. Long waves

7. Expansion

8. Optimism and pessimism

12.13 References/ Suggested Readings

Dwiwedi, D. N., Macroeconomics: Theory and Policy, Tata McGraw Hill Publishing,

New Delhi.

McConnel , C. R. & H. C. Gupta, Introduction to Macro Economics , Tata McGraw–

Hill, New Delhi

K.K .Dewett, Modern Economic Theory, S. Chand Publication

D.M.Mithani, Managerial Economics Theory and Applications, Himalaya Publication

Peterson and Lewis, Managerial Economic, Prentice Hall of India

Gupta, Managerial Economics, TataMcGraw Hills

Froeb, Managerial Economics, Cengage Learning


1. What do you mean by a trade cycle?

2. Discuss the various phases of business cycles?

3. Explain the causes of trade cycles.

4. Discuss in detail the Hicks’ theory of trade cycles.

5. How can monetary policy be used to tackle fluctuations in the business activity?

Self Learning Material Managerial Economics

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