Economics and Management Decions

UNIT 20: Case Study
MBCE-701D
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Economics &
Management Decisions UP
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CC
(c)
Economics & Management Decisions
Course Design
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Advisory Council
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Chairman
Dr Parag Diwan
Members
Dr Anirban Sengupta Dr Ashish Bhardwaj
UP
Dr Kamal Bansal
Dean Dean CIO
Dr S R Das Dr Sanjay Mittal Prof V K Nangia

VP Academic Affairs Professor IIT Kanpur IIT Roorkee
SLM Development Team

Wg Cdr P K Gupta
Dr Joji Rao
Dr Neeraj Anand
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Dr K K Pandey
Print Production
Mr Kapil Mehra Mr A N Sinha

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Manager Material Sr Manager Printing
Author
Vivek Mittal
All rights reserved. No part of this work may be reproduced in any form, by mimeograph or any other means,
without permission in writing from MPower Applied Learning Enterprise.
(c)
Course Code: MBCE-701D
Course Name: Economics & Management Decisions
Version: July 2013
MPower Applied Learning Enterprise

UNIT 20: Case Study
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Contents
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Block-I
Unit 1 Introduction to Managerial Economics ......................................................................... 3

Unit 2 A Brief Analysis of Utility ............................................................................................ 13
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Unit 3 Laws of Utility ............................................................................................................. 19
Unit 4 Demand Analysis.......................................................................................................... 33
Unit 5 Case Studies.................................................................................................................. 41
Block-II
Unit 6 Law of Demand ............................................................................................................. 47

Unit 7 Elasticity of Demand .................................................................................................... 55
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Unit 8 Demand Forecasting Concept and Survey Methods................................................ 67
Unit 9 Statistical Methods of Demand Forecasting ............................................................... 73
Unit 10 Case Studies.................................................................................................................. 85
Block-III
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Unit 11 Supply Analysis ............................................................................................................ 91

Unit 12 Cost ............................................................................................................................... 99
Unit 13 Production ................................................................................................................... 119
Unit 14 Supply & Demand as Market Forces......................................................................... 129
Unit 15 Case Study .................................................................................................................. 143
Block-IV
Unit 16 Market Equilibrium.................................................................................................... 149

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Unit 17 Market Structures & their Pricing - I ....................................................................... 159

Unit 18 Market Structure & their Pricing - II........................................................................ 167
Unit 19 Pricing Methods .......................................................................................................... 179
Unit 20 Case Studies................................................................................................................ 193
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Block-V
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Unit 21 Economic Profits ........................................................................................................ 201
Unit 22 Break-Even Analysis .................................................................................................. 207
Unit 23 Decision Making Process............................................................................................ 215
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Unit 24 Leadership in Economic Decisions ............................................................................ 227
Unit 25 Case Studies................................................................................................................ 237
Glossary ............................................................................................................................................ 243
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UNIT 1: Introduction to Managerial Economics
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Notes
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BLOCK-I
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Detailed Contents Economics & Management Decisions
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UNIT 1: INTRODUCTION TO MANAGERIAL
___________________ UNIT 3: LAWS OF UTILITY
ECONOMICS
z Introduction
z ___________________
Introduction
z The Law of Diminishing Marginal Utility
Nature of Managerial Economics
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z Cardinal and Ordinal Concepts of Utility
z Scope & Significance of Managerial Economics
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z The Equi-marginal Concept
z Role of Managerial Economist
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z Economics and Managerial Decision Making UNIT 4: DEMAND ANALYSIS

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z Introduction
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UNIT 2: A BRIEF ANALYSIS OF UTILITY z Concept of Demand
z Introduction
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z Demand Function
z Meaning of Utility
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z Quantifying Utility UNIT 5: CASE STUDIES

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z Total Utility
z Marginal Utility
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Unit 1
3
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Notes
Introduction to Managerial
___________________
___________________
Economics
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___________________
___________________
Objectives ___________________
After completion of this unit, the students will be aware of the following
___________________
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topics:
___________________
\ Nature and scope of managerial economics
\ Role of economics in decision making ___________________
\ Concepts of economic analysis ___________________
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Introduction
Managerial Economics is a discipline that combines economic
theory with managerial practice. It tries to bridge the gap between
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the problems of logic that intrigue economic theorists and the
problems of policy that plague practical managers. The subject
offers powerful tools and techniques for managerial policy making.
An integration of economic theory and tools of decision sciences
works successfully in optimal decision making, in face of
constraints. A study of managerial economics enriches the
analytical skills, helps in the logical structuring of problems, and
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provides adequate solution to the economic problems. To quote

Mansfield, Managerial Economics is concerned with the
application of economic concepts and economic analysis to the
problems of formulating rational managerial decisions. Spencer
and Siegel man have defined the subject as the integration of
economic theory with business practice for the purpose of
facilitating decision making and forward planning by
management.
Nature of Managerial Economics

(c)
Contribution of Economic Theory to Managerial Economics
Baumol believes that economic theory is helpful to managers for

three reasons. First, it helps in recognizing managerial problems,
eliminating minor details which might obstruct decision making
and in concentrating on the main issue. A manager is able to
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ascertain the relevant variables and specify relevant data. Second,
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Notes
Activity it offers them a set of analytical methods to solve problems.
How___________________
economic theory is helpful
to managers?
Economic concepts like consumer demand, production function,
___________________ economies of scale and marginalize help in analysis of a problem.
Third, it helps in clarity of concepts used in business analysis,
___________________
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which avoids conceptual pitfalls by logical structuring of big issues.
___________________
Understanding of inter-relationships between economic variables
___________________ and events provides consistency in business analysis and decisions.
___________________ For example, profit margins may be reduced despite an increase in
sales due to an increase in marginal cost greater than the increase
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___________________
in marginal revenue. Ragnar Frisch divided economics in two
___________________ broad categories macro and micro. Macroeconomics is the study
___________________ of economy as a whole. It deals with questions relating to national
income, unemployment, inflation, fiscal policies and monetary
___________________
policies. Microeconomics is concerned with the study of individuals
like a consumer, a commodity, a market and a producer.
Managerial Economics is micro-economic in nature because it deals

with the study of a firm, which is an individual entity. It analyses
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the supply and demand in a market, the pricing of specific input,
the cost structure of individual goods and services and the like.
The macroeconomic conditions of the economy definitely influence
working of the firm, for instance, a recession has an unfavorable
impact on the sales of companies sensitive to business cycles, while
expansion would be beneficial. But Managerial Economics
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encompasses variables, concepts and models that constitute micro-

economic theory, as both the manager and the firm where he works
are individual units.
Contribution of Quantitative Techniques to Managerial

Economics
Mathematical Economics and Econometrics are utilized to
construct and estimate decision models useful in determining the
optimal behavior of a firm. The former helps to express economic
theory in the form of equations while the latter applies statistical
techniques and real world data to economic problems. Like,
(c)
regression is applied for forecasting and probability theory is used

in risk analysis. In addition to this, economists use various
optimization techniques, such as linear programming, in the study
of behavior of a firm. They have also found it most efficient to
express their models of behavior of firms and consumers in terms
of the symbols and logic of calculus.
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Notes
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___________________
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___________________
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___________________
___________________
Figure 1.1: Managerial Economics and Related Discipline ___________________
Thus, Managerial Economics deals with the economic principles

and concepts, which constitute Theory of the Firm. The subject is
a synthesis of economic theory and quantitative techniques to solve
managerial decision problems. It is micro-economic in character.
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Further, it is normative since it makes value judgments, that is, it
states what goals a firm should pursue. Figure 1.1 summarizes our
discussion of the principal ways in which Economics relates to
managerial decision making.
Managerial Economics plays an equally important role in the

management of non-business organizations such as government
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agencies, hospitals and educational institutions. Regardless of

whether one manages the ABC hospital, Eastman Kodak or
College of Fine Arts, logical managerial decisions can be taken by a
mind trained in economic logic.
Check Your Progress

Fill in the blanks:
1. ................... is a discipline that combines economic
theory with managerial practice.
2. ................... is the study of economy as a whole. It deals
with questions relating to national income,
(c)
unemployment, inflation, fiscal policies and monetary

policies.
3. ................... is concerned with the study of individuals
like a consumer, a commodity, a market and a
producer.
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Scope & Significance of Managerial Economics
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What are the three basic
___________________ An analysis of scarcity of resources and choice making poses three
questions that arise due to
scarcity of resources?
basic questions:
___________________
1. What to produce and how much to produce?
___________________
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2. How to produce?
___________________
___________________
3. For whom to produce?
___________________ A firm applies principles of economics to answer these questions.

The first question relates to what goods and services should be
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___________________ produced and in what quantities. Demand theory guides the
___________________
manager in the selection of goods and services for production. It
analyses consumer behavior with regard to:
___________________
1. Type of goods and services they are likely to purchase in the
___________________ current period and in the future,
2. Goods and services which they may stop consuming,
3. Factors influencing the consumption of a particular good or
service, and
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4. The effect of a change in these factors on the demand of that
particular good or service.
A detailed study of these aspects of consumer behavior helps the
manager to make product decision. At some particular time, a firm
may decide to launch new goods and services or stop providing a
particular good or service. For example, in 1990s, Videocon group
launched a new company of kitchen appliances. In 1961, Tata
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started TCS, while in 1993, the company ceded TOMCO to HLL.

Knowledge of demand elasticitys helps in setting up of prices in
context of revenue of a firm. Methods of demand forecasting help in
deciding the quantity of a good or service to be produced.
How to produce the goods and services is the second basic question.
It involves selection of inputs and techniques of production.
Decisions are made with regard to the purchase of items ranging
from raw materials to capital equipment. Production and cost
analysis guides a manager in personnel practices such as hiring
and staffing and procurement of inputs. For example, the decision
to automate clerical activities using PC network results in a more
capital-intensive mode of production. Capital budgeting decisions
also constitute an integral part of the second basic question.
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Allocation of available capital in long-term investment projects can

be done through project appraisal methods.
Firms third basic question relates to segmentation of market. A
firm has to decide for whom it should produce the goods and
services. For example, it has to decide whether to target the
domestic market or the foreign market. Production of a premium 7
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good is another example of market segmentation. An analysis of Notes
market structure explains how price and output decisions are
taken under different market forms. Table 1.1 depicts the three ___________________
basic questions and concepts of economics used to solve them. ___________________
Table 1.1: Basic Questions & Related Concepts
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___________________
Basic Questions Related Concepts
___________________
1. What to produce and how Product decision: consumer demand,
much to produce? demand elasticitys and demand ___________________
forecasting.
___________________
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2. How to produce? Input-output decisions: production and
cost analysis and capital budgeting. ___________________
3. For whom to produce? Market segmentation decision.
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Appropriate business decision making with the help of economic ___________________

tools has gained recognition in view of complex business
___________________
environment. Since the macroeconomic environment is dynamic, it
changes over time; managerial decisions have to be reviewed
constantly. In this context, concepts of consumer behavior, demand
elasticities, demand forecasting, production and cost analysis,
market structure analysis and investment planning help in
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making prudent decisions.
Check Your Progress

Fill in the blanks:
1. ................... theory guides the manager in the selection of

goods and services for production.
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2. Allocation of available capital in long-term investment

projects can be done through ................... methods.
Role of Managerial Economist

Companies like Tata, DCM, HLL and IPCL employ managerial
economists to guide them in making appropriate economic
decisions. A managerial economist makes an assessment of change
in the consumer preferences, input prices, and related variables to
make successful forecasts of their probable effect on the internal
policies of the firm. They inform the management of a change in
the competitive environment in which a firm functions, and
(c)
suggest suitable policies for solution of problems like:
1. What product and services should be produced?
2. What inputs and production techniques should be used?

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3. How much output should be produced and at what prices
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should it be sold?
What does the managerial
___________________
economist inform the
management about? 4. What are the best sizes and locations of the new plant?
___________________
___________________ 5. When should the equipment be replaced?
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___________________ 6. How should the available capital be allocated?
___________________ A managerial economist has to evaluate changes in the
___________________ macroeconomic indicators like national income, population, and
business cycles, and their likely impact on the functioning of the
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___________________
firm. He also studies the impact of changes in fiscal policy,
___________________ monetary policy, employment policy and the like on the functioning
of the firm. These topics come under the purview of
___________________
macroeconomics. Therefore, they deserve a separate treatment.
___________________ The scope of managerial economics is restricted to microeconomics.
Check Your Progress

Fill in the blanks:
1. A ........................... makes an assessment of change.

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2. A managerial economist has to evaluate changes in
the.......................... indicators.
Economics and Managerial Decision Making

The best way to become acquainted with Managerial Economics is
to come face to face with real world decision problems. Many
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companies have applied established principles of Managerial

Economics to improve their profitability. In the past decade, a
number of known companies have experienced successful changes
in the economics of their business by using economic tools and
techniques. Some cases have been discussed here.
Example 1: Reliance Industries has maintained top position in

polymers by building a world-scale plant and upgrading
technology. This has resulted in low operating costs due to
economies of scale. Reliance Petroleum Ltd. registered a net profit
of ` 726 crores on sales of ` 14,308 crores for the six months ended
September 30, 2000. Of these, exports amounted to ` 2,138 crores,
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which make RPL Indias largest manufacturer, exporter.
RPL is planning to expand its capacity from 27 to 30 million tonnes

in April 2001 and further to 40.5 million tonnes by April 2002. The
overall economies of scale are in favour of expansion. This
expansion will further consolidate the position of RPL in the sector 9
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and help in warding off rivals. Notes
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Example 2: Leading multinational players like Samsung, LG,
Sony and Panasonic cornered a large part of Indian consumer ___________________
durables market in the late 1990s. This was possible because of
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___________________
global manufacturing facilities and investment in technologies. To
___________________
maintain their market share, they resorted to product
differentiation. These companies introduced technologically ___________________
advanced models with specific product features and product ___________________
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styling.
___________________
Example 3: For P&G, the 1990s was a decade of value-oriented
___________________
consumer. The company formulated policies in view of emergence
of India as value for money product market. This means that ___________________
consumers are willing to pay premium price only for quality goods. ___________________
Customers are becoming more price-sensitive and quality
consciousmore focused on self satisfaction It can, therefore, be
said that consumer preferences and tastes have come to play a
vital role in the survival of companies.
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Example 4: In late 1990s, HLL earned supernormal profits by
selling low-priced branded products in the rural areas. This was a
result of market segmentation policy adopted by the company. The
company considers the rural market as a separate market. It is
now developing packages for the rural market with products,
packaging, and pricing tailor made for the rural consumers.
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To ward off rivals and to make it a better competitor the company

resorted to mergers and acquisitions. Merger of BBIL with HLL in
1996 made it the largest conglomerate in the consumer goods
market in India. Over the years HLL has acquired Kissan and
Dipys from UB group; Dollops from Cadburys in 1993; and
International Bestfoods in 2000, to achieve economies of scope.
Example 5: Apple, the company that began the PC revolution, had

always managed to maintain its market share and profitability by
differentiating its products from the IBM PC compatibles.
However, the introduction of Microsofts Windows operating
system gave the IBM and IBM compatible PCs the look feel, and
(c)
ease of use of the Apple Macintosh. This change in the competitive

environment forced Apple to lower its prices to levels much closer
to IBM compatibles. The result has been an erosion of profit
margins. For example, between 1991 and 1993, Apples net profit
margins fell from 5 to 1 per cent. In all the above examples,
decision making has primarily been economic in nature as it
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involves an act of choice. The decision of Reliance Industries to
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Notes build a plant of international scale and to further expand capacity
___________________ was made on the basis of the law of returns to scale and economies
of scale. Similarly, the MNCs in the consumer durables market in
___________________
India emphasized on global manufacturing facilities coupled with
___________________ product differentiation to capture and maintain a major portion of
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___________________ market share. It should be noted that scale economies are
sufficient for RPL as it operates under homogenous oligopoly but
___________________
consumer durables market falls under differentiated oligopoly
___________________ market structure, so it requires emphasis on differentiation as
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well. Likewise, Apple had always managed to maintain market
___________________
share due to product differentiation.
___________________
Fast moving consumer goods (FMCG) companies, P&G and HLL
___________________
took concepts of consumer demand analysis, namely, consumer
___________________ preferences and market segmentation respectively, to maintain
their dominant position in various product categories. Selection of
product portfolio of P & G is an expression of consumer choice for
quality products. HLL strategy to earn supernormal profits by
catering to rural areas is an economic decision based on selection of
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an expanding market segment. The objective of HLL of being the
largest firm in the industry was achieved by economies of scope
acquired through mergers and acquisitions.
Check Your Progress

Fill in the blanks:
1. Many companies have applied established principles of
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Managerial Economics to improve their .. .

2. The best way to become acquainted with Managerial
Economics is to come face to face with real world
.............................
Summary
Managerial Economics is a discipline that combines economic
theory with managerial practice. It is micro-economic in nature
because it deals with the study of a firm, which is an individual
entity. It encompasses variables, concepts and models that
(c)
constitute micro-economic theory. Mathematical Economics and

Econometrics are utilized to construct and estimate decision
models useful in determining the optimal behavior of a firm. An
analysis of scarcity of resources and choice making poses three
basic questions, i.e., what to produce and how much to produce?
How to produce? For whom to produce? A managerial economist
has to evaluate changes in the macroeconomic indicators like 11
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national income, population, and business cycles, and their likely Notes
impact on the functioning of the firm. He also studies the impact of ___________________
changes in fiscal policy, monetary policy, employment policy and
___________________
the like on the functioning of the firm. The essence of economic
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science is determination of optimal behavior which is subject to ___________________
constraints arising basically due to scarcity of resources. ___________________

Constraints are so pervasive and important that economists use
___________________
the term constrained optimization synonymous to maximization.
___________________
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Lesson End Activity ___________________
Visit an organisation and try to collect the last information ___________________

provided by the managerial economist of that organisation.
___________________
Keywords ___________________
Firm: It is an organization that combines and organizes resources

for the purpose of producing goods and/or services for sale.
Long Run: It refers to a time period sufficient enough to vary all

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inputs used in production of a good or service.
Macroeconomics: It is the study of economy as a whole. It deals

with questions relating to national income, unemployment,
inflation, fiscal policies and monetary policies.
Microeconomics: It is concerned with the study of individuals like

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a consumer, a commodity, a market and a producer.
Opportunity Cost: This is the amount of subjective value foregone

in choosing one alternative over the next best alternative. It is the
cost of sacrificed alternatives.
Scarcity: It can be defined as a condition in which resources are

not available in adequate amount to satisfy all the needs and
wants of a specified group of people.
Short Run Costs: These are the costs incurred on the variable
inputs in the short run.
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Questions for Discussion

1. Define managerial economics with definition.
2. How does managerial economics differ from economics?
3. Write a short note on managerial economist.

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4. Explain the scope of managerial economics.
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Notes
___________________ 5. Explain the role and responsibilities of managerial economist.

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Further Readings
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___________________ Books
___________________
Managerial Economic by Christopher R Thomas, S Charles
___________________ Maurice Special Indian, 8th Ed, Mc-Graw Hill Education.
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___________________ Managerial Economics by Atmanand, 2nd Edition, Excel Books
___________________ Publication
___________________ Managerial Economics by Karampal and Surender Kumar, 1st

Edition. Excel Books Publication.
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Web Readings
en.wikipedia.org/wiki/Managerial_economics
www.swlearning.com/economics/hirschey/managerial.../chap01.pdf
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www.booksites.net/download/davieslam/download.../Chapter1.ppt
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UNIT 2: A Brief Analysis of Utility
Unit 2
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A Brief Analysis of Utility

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___________________
Objectives
___________________
topics: ___________________
\ Meaning of utility ___________________
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\ Total Utility ___________________
\ Marginal Utility
___________________
___________________
Introduction
___________________
Generally, we know that our needs are unlimited and we require or
demand products/commodities to satisfy needs as products which
are of bundle of utilities. In other words, consumers demand a
commodity because they derive or expect to derive utility from that
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commodity. The expected utility from a commodity is the basis of
demand for it.
Meaning of Utility
The term utility is commonly used term, but it has a specific
meaning and use in the analysis of consumer demand or consumer
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behaviour in terms of cardinal analysis. The concept of utility can

be looked upon from two angles: the commodity angle and the
consumers angle. At first sight, utility is the want-satisfying
property of a commodity. And at the other, utility is the
psychological feeling of satisfaction; pleasure, happiness or well-
being which a consumer derives from the consumption, possession
or the use of a commodity. There is a disparity between these two
concepts, which must be kept in mind. The concept of a want-
satisfying property of a commodity is absolute in the sense that
this property is inbuilt in the commodity irrespective of whether
one needs it or not. For instance, a pen has its own utility of
(c)
writing irrespective of whether a person is literate or illiterate.

Another important feature of the absolute concept of utility is that
it is ethical neutral because a commodity may satisfy socially
immoral needs, for example alcohol. Contrary to the consumers
point of view, utility is supposed as a post-consumption
14 phenomenon as one derives satisfaction from a commodity only
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Notes
Activity when one consumes or uses it.
What is the want-satisfying
___________________
property of a commodity?
Utility in terms of satisfaction is a subjective or relative concept
___________________ because (i) a commodity need not be useful for all. For instance,
___________________ cigarettes do not have any utility for non-smokers and meat has no
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utility for pure vegetarians; (ii) utility of a commodity varies from
___________________
person to person and from time to time; and (iii) a commodity need
___________________ not have the same utility for the same consumer at different points
___________________ of times, at different levels of consumption and at different moods
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of a consumer. In consumer analysis, only the subjective concept
___________________
of utility is used.
___________________
In economics, utility is a representation of preferences over some
___________________
set of goods and services. Preferences have a (continuous) utility
___________________ representation so long as they are transitive, complete, and
continuous.
Utility is usually applied by economists in such constructs as
the indifference curve, which plot the combination of commodities
that an individual or a society would accept to maintain a given
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level of satisfaction. Individual utility and social utility can be
construed as the value of a utility function and a social welfare
function respectively. When coupled with production or commodity
constraints, under some assumptions, these functions can be used
to analyze Pareto efficiency, such as illustrated by Edgeworth
boxes in contract curves. Such efficiency is a central concept
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in welfare economics.
In finance, utility is applied to generate an individual's price for
an asset called the indifference price. Utility functions are also
related to risk measures, with the most common example being
the entropic risk measure.
Quantifying Utility
It was recognized that utility could not be measured or observed
directly, so instead economists devised a way to infer underlying
relative utilities from observed choice. These 'revealed preferences',
(c)
as they were named by Paul Samuelson, were revealed e.g. in

people's willingness to pay:
Utility is taken to be correlative to Desire or Want. It has been
already argued that desires cannot be measured directly, but only
indirectly, by the outward phenomena to which they give rise: and
that in those cases with which economics is chiefly concerned the 15
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measure is found in the price which a person is willing to pay for Notes
Activity
the fulfilment or satisfaction of his desire. Who___________________
named utility as revealed
preferences?
For example, suppose a consumer's consumption set is X = ___________________
{nothing, 1 apple,1 orange, 1 apple and 1 orange, 2 apples, 2
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___________________
oranges}, and its utility function is u (nothing) = 0, u (1 apple) = 1,
u (1 orange) = 2, u (1 apple and 1 orange) = 4, u (2 apples) = 2 and ___________________
u (2 oranges) = 3. Then this consumer prefers 1 orange to 1 apple, ___________________

but prefers one of each to 2 oranges. ___________________
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Check Your Progress ___________________
Fill in the blanks: ___________________
1. ...................is a representation of preferences over some ___________________
set of goods and services. ___________________
2. Contrary to the consumers point of view, utility is

supposed as a ................... phenomenon.
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Total Utility
Assuming that utility is measurable and additive, total utility may
be defined as the sum of the utilities derived by a consumer from
the various units of goods and services he consumes. Suppose a
consumer consumes four units of a commodity, X, at a time and
derives utility as u1, u2, u3 and u4. His total utility from commodity
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X (TUx) can be measured as follows.
TUx = u1+u2+u3+u4
If a consumer consumes n number of commodities, his total utility,

TUn, will be the sum of total utilities derived form each commodity.
For example, if the consumed goods are X, Y and Z and their total
respective utilities are Ux, Uy, and Uz, then
TUn = Ux+Uy+Uz
Check Your Progress

Fill in the blanks:
(c)
1. ................... may be defined as the sum of the utilities

derived by a consumer from the various units of goods
and services he consumes.
2. TU is the abbreviation for ....................
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Marginal Utility
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Notes
Activity
How___________________
can MU be expressed? Marginal utility is another most important concept used in
economic analysis. Marginal utility may be defined as the utility
___________________
derived from the marginal unit consumed. It may also be defined
___________________
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as the addition to the total utility resulting from the consumption
___________________ of one additional unit. Marginal Utility (MU) thus refers to the
___________________ change in the Total Utility (DTU) obtained from the consumption
of an additional unit of a commodity. It may be expressed as
___________________
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___________________
MU = DTU/DQ
___________________ Where TU = total utility, and DQ = change in quantity consumed

by one unit.
___________________
___________________ Another way of expressing marginal utility (MU), when the

number of units consumed is n, can be as follows:
MU of nth unit = TUn TUn-1
Check Your Progress

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Fill in the blanks:
1. ................... may be defined as the utility derived from
the marginal unit consumed.
2. MU is the abbreviation for ....................
Summary
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An individual demands commodities due to their utility and utility

is the want-satisfying property of a commodity. In addition, it is
the psychological feeling of satisfaction; pleasure, happiness or well
being which a consumer derives from the consumption, possession
or the use of a commodity. Further, the demand for goods in terms
of quantity is based upon their MU. If the marketers increase MU
in terms of reuse of the product, reduction in price, change in the
design of the product etc.; than they may create the demand for the
same commodities.
(c)
Lesson End Activity

Derive the TU and the MU curve with the help of the explanation
given in this unit.
Keywords 17
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Notes
Marginal Utility: The addition to the total utility resulting from
___________________
the consumption of one additional unit.
___________________
Total Utility: The sum of the utilities derived by a consumer from
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___________________
the various units of goods and services he consumes.
___________________
Utility: Utility is the want-satisfying property of a commodity.
___________________
Questions for Discussion ___________________
UP
___________________
1. What do you mean by utility and the concept of cardinal
utility? ___________________
2. Define the concept of total utility. ___________________
3. What is the meaning of marginal utility? ___________________
4. Explain whether utility is quantifiable. Give reasons.

5. Distinguish between the concepts of TU and MU.
E-
Further Readings
Books
Salvatore, Dominick: Managerial Economics in a Global Economy,
4th ed. (Singapore: South-Western, 2001).
CC
Dornbusch, R., Stanley Fisher and Richard Startz (2001),

Microeconomics, New Delhi: Tata McGraw-Hill.
Petersen, H. Craig and Lewis, W. Cris (2001), Managerial

Economics, Pearson Education Asia, New Delhi-110092.
Koutsoyanis, A, Modern Microeconomics (1979), (Macmillan

Publishing Company, New York).
Boulding, K. E., (1966) Economics Analysis: Microeconomics, Vol. I,

4th ed., (New York, Harper and Row).
Web Readings
en.wikipedia.org/wiki/Marginal_utility
(c)
www.britannica.com/EBchecked/topic/364750/marginal-utility
18
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Notes
___________________
___________________
___________________
E
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
E-
CC
(c)
UNIT 3: Laws of Utility
Unit 3
19
S
Notes
Laws of Utility
___________________
___________________
E
___________________
Objectives
___________________
topics: ___________________
\ Law of diminishing marginal utility ___________________
UP
\ Equi-marginal concept ___________________
\ Law of Equi-marginal utility
___________________
___________________
Introduction
___________________
Economists use the word utility to describe the ability of a good or
service to satisfy some want we possess. A donut has utility if it
can satisfy our hunger; a movie has utility if it satisfies our desire
for entertainment. Economists also recognize that the ability of a
E-
product to satisfy our want or need may diminish the more
frequently it is consumed. The first donut you buy may do a great
job of satisfying your hunger, the second may as well. But the third
may be less satisfying to you, and you may be totally uninterested
in the fourth. The once invaluable donut has lost much of its
seductive appeal. We might call this the law of diminishing
CC
seductive appeal. But economists are a stodgy bunch, so they call

this the law of diminishing marginal utility.
Now given our law of demand, we realize that if the donut vendor
cuts his price, we may recover some interest. At half price, we
might muscle-up for one more 417 calorie chocolate covered
cholesterol enhancing treat. But even at a reduced price, utility
will eventually diminish until prices drop again and then again
and again.
The laws of demand and diminishing marginal utility combine to
produce demand curves that predictably flow downward from left
to right. The actual market price for a good may change, and that
(c)
will trigger a change in the number of units sold, but the

relationship between demand and price will remain constant
prices and demand will shift in sync with one another along the
demand curve.
20
Economists refer to this sliding along the demand curve as
S
Notes
Activity
movement. Movement occurs when changes in the market price for
What does the downward
___________________
sloping MU curve illustrate? a good causes demand to slide up or down the curveor when a
___________________ change in the demand causes prices to slide up or down the curve.
___________________ But economists also recognize the existence of certain factors that
E
___________________ will cause the entire curve to shiftmove either to the left or the
right. Changes in income, consumer tastes or preferences, and in
___________________
the price of substitution goods and complementary goods will
___________________ prompt not just movement along the curve but a shift of the curve
UP
___________________ in one direction or the other.
___________________
___________________
The Law of Diminishing Marginal Utility
___________________ The law of diminishing marginal utility is one of the fundamental
laws of economics. It states, as the quantity consumed of a
commodity increases, the utility derived from each successive unit
decreases, remaining the same consumption of all other
commodities. In simple words, when a person consumes more and
E-
more units of a commodity per unit of time, example, ice cream,
keeping the consumption of all other commodities constant, the
utility which he derives from the successive units of consumption
goes on diminishing. This law applies to all kinds of consumer
goods-durable and non-durable sooner or later. Let us assume that
utility is measurable in quantitative terms and illustrate the law
of diminishing marginal utility. The law of diminishing marginal
CC
utility is illustrated numerically in Table 3.1.
Table 3.1: Total and Marginal Utility Schedules
No. of units Total Utility Marginal Utility

1 30 30
2 50 20
3 60 10
4 65 5
5 60 -5
(c)
6 45 -15
As shown in Table 3.1, with the increase in the number of units

consumed per unit of time, the TU increases but at a diminishing
rate. The diminishing MU is shown in the last column.
21
The rate of increase in TU as the result of increase in the number
S
Notes
of units consumed is shown by the MU curve in Table 3.1. The
___________________
downward sloping MU curve shows that marginal utility goes on
decreasing as consumption increases: After four units ___________________
consumption, the TU reaches its maximum level, the point of
E
___________________
saturation, and MU becomes zero. Beyond this, MU becomes
___________________
negative and TU begins to decline. The downward sloping MU
curve illustrates the law of diminishing marginal utility. ___________________
___________________
Why does the MU Decrease?
UP
___________________
The utility gained from a unit of a commodity depends on the
___________________
intensity of the desire for it. When a person consumes successive
___________________
units of a commodity, his need is satisfied by degrees in the process
of consumption and the intensity of his need goes on decreasing: ___________________
Therefore, the utility obtained from each successive unit goes on
decreasing.
Assumptions: The law of diminishing marginal utility holds only

E-
under certain conditions. These conditions are referred to as the
assumptions of the law. The assumptions of the law of
diminishing marginal utility are: (i) the unit of the consumer good
must be a standard one, such as a cup of tea, a bottle of cold
drink, a pair of shoes or trousers. If the units are excessively
small or large the law may not hold; (ii) the consumers taste or
preference must remain the same during the period of
CC
consumption; (iii) there must be continuity in consumption.

Where a break in continuity is necessary, the time interval
between the consumption of two units must be appropriately
short; and (iv) the mental condition of the consumer must remain
normal during the period of consumption.
Given these conditions, the law of diminishing marginal utility

holds universally. In some cases, such as accumulation of money,
collection of hobby items like stamps, old coins, rare paintings and
books and melodious songs. The marginal utility may initially
increase rather than decrease. But eventually it does decrease. As
(c)
a matter of fact, the law of marginal utility generally operates

universally.
22
Check Your Progress
S
Notes
Activity
What is the ordinal concept of Fill in the blanks:
___________________
utility?
___________________
1. The law of ...................................... is one of the
fundamental laws of economics.
___________________
E
2. In simple words, when a person consumes more and
___________________
more units of a commodity per unit of time, keeping the
___________________ consumption of all other commodities constant, the
___________________ utility which he derives from the successive units of
UP
consumption goes on ....................
___________________
___________________ Cardinal and Ordinal Concepts of Utility

___________________
Utility is a psychological phenomenon. It is a feeling of
___________________ satisfaction, pleasure or happiness. Measurability of utility has,
however, been a controversial issue. The classical economists
Jeremy Bentham, Leon Walrus and Carl Menger and neo-classical
economist, notably Alfred Marshall believed that utility is
cardinally or quantitatively measurable like height, weight, length,
E-
temperature, and air pressure. This belief resulted in the Cardinal
Utility concept. The modern economists J.R. Hicks and R. G. D.
Allen, however, hold the view that utility is not quantitatively
measurable-it is not measurable in absolute terms. Utility can be
expressed only ordinally, relatively or in terms of less than or more
than. It is, therefore, possible to list the goods and services in order
of their preferences or desirability. This is known as the ordinal
CC
concept of utility.
Cardinal Utility
The concept of cardinal utility implies that utility can be assigned
a cardinal number like 1, 2, 3, etc. the Neo-classical economists
built up the theory of consumption on the assumption that utility
is cardinally measurable. They used a term util meaning units of
utility. In their economic analysis, they assumed (i) that one util
equals one unit of money, and (ii) that utility of money remains
constant. It has, however, been realized over time that absolute or
cardinal measurement of utility is not possible. Difficulties in
(c)
measuring utility have proved to be impossible. Neither economists

nor scientists have succeeded in devising a technique or an
instrument for measuring the feeling of satisfaction, that is, utility.
Nor could an appropriate measure of unit be devised. Numerous
factors affect the state of consumers mood, which are impossible to
determine and quantify. Utility is therefore immeasurable in 23
S
cardinal terms. Notes
___________________
Approaches to Consumer Demand Analysis
___________________
There are two approaches to the analysis of consumer behaviour.
E
___________________
1. Cardinal Utility Approach: attributed to Alfred Marshall ___________________
and his followers, is also called the Neo-classical Approach.
___________________
2. Ordinal Utility Approach: pioneered by J. R. Hicks, a Nobel
___________________
UP
laureate and R. G. D. Allen, is also called the Indifference
___________________
Curve Analysis.
___________________
The two approaches are not in conflict with one another. In fact,
___________________
they represent two levels of superiority in the analysis of consumer
behaviour. Both the approaches are important for managerial ___________________
decisions depending on the level of superiority required. It is
important to note in this regard that in spite of tremendous
developments in consumption theory based on ordinal utility, the
classical demand theory based on cardinal utility has retained its
E-
appeal and applicability to the analysis of market behaviour.
Besides, the study of classical demand theory serves as a
foundation for understanding the advanced theories of consumer
behaviour. The study of classical theory of demand is of particular
importance and contributes a great deal in managerial decisions.
In the following sections, we will discuss the theory of consumer

CC
behaviour based on the cardinal utility approach.
Analysis of Consumer Behaviour: Cardinal Utility Approach
The central theme of the consumption theory is the utility

maximizing behaviour of the consumer. The fundamental postulate
of the consumption theory is that all the consumers: individuals
and households aim at utility maximization and all their decisions
and actions as consumers are directed towards utility
maximization. The cardinal utility approach to consumer analysis
makes the following assumptions.
(c)
1. Consumer is rational: It is assumed that the consumer is a

rational being in the sense that he satisfies his wants in the
order of their preference. That is, he or she buys that
commodity first which yields the highest utility and that last
which gives the least utility.
24
2. Limited income: The consumer has a limited income to
S
Notes
spend on the goods and services he or she chooses to consume.
___________________ Limitedness of income, along with utility maximization
___________________ objective makes the choice between goods inevitable.
___________________ 3. Maximisation of satisfaction: Every rational consumer
E
___________________ intends to maximize his/her satisfaction from his/her given
money income.
___________________
___________________ 4. Utility is cardinally measurable: The cardinalists have
UP
assumed that utility is cardinally measurable and that utility
___________________
of one unit of a commodity equals the money which a
___________________ consumer is ready to pay for it or 1 unit = 1 unit of money.
___________________
5. Diminishing marginal utility: It is assumed that the
___________________ utility gained from the successive units of a commodity
consumed decreases as a consumer consumes larger quantity
of the commodity.
6. Constant marginal utility of money: The cardinal utility

E-
approach assumes that marginal utility of money remains
constant whatever the level of a consumers income. This
assumption is necessary to keep the scale of measuring rod of
utility fixed. It is important to recall in this regard that
cardinalists used money as a measure of utility.
7. Utility is additive: Cardinalists assumed not only that

CC
utility is cardinally measurable but also that utility derived

from various goods and services consumed by a consumer can
be added together to obtain the total utility. In other words,
the consumer has a utility function, which may be expressed
as:
U = f(X1, X2, X3, Xn), where X1, X2, X3, Xn denote the total
quantities of the various goods consumed.
Given the utility function, total utility obtained form n items

can be expressed as: Un = U1(X1) + U2(X2) + U3(X3) + ... + Un(Xn)
(c)
It is this utility function, which the consumer aims to

maximize.
Consumers Equilibrium
Conceptually, a consumer is said to have reached his equilibrium
position when he has maximized the level of his satisfaction, given
his resources and other conditions. Technically, a utility- 25
S
maximizing consumer reaches his equilibrium position when Notes
allocation of his expenditure is such that the last penny spent on ___________________
each commodity yields the same utility. How does a consumer
___________________
reach this position? We know from assumptions 2 and 5, that the
consumer has limited income and that the utility, which he derives
E
___________________
from various commodities, is subject to diminishing returns. Some ___________________
commodities yield a higher marginal utility and some lower for the
same number of units consumed. In some cases, MU decreases ___________________
more rapidly than in case of others for the same number of units ___________________
UP
consumed. A rational and utility-maximizing consumer consumes
___________________
commodities in the order of their utilities. He first picks up the
commodity, which yields the highest utility followed by the ___________________
commodity yielding the second highest utility and so on. He ___________________

switches his expenditure from one commodity to the other in
___________________
accordance with their marginal utilities. He continues to switch his
expenditure from one commodity to another till he reaches a stage
where MU of each commodity is the same per unit of expenditure.
This is the state of consumers equilibrium.
E-
1. Consumers Equilibrium: One-Commodity Model: Let us
first illustrate consumers equilibrium in a simple one-
commodity model. Suppose that a consumer with certain
money income consumes only one commodity, X. Since both
his money income and commodity X have utility) for him, he
can either spend his income on commodity X or retain it in the
form of asset. If the marginal utility of commodity X, (MUx), is
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greater than marginal utility of money (MUm) as an asset, a

utility-maximizing consumer will exchange his money income
for the commodity. By assumption, MUx is subject to
diminishing returns (assumption 5), whereas marginal utility
of money (MUm) as an asset remains constant (assumption 6).
Therefore, the consumer will exchange his money income on
commodity X so long as MUx > Px(MUm), Px being the price of
commodity X and MUm = 1 (constant). The utility- maximizing
consumer reaches his equilibrium, i.e., the level of maximum
satisfaction, where
MUx = Px(MUm)
(c)
Alternatively, the consumer reaches equilibrium point where,

MUm = 1
Consumers equilibrium in a single commodity model is

graphically illustrated in Figure 3.1 as follows.
26
S
Notes Y
___________________
___________________
Px
___________________
E
___________________
K MUm
___________________
___________________
MU
&
UP
___________________
Price
___________________
___________________ O Px (MUm )
___________________ Qx
Figure 3.1: Consumers Equilibrium in a Single Commudity Model
The horizontal line Px(MUm) shows the constant utility of

E-
money weighted by the price of commodity X (i.e. Px) and MUx
curve represents the diminishing marginal utility of
commodity X. The Px(MUm) line and MUx curve intersect each
other at point E. Point E indicates that at quantity OQx
consumed, MUx= Px(MUm), Therefore, the consumer is in
equilibrium at point E. At any point beyond E, MUx> Px(MUm).
Therefore, if the consumer exchanges his money for
CC
commodity X, he will increase his total satisfaction because

his gain in terms of MUx is greater than his loss in terms of
MUm, This conditions exists till he reaches point E. And, at
Quantity any point below E, MUx < Px(MUm). Therefore, if he
consumes more than OQx, he loses more utility than he gains.
He is therefore a net loser. The consumer can, therefore,
increase his satisfaction by reducing his consumption. This
means that at any point other than E, consumers total
satisfaction is less than maximum satisfaction. Therefore,
point E is the point of equilibrium.
2. Consumers Equilibrium with Multiple-commodity

(c)
Model or the Law of Equi-marginal Utility: In real life,

however, a consumer consumes multiple numbers of goods
and services. So the question arises: How does a consumer
consuming multiple goods reach his equilibrium? The law of
Equi-marginal utility explains the consumers equilibrium in
a multi-commodity model. This law states that a consumer 27
S
consumes various goods in such quantities that the MU Notes
derived per unit of expenditure on each good is the same. In ___________________
other words, a rational consumer spends his income on
___________________
various goods in such a manner that each rupee spent on each
good yields the same MU. Let us now explain consumers
E
___________________
equilibrium in a multi-commodity model. Here, we will ___________________
consider only a two-commodity case. Suppose that a consumer
consumes only two commodities, X and Y, their prices being ___________________
Px and Py, respectively. Following the equilibrium rule of the ___________________
UP
single commodity case, the consumer will distribute his
___________________
income between commodities X and Y, so that
___________________
Y ___________________
___________________
K e e MUm
E-
MUx MUy
Px Py
MUx MUy
Px Py
O X
CC
X Y
Figure 3.2: Units of X and Y Commodities
Consumers Equilibrium in case of Multiple Commodities

MUx = Px(MUm) and MUy = Py(MUm)
Given these conditions, the consumer is in equilibrium where

MUx/ Px(MUm) =1= MUy/ Py(MUm). ...(2.1)
Since, according to assumption (6), MU of each unit of money (or

each rupee) is constant at I, Equation (2.1) can be rewritten as
(c)
MUx/ Px = MUy/ Py = MUm ... (2.2)
MUx/ MUy = Px/ Py ... (2.3)
Equation (2.2) leads to the conclusion that the consumer reaches

his equilibrium when the marginal utility derived from each rupee
spent on the two commodities X and Y is the same. The two-
28
commodity case can be used to generalize the rule for consumers
S
Notes
Activity equilibrium for a consumer consuming a, large number of goods
How___________________
will a consumer seeking and services with a given income and at different prices.
maximum utility from the Supposing, a consumer consumes A to Z goods and services, his
consumption basket allocate
___________________
the consumption budget on equilibrium condition may be expressed as
goods and services?
___________________
E
MUA / PA = MUB / PB = = MUZ / PZ = MUm ...(2.4)
___________________
Equation (2.4) gives the Law of Equi-marginal Utility.
___________________
It is important to note that, in order to achieve his equilibrium,
___________________
what a utility maximizing consumer intends to equalize is not the
UP
___________________ marginal utility of each commodity he consumes, but the marginal
___________________
utility per unit of his money expenditure on various goods and
services.
___________________
___________________
Check Your Progress
Fill in the blanks:
1. The study of ................... serves as a foundation for
understanding the advanced theories of consumer
behaviour.
E-
2. Every rational consumer intends to ................. his/her
satisfaction from his/her given money income.
The Equi-marginal Concept

The principle of equi-marginalism states that resources should be
allocated or hired in such a way that the ratio of marginal costs of
CC
various uses of a given resource or of various resources in a given

use is the same. For example, such that:
MU/MC1= MU2/MC2=.MUn/MCn
Where,
MU1= marginal utility from good 1, MC1 = marginal cost of good 1,
and so on.
Similarly, a producer seeking maximum profit would use that

technique of production (input-mix), which ensure
MRP1/MC1= MRP2/MC2=.MRPn/MCn
(c)
Where,
MRP1 = maximum revenue product of impact for example, labor,
MC1 = marginal cost of input, and so on.
29
If the preceding equations were not true, utility/profit can be
S
increased by reshuffling resources/inputs. Notes
___________________
For example,
___________________
If MU1/MC1 > MU2/MC2
E
___________________
As a result, the consumer must buy more of goods 1 and less of ___________________
goods 2 to increase utility.
___________________
The essence of Equi-marginal principle is that purchases, ___________________
UP
activities, or productive resources should be allocated so that the
___________________
marginal utilities, benefits, or value-added accruing from each
___________________
purchase, activity or productive resources are identical in all uses.
___________________
Example
___________________
A multi commodity consumer wishes to purchase successive utility
of A, B and C. Each unit cost the same and the consumer is
determined to have combination including all the three items.
However, due to budget constraint, the consumer cannot buy more
E-
than six units in all.
The consumer wants the less of it.
To maximize utility, the consumer will end up with a purchase of

3A + 2B + 1C because that combination satisfies equi-marginalism.
MUa = MUb = MUc = 8

CC
Units Marginal Utilities
Item A Item B Item C
1 10 9 8
2 9 8 7
3 8 7 6
4 7 6 5
5 6 5 4
6 5 4 3
(c)
Often the equi-marginalism concept has to be replaced by equi-

incrementalism. However, the decision rule or optimizing principle
will remain the same.
30
Check Your Progress
S
Notes
Fill in the blanks:
___________________
___________________
1. The principle of ................... states that resources
should be allocated or hired in such a way that the ratio
___________________
E
of marginal costs of various uses of a given resource or
___________________ of various resources in a given use is the same.
___________________ 2. MRP is the abbreviation for ................... maximum
___________________ revenue product.
UP
___________________
___________________
Summary
___________________ The law of diminishing utility explains how increasing supply
means decreasing utility per unit of supply. Initial utility is the
___________________
utility of the first unit; marginal utility, the potential utility of a
unit not possessed; total utility, that of all the units. The law of
diminishing utility applies to money as to other commodities.
E-
Keywords
Cardinal Utility: The concept of cardinal utility implies that
utility can be assigned a cardinal number like 1, 2, 3, etc.
Consumer Equilibrium: A consumer is said to have reached his
equilibrium position when he has maximized the level of his
satisfaction, given his resources and other conditions.
CC
Diminishing Marginal Utility: The quantity consumed of a

commodities.
Rationality: Rational being in the sense that consumer satisfies
his wants in the order of their preference.

1. What do you mean by the concept of cardinal utility?
(c)
2. Define the law of diminishing marginal utility.
3. What is the meaning of consumer equilibrium with reference

to cardinal approach?
4. Define the marginal rate of substitution. What is the law
behind the diminishing marginal rate of substitution?
Further Readings 31
S
Notes
Books ___________________
Salvatore, Dominick: Managerial Economics in a Global Economy, ___________________

4th ed. (Singapore: South-Western, 2001).
E
___________________
Dornbusch, R., Stanley Fisher and Richard Startz (2001),
___________________
Microeconomics, New Delhi : Tata McGraw-Hill.
___________________
Petersen, H. Craig and Lewis, W. Cris (2001), Managerial
Economics, Pearson Education Asia, New Delhi-110092. ___________________
UP
___________________
Koutsoyanis, A, Modern Microeconomics (1979), (Macmillan
Publishing Company, New York). ___________________
Boulding, K. E., (1966) Economics Analysis: Microeconomics, Vol. I, ___________________

4th ed., (New York, Harper and Row).
___________________
Web Readings
en.wikipedia.org/wiki/Marginal_utility
www.britannica.com/EBchecked/topic/364750/marginal-utility
E-
CC
(c)
32
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Notes
___________________
___________________
___________________
E
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
E-
CC
(c)
UNIT 4: Demand Analysis
Unit 4
33
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Notes
Demand Analysis
___________________
___________________
E
___________________
Objectives
___________________
topics: ___________________
\ Demand concepts ___________________
UP
\ Exemplify their use ___________________
\ Demand Function
___________________
\ Factors influencing the demand of a consumer
___________________
___________________
Introduction
Companies across the world acknowledge that consumer demand
plays a significant role in the creation and survival of a firm. In the
initial stage, sufficient demand for a good or service is essential for
E-
setting up of a firm. Later, the success or failure of a business
depends mainly on its ability to generate revenues by satisfying
consumer preferences. Greater the customer satisfaction more will
be the market share and profitability of the firm. As a result, most
companies generally introduce a change in the product-mix and
service-mix with a change in customer requirements and
CC
expectations. Therefore, it can be said that, the customer is the

pivot around whom the modern business revolves.
Concept of Demand
The demand for a good or service refers to the quantity that people
are ready to buy at various prices within some given time period,
other factors held constant. It is always defined with reference to a
price, a particular time, a place and given values of variables.
Demand can also be called as the desire for the product backed by
willingness and ability to pay for it. The desire to own a computer
but inability to pay for it is not regarded as demand. Similarly, the
(c)
desire of a miser to own a car is not demand as he is not willing to

pay for it, despite affordability. And above all there should be a
desire for a good or service. Therefore, a want becomes effective
demand when there is:
z Desire to buy,
34
z Ability to pay, and
S
Notes
Activity
Give an example for demand.
z Willingness to pay.
___________________
___________________ Check Your Progress

___________________ Fill in the blanks:
E
___________________ 1. The demand for a good or service refers to the
.................. that people are ready to buy at various
___________________
prices within some given time period.
___________________
2. Demand can also be called as the .................. for the
UP
___________________
product backed by willingness and ability to pay for it.
___________________
___________________ Demand Function

___________________ There are numerous factors that influence the demand for a
product. Therefore, it is difficult to build an exhaustive list. Major
factors influencing demand are the price of the product (Px),
purchasing power or income of the consumer (Py), preferences and
tastes of consumers (Pt), price of related goods (Pr), promotional
E-
activities (Pa), prime population (Pp) and price expectation (Pe).
Thus, we can say that in general, there are seven P's that influence
the demand for a product. These demand determinants can be
presented in form of a demand function.
A demand function is a comprehensive formulation in an equation

CC
form, which specifies the major factors that influence the demand
for a product. Equation 3.1 is such a function which shows the
factors influencing the demand, say for good x (Dx), per time
period.
Dx = f (Px, Py, Pt, Pr, Pa, Pp, Pe, U) ...(4.1)
U refers to the specific factors that influence the demand for a good
or service. Figure 4.1 depicts general and specific factors
influencing demand.
(c)
35
S
Notes
Activity
List___________________
the major factors
influencing demand.
___________________
E
___________________
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
E-
Figure 4.1: Factors Influencing Consumer Demand
We will discuss the major factors that influence demand for a good
or service.
1. Price of the Product: Other factors remaining constant, the

demand or sale of a product is inversely related to its price
(own price of the good or service). It implies that, when the
CC
price rises, the quantity demanded or sold decreases and when

the price falls, the quantity demanded or sold increases.
2. Purchasing Power (Income) of the Consumer: The

quantity demanded usually increases with an increase in
income or purchasing power of the consumer. This is so in
case of normal or superior goods like refrigerators, education
and housing. However, there are some goods and services
which are consumed less with an increase in income. These
goods are known as inferior goods, like bajra, hamburgers and
potatoes. The consumer decreases their consumption since he
can now afford to purchase goods of better quality. A
(c)
knowledge of relation of the good produced by the firm to the

income of the consumer helps in estimation of current and
future demand.
3. Preferences and Tastes of the Consumer: Goods and

services in fashion have more demand than goods that are out
36
of fashion. Consumer may purchase a good which is popular
S
Notes and discard the old one. Like in many homes, interiors are
___________________ changed with a change in fashion trends. Various trends in
the past two decades have supported growth in demand for
___________________
new foods (low calorie food, fast food and diet food), new
___________________ electronic products (computer, CDs and Laptops) and new
E
___________________ recreation services (video parlours, bowling alleys and bungee
jumping).
___________________
___________________
Socio-cultural factors like customs and religious practices
determine the preferences and tastes of the consumer. For
UP
___________________
instance, in India, demand for non-vegetarian food decreases
___________________ during Navratras.
___________________ 4. Price of Related Goods: When goods are substitutes, a fall
___________________ in price of one leads to a fall in quantity demanded of its
substitutes and vice versa. For example, ink pen and ball pen
and different brands of a good (like various brands of soaps
and cars). Curve Ds in Figure 4.2 shows that a significant
increase in price of Zen may lead to an increase in demand of
E-
Santro.
Complementary goods are often consumed simultaneously, for

example, tea and sugar and car and petrol. A pair of goods is
complementary if an increase in price of one leads to a
decrease in demand for the other. Other things remaining
constant a fall in price of cars will increase the demand for
petrol. Curve Dc in Figure 4.2 shows this relationship.
CC
Substitute Goods Complementary goods
DS
Price of Price
Zen of cars
DC
O O
Demand for Santro Demand for petrol
Figure 4.2: Price of Related Goods and Demand

(c)
5. Promotional Activities: Advertising and promotional

campaigns have a profound impact on consumer tastes and
preferences. It has been observed that demand for a good
increase with an increase in after sales service, pre sales
service, demonstrations, advertisements and other related
activities.
37
S
6. Prime Population: The segment of population which Notes
consumes a particular good or service is called as prime
___________________
population. A growth in the prime group has a favorable
___________________
influence on demand. But demographic changes affect demand
over a long period of time.
E
___________________
___________________
7. Price Expectation: Future expectations of an increase
(decrease) in the price of a good or service may cause current ___________________
demand to increase (decrease). In markets for financial ___________________
UP
instruments (example stocks, shares, bonds, treasury bills
___________________
etc.) as well as agricultural commodities and precious metals,
___________________
expectation of future price changes influences the market
demand. ___________________
___________________
Other or specific factors like credit facilities, seasonal changes
and changes in macroeconomic policies also have a significant
effect on the demand of a product. In case of durable goods,
factors like availability of credit facilities, after sales service,
E-
brand loyalty and product features play a crucial role in
determining demand.
Check Your Progress

Fill in the blanks:
1. The demand function is ....................
CC
2. The segment of population which consumes a particular

good or service is called ....................
Summary
Demand shows what customers are willing and able to purchase at
each and every price, not only what they want to buy. A movement
along a demand curve occurs when there is a change in the price,
all other things being unchanged. A shift in the demand curve
occurs when more or less is demanded at each and every price. A
demand curve is usually downward-sloping, but in some cases
(c)
(such as a Veblen or Giffen good), it can be upward-sloping. The

marginal utility shows the extra utility from consuming a unit; the
total utility shows the total satisfaction that a consumer has from
consuming a product. The marginal utility from consuming a
product declines when additional units are consumed.
38
Lesson End Activity
S
Notes
A demand curve can be derived using indifference curve analysis.
___________________
This analyses the impact of a change in price and income in terms
___________________ of consumers utility. To find out more about indifference curve
___________________ analysis and how a consumer maximizes utility, visit the Online
E
___________________
Resource Centre.
___________________ Visit the Online Resource Centre at

http://www.oxfordtextbooks.co.uk/orc/gillespie_econ2e/
___________________
UP
___________________
Keywords
___________________
Complementary goods: These are goods that are often consumed
___________________
simultaneously.
___________________
Demand: Demand is the desire for the product backed by
willingness and ability to pay for it.
Demand Function: A demand function is a comprehensive
formulation in an equation form, which specifies the major factors
E-
that influence the demand for a product.
Socio-cultural factors: These are factors like customs and
religious practices determine the preferences and tastes of the
consumer.
Substitutes goods: These are goods which can replace the
demand for each other.
CC

1. Define demand.
2. Explain the concept of Demand Function.
3. Does the quantity demanded always fall if the price increases?
4. To what extent do you think a business can control the

demand for its products?
(c)
Further Readings
Books
Managerial Economics by Christopher R Thomas, S Charles
Maurice Special Indian, 8th Ed, McGraw Hill Education.
39
Managerial Economics by Atmanand, 2nd Edition, Excel Books
S
Notes
Publication
___________________
Managerial Economics by Karampal and Surender Kumar, 1st
Edition. Excel Books Publication. ___________________
E
___________________
Web Readings
___________________
www.adb.org/documents/handbooks/water_supply.../Chap3-r6.PDF ___________________
nptel.iitm.ac.in/courses/Webcoursecontents/IIT...e/.../2slide.html ___________________
UP
www.nvc.vt.edu/abon/micro_analysis.ppt ___________________
___________________
___________________
___________________
E-
CC
(c)
40
S
Notes
___________________
___________________
___________________
E
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
E-
CC
(c)
UNIT 5: Case Studies
Unit 5
41
S
Notes
Case Studies
___________________
___________________
E
___________________
Objectives
___________________
After analyzing these cases, the student will have an appreciation of the
concept of topics studied in this Block. ___________________
___________________
UP
___________________
Case Study 1: Coke Bottles Losses in India with a $400 Million
Asset ___________________
That Coke was taking a hit in India was known, but to what ___________________
extent wasn't. Now it is and it's stunning. Coca-Cola Co's chief
___________________
financial officer, Gary Fayard told analysts in New York on
Tuesday that the company was writing off $ 400 million of its
assets in India in the first quarter of 2000. In other words,
virtually half the investment made by the beverages giant in
India has turned to ashes.
E-
This huge dent in its Indian assets, the company clarified, didn't
in any way alter Coca-Cola's commitment to India. "We remain
just as committed," said a company spokesman here, while
declining to comment any further. He wouldn't be drawn into a
discussion on the implications of the write off on Coke's future
plans here or on whether this would lead to changes in the
CC
management structure.
The cat was out of the bag on January 26. When Coke filed its
1999 fourth quarter results with the US Securities & Exchange
Commission on that day, it had admitted to a 21 per cent dent in
its bottom line and a $ 45 million loss in that quarter.
It had admitted to more: "The reason for this is the company's

investments in Japan and India." It had also said that it would
carry out a comprehensive re-evaluation of its assets in India.
The job, therefore, was cut out for its new worldwide boss.
Douglas Daft and his new Indian lieutenant Alex von Behr. And it
was obvious that it wouldn't be a pleasant one. The magnitude of
(c)
the writing down of its assets makes it appear that the Coke brass
has chosen to make a clean breast of the Indian mess and restart
it with a clean slate.
But why had the mess piled up in the first place. While Coke
India itself is not communicative about it, piecing together
Contd.
42 available information makes it appear that the large losses were
S
Notes mainly due to three reasons - the huge expenses Coke incurred in
buying out bottlers, its lavish market discounting schemes and its
___________________
expensive advertising campaigns.
___________________
Coke is estimated to have paid off its bottlers about ` 1,500 crores
___________________ for a smooth acquisition process, which apart from giving the
E
___________________ company an integrating bottling network, hasn't really given
commensurate returns. On top of that, there have been high
___________________
discounting scheme expenses as well as the expenses to acquire
___________________ key accounts (restaurants, five-star hotels, movie theatres) as
UP
well as costly ad campaigns (it's said that it has signed on current
___________________
Bollywood sensation Hrithik Roshan for more than ` 5 crore).
___________________
The runaway expenses in India is said to have been worrying
___________________ Atalanta for a while.
___________________ Coke's former boss, Doug Ivestor, had come to India in August
1999 to see things for himself. Prior to that, an audit team from
the headquarters had visited the local HQ in Gurgaon and said to
have found the expenses high indeed. Thereafter, there has been
a change in local management structure and cost control
E-
measures were initiated.
Now, the impact of the write off could be two fold. One: Coca-Cola
India now gets to start afresh. And two: the big brother in
Atalanta is likely to keep a close eye on future expenses which
might reduce the operating freedom of the local management.
Questions
CC
1. Analyze the case. Comment on the nature of 'economic

problem' and 'choice of strategy'.
2. Analyze the market environment of Coca-Cola in India today.

Comment on the observation, "AD war is a mad war; it is just
a zero-sum game at the end."
Source: The Economic Times, April 5, 2000
(c)
Case Study 2: Eco-friendly Business 43
S
The financial dealings of a company may be private concern but Notes
its environment record is a matter of public concern. Civic society ___________________
has every right to know and pressurize private companies and
___________________
industries to adopt a more environment friendly approach to
business.
E
___________________
This view prompted the Centre for Science and Environment to ___________________
rate Indian companies on the basis of how environmental friendly
___________________
they are, and inform and create an image in the public about their
environment concerns - their social obligation towards the public. ___________________
UP
The rating, first of its kind in India, has been supported by the ___________________
United Nation Development Programme and the Ministry of ___________________
Environment and Forests. One of the first industries to be rated
___________________
by the centre are the paper and pulp industries which are
considered highly polluting. The next most highly polluting ___________________
industries are the automobile industries.
J K Paper Mills has been rated as the most environments friendly

among the 28 industries with a minimum production capacity of
more than 100 tonnes a day. The next best was Andhra Pradesh
E-
Paper Mills Limited. Though Sinar Mas Pulp and Paper (India)
Limited is also green thinking, it could not be given a rating as it
was not in operation for the entire period of three years in which
the performance of the mills were reviewed.
Sadly, even the J K Paper Mills failed to score 50 per cent of the
marks on the evaluation scale and could manage only 42.75 per
CC
cent. The companies were rated on a scale of 100 and the

parameters included corporate environment policy and
management systems, plant-level environmental performance and
the public perceptions of the mill's environmental responsibility,
including that of local community.
Industrialization is always accompanied by the problems of

pollution. The whole world has gone through this phase.
Industrial revolution in England barely left the Thames of
London a river. People in Tokyo (Japan) would carry Oxygen
cylinder with them on roads.
"Economic development is a must for tackling the mass poverty

but at the same time it must be sustainable, especially for the
(c)
masses who are living on the edge," said Dr Manmohan Singh,

former Union minister formally releasing the ratings. Manmohan
Singh, also the head of the project advisory panel of the green
rating project added that initiative for effective environment
management however must invariably come from the industries
Contd.
44 themselves. "We need capitalist to be concerned about masses and
S
Notes pollution. Self regulation is the best regulation," he added.
___________________ "Government and various pollution controlling bodies are there to
lay norms for industries to check pollution, but this is not enough.
___________________
The CSE director, Mr. Anil Agarwal said, "No amount of
___________________ governmental regulation will suffice. The government can only set
E
___________________ the minimum guidelines to be followed, failure of which will make
it illegal. But it is for the industries to take initiative and move
___________________
further."
___________________
Mr. H P Singhania, deputy managing director of J K Corps said
UP
___________________ that the industrialists are as concerned as the environmentalist
but there are too many problems. "We in India use all kinds of
___________________
raw material from bamboo to bagasse to grass. But things are
___________________ changing. We now talk of forests as sustainable forest and
___________________ renewable forest. The industry needs an agenda to change
concerning all factors like availability, cost factors and feasibility.
I believe this rating will help in providing the same."
According to a CSE report, the industry is leagued by resource

use inefficiency, improper sourcing of raw material, outdated
E-
technology and a highly wasteful and polluting production
process.
The CSE was highly critical about the use of chlorine as the
bleaching agent and the amount of water used and wasted by the
Indian Industries. "Many mills in India use 250 to 300 tonne of
water as opposed to 25 tonnes in the industrialized countries.
Cheap availability of water is the main reason for such trend.
CC
Water should be made available at a costlier rate, while the

industries too should look for alternatives like harvesting rain
water and recycling effluents," said Agarwal.
Questions
1. What do you mean by 'Eco-friendly Business'?
2. Explain the economics of such Business.
3. Relate your discussion to "Social and Moral Responsibilities of

Business" in India today.
(c)
UNIT 6: Law of Demand
45
S
Notes
___________________
___________________
E
___________________
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
BLOCK-II
E-
CC
(c)
46
S
Notes
UNIT 6: LAW OF DEMAND
___________________ UNIT 8: DEMAND FORECASTING CONCEPT
AND SURVEY METHODS
z Introduction
___________________ z Introduction
z Concept of Law of Demand
___________________ z Significance of Demand Forecasting
E
z Exceptions to the Law of Demand
___________________ z Methods of Demand Forecasting
z Movements and Shifts in Demand
___________________
UNIT 9: STATISTICAL METHODS OF DEMAND
UNIT 7: ELASTICITY OF DEMAND FORECASTING
___________________
UP
z Introduction z Introduction
___________________
z Determinants of Price Elasticity z Statistical Methods of Demand Forecasting
___________________
z Price Elasticity of Demand (Ep)
UNIT 10: CASE STUDIES
z
___________________
Income Elasticity of Demand (Ei)
z ___________________
Cross Elasticity of Demand (Exy)
z Advertisement Elasticity of Demand (EA)

E-
CC
(c)
Unit 6
47
S
Notes
Law of Demand
___________________
___________________
E
___________________
Objectives
___________________
topics: ___________________
\ Concept of law of demand ___________________
UP
\ Exceptions to the law of demand ___________________
\ Movement and Shifts in Demand
___________________
___________________
Introduction
___________________
It has been observed that the so-called 'customer power' has
increased considerably with economic liberalization (1980s and
1990s) and customer protection laws. For this reason, the focus of
the companies nowadays seems to be on building 'customer share
E-
rather than market share'. In this context, analysis of consumer
demand commands greater relevance. Such knowledge also helps
in making pricing decisions, forecast sales and formulate
marketing strategies.
The degree of change in demand cannot be assessed by demand
curves and demand schedules. Therefore, in this unit we will
CC
introduce the concept of elasticity that studies the magnitude of

change in demand. Another important topic covered in this unit is
demand forecasting. Predicting future events can solve real world
problems of risk and uncertainty. Different forecasting techniques
can be applied for short-term and long-term predictions.
Concept of Law of Demand

The law of demand states that, other factors held constant, as price
of a good or service increases, its quantity demanded by consumer's
decreases. The law shows that there is an inverse relation between
price and quantity demanded. Managers should be aware that the
(c)
law indicates that a price change will have an impact on a firms'

sales volume and total volume and thus, its profitability. It should
be noted that the law is applicable when other factors influencing
demand are taken as constant and only price is changed. The law
48
can be depicted in the form of a demand schedule and demand
S
Notes
Activity curve.
State the law of demand.
___________________
The demand schedule for a good is a table that shows the total
___________________ quantity of a good that will be purchased at various prices.
___________________ Suppose there are two buyers for computers in the market, namely
E
___________________
buyer X and buyer Y.
Table 6.1: Demand Schedule for PC's
___________________
Price (` ooo) Buyer X Buyer Y Market Demand
___________________
50 100 80 180
UP
___________________
40 150 120 270
___________________ 30 200 170 370
___________________ 20 350 250 600

10 600 350 950
___________________
The demand by buyer X and buyer Y are individual demands.
Total demand by the two is market demand. Thus, the total
market demand can be derived by adding the quantity of a good
demanded by all buyers, at various price. Table 6.1 shows that the
E-
market demand for computers is 950 per year at ` 10,000 and 600
computers will be demanded at ` 20,000, and so on.
A demand curve is a graphical depiction of price-quantity

relationships. In Figure 6.1, Dx and Dy are individual demand
curves and Dm is the market demand curve which is derived by
horizontal summation of individual demand curves. Each point on
CC
the demand curve shows a unique combination of price and

quantity. It can be observed from Figure 6.1 that the demand curve
slopes downwards to the right. Now the question that arises is:
z Why does the demand curve slope downwards to the right? Or
z Why does the law of demand operate?

(c)
Figure 6.1: Demand Curve for PC's

The law can be explained in terms of substitution and income 49
S
effect. When the price of a good falls (prices of related goods Notes
Activity
remaining constant), it becomes relatively cheaper than other List___________________
the cases where the
goods. For instance, the quantity purchase of relatively more exceptions to law of demand
apply.
___________________
oranges, when the price of apples increases is due to substitution
effect. Therefore, substitution effect is due to consumers' inherent
E
___________________
tendency to substitute cheaper goods for the relatively expensive ___________________
ones. Income effect arises with an increase in the purchasing
power of the consumer due to a decrease in the price of the good. ___________________
That is, at lower prices the individual can buy same bundle of ___________________
UP
goods with lesser money or he can buy more of the same good with
___________________
the same money. The change in the purchasing power of the
consumer due to a price change is called income effect. ___________________
___________________
Check Your Progress
___________________
Fill in the blanks:
1. The ................... states that, other factors held constant,
as price of a good or service increases, its quantity
demanded by consumer's decreases.
E-
2. The ................... for a good is a table that shows the
total quantity of a good that will be purchased at
various price.
Exceptions to the Law of Demand

CC
The law of demand is not applicable in certain cases:
(a) The law of demand is violated in case of Veblen or conspicuous

goods. Some goods are purchased for snob appeal, ostentation
and prestige value. As a result higher their price, the greater
is their demand. Diamonds, antique pieces and rare paintings
are purchased more at a high price due to an increase in the
prestige value attached to them.
(b) Giffen goods or inferior goods are another category of goods

that depict direct price - demand relationship. A Giffen good is
an inferior commodity, much cheaper than its superior
substitutes, consumed by poor households as an essential
(c)
commodity. An increase in the price of such good increases its

demand. Inferior quality rice, bajra and potatoes fall in this
category.
(c) The law of demand does not apply in case of speculation.

Consumers tend to purchase more at a high price expecting
50
the prices to rise in future. This is usually due to sudden
S
Notes
Activity scarcity of goods especially in case of necessities and shares in
Define the movement along
___________________ stock market.
the demand curve.
E
___________________
1. ................... are purchased for snob appeal, ostentation
___________________ and prestige value.
___________________ 2. ................... is an inferior commodity, much cheaper
UP
___________________ than its superior substitutes, consumed by poor
households as an essential commodity.
___________________
___________________ Movements and Shifts in Demand

___________________
Change in quantity demanded due to a change in price is called as
a movement along a demand curve. It measures the effect of a
change in price while other factors influencing demand are taken
as constant. In Figure 6.2(a) a decrease in price from P to P2 leads
to an expansion of quantity demanded from Q to Q2 and an
E-
increase in price to P1 results in contraction of demand to Q1.
Price Price
(a) (b)
E1
P1
P
E2 P D1
CC
P2 D
D
O O D2
Q1 Q Q2 Quantity Q2 Q Q1 Quantity
Figure 6.2: Movements and Shifts in Demand
Changes in non-price determinants (price remaining constant)

result in changes in demand, that is, shift in the demand. In the
Figure 6.2 (b) the demand curve shifts to the right from D to D1
with an increase in demand. An increase in income, rise in price of
substitutes, increase in population, decrease in price of
complements, change in tastes in favour of a good, and advertising,
(c)
increase the demand of a good. Leftward shift in the demand curve

from D to D2 indicates a decrease in demand. This is due to a
decrease in income, a fall in price of substitutes, decrease in prime
population, a rise in price of complements and change in tastes
against the good.
51
A comparison between the two concepts is done in Figure 6.3. The
S
Notes
increase in quantity demanded from OQ to OQ1 can be attributed
to (a) a decrease in price from P to P1 along the demand curve D1 ___________________
and (b) an increase in demand due to a shift in demand from D1 to ___________________

D2. In the second case, the price is constant at P while other factors
E
___________________
like increase in income, increase in prime population etc., lead to
___________________
an upward shift in demand curve.
___________________
Price
___________________
UP
___________________
L
___________________
P N
D3 ___________________
P1 M
D2 ___________________
O D1
Q Q1
Quantity
Figure 6.3: Comparison between Movement and

E-
Shift in Demand
In the former case, demand expands by partly foregoing some

amount of revenue (since TR = P Q). On the other hand, shift in
demand leads only to an increase in revenue. But it should be
noted that, increase in demand due to advertising and sales
promotion techniques is possible only with additional cost.
CC
Managers should try to increase demand with the latter method by

taking additional cost into account.
Check Your Progress

Fill in the blanks:
1. Change in quantity demanded due to a change in price
is called as a ....................
2. Changes in non-price determinants (price remaining
constant) result in changes in demand, that is,
....................
(c)
Summary
A desire for goods or services become effective demand when there
is a desire to buy, ability to pay and willingness to pay. There are
various factors influencing the demand for the product for example
52 price of the product, income of the consumer, preference and tastes
S
Notes of consumers, price of related goods etc. The Law of Demand states
___________________ keeping other factors constant, the quantity demanded for a
product increases with decrease in the price and vice versa.
___________________
___________________
E
Keywords
___________________
___________________ Advertisement: Advertisement or promotional elasticity of

demand is the ratio of percentage change in quantity demanded to
___________________
a percentage change in advertisement outlay.
UP
___________________
Autonomous Demand: It is not linked to demand of any other
___________________
product. It is independent of demand of any other good.
___________________
Demand curve: It is a graphical depiction of price-quantity
___________________ relationships.
Giffen goods or inferior goods: These are an inferior commodity,

much cheaper than its superior substitutes, consumed by poor
E-
Movement along a demand curve: It is the change in quantity
demanded due to a change in price.
Shift in the demand: It is the changes in non-price determinants
(price remaining constant) result in changes in demand.
Veblen or conspicuous goods: These goods are purchased for

snob appeal, ostentation and prestige value.
CC
1. State and illustrate the law of demand with examples.
2. What are the exceptional points in case of Law of Demand?
3. Does a demand curve show what a consumer would like to buy

at each and every price?
4. What is the difference between a movement along, and a shift

in, a demand curve?
(c)
5. Does an increase in income always shift the demand curve to

the right? Explain your answer.
Further Readings 53
S
Notes
Books ___________________
Managerial Economics by Christopher R Thomas, S Charles ___________________

Maurice Special Indian, 8th Ed, McGraw Hill Education.
E
___________________
Managerial Economics by Atmanand, 2nd Edition, Excel Books ___________________

Publication
___________________
___________________
UP
___________________
Web Readings ___________________
www.adb.org/documents/handbooks/water_supply.../Chap3-r6.PDF ___________________
nptel.iitm.ac.in/courses/Webcoursecontents/IIT...e/.../2slide.html ___________________
www.nvc.vt.edu/abon/micro_analysis.ppt
E-
CC
(c)
54
S
Notes
___________________
___________________
___________________
E
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
E-
CC
(c)
UNIT 7: Elasticity of Demand
Unit 7
55
S
Notes
Elasticity of Demand
___________________
___________________
E
___________________
Objectives
___________________
topics: ___________________
\ Concept of elasticity of demand ___________________
UP
\ Price elasticity of demand ___________________
\ Income elasticity of demand
___________________
\ Cross-elasticity of demand
___________________
___________________
Introduction
Elasticity of demand is the responsiveness of the quantity
demanded of a good or service to a change in any one variable
influencing demand. As such there is a specific type of elasticity for
E-
a single determinant of demand. We will discuss about price,
income, cross, and promotional elasticities of demand. Various
pricing decisions and policy decisions are dependent on these
demand elasticities.
Determinants of Price Elasticity

CC
Let us look into the reasons for the demand for some goods being
elastic and others inelastic. The main factors governing the
magnitude of price elasticity are discussed here.
1. Closeness of Substitutes: The price elasticity for a product is

high if it has numerous close substitutes. Increase in the price
of the product results in consumers buying close substitutes.
Hence the price elasticity of demand for a particular brand of
product is higher than the product as a whole. It is for this
reason that the demand curve faced by a firm is more elastic
than the one faced by the corresponding industry. For
(c)
instance, the demand for cold drinks is inelastic but the

demand for Coke is elastic.
2. Nature of the Good: In general, luxury goods are price

elastic and necessities are price inelastic. Demand for PCs is
more responsive to change in price while demand for wheat
56
has low elasticity, since it is an essential commodity. But the
S
Notes
Activity luxury/necessity dichotomy is ambiguous. This is so because
List___________________
the determinants of price one person's luxury is another person's necessity. For
elasticity.
example, demand for premium end automobiles may be
___________________
elastic, but a high price of Mercedes may not affect demand
___________________ for consumers who regard it as a necessity.
E
___________________
3. Proportion of Income Spent: The greater the income spent
___________________ on a good the greater the elasticity of demand, and vice versa.
___________________
Demand for common salt, matches, and buttons may be highly
inelastic because a typical consumer spends a very small
UP
___________________
fraction of his income on such goods. In contrast, demand for
___________________ goods like TV and clothing tends to be elastic, as they
constitute a major proportion of consumers' budget.
___________________

Fill in the blanks:
1. ................... in the price of the product results in
consumers buying close substitutes.
E-
2. In general, luxury goods are price elastic and
necessities are price ....................
Price Elasticity of Demand (Ep)

The price elasticity of demand is the ratio of a percentage change
in quantity demanded and the percentage in price, other factors
CC
remaining constant. It measures the responsiveness of sales of a

good to changes in its price. It can be written as:
Percentage change in quantity demanded
Ep =
Percentage change in price
/Q
=
P/P
Q P
=
P Q
Where Q and P refer respectively to incremental change in

quantity and change in price. Q and P depict original quantity
(c)
and price. It should be noted that refers to absolute change while

Q/Q is a percentage change.
Suppose a 1% reduction in price is followed by a 1.3% increase in

quantity demanded then the price elasticity is 1.3. An elasticity of
2 is greater than an elasticity of -1 even though algebraically, the
opposite may be true. The elasticity is given a positive sign despite 57
S
inverse relation between price and quantity demanded to make Notes
Activity
analysis simple. Give the formula for income
___________________
elasticity of demand.
Fill in the blanks:
E
___________________
1. ................... measures the responsiveness of sales of a ___________________

good to changes in its price. ___________________
2. The elasticity is given a ................... sign despite ___________________
UP
inverse relation between price and quantity demanded ___________________
to make analysis simple.
___________________
Income Elasticity of Demand (Ei) ___________________
___________________
Income elasticity is the ratio of a percentage change in the
quantity demanded to a percentage in income, other factors
remaining constant. The point income elasticity of demand is
Q / Q Q I
Ei = =
E-
I/ I I Q
Where Q and I refer to change in quantity and change in income

respectively. Note that Ei measures the shift in the demand curve
at each price level.
To determine the arc income elasticity of demand we use the

average of the original and new incomes and quantities.
CC
Ei =
Q

b g
I2 + I 1 / 2 Q Q1 I 2 + I1
= 2
b
I Q 2 + Q 1 / 2 g I 2 I1 Q 2 + Q 1
Where, the subscripts 1 and 2 refer to the original and the new
levels of income and quantity respectively, or vice versa.
Income Elasticity can be Positive or Negative

It is positive (Ei > 0) for normal or superior goods. An increase in
income leads to an increase in consumption. Inferior goods have
negative (Ei < 0) income elasticity. Different types of goods have
varying positive income elasticities.
(c)
1. Necessities have low income elasticity (Ei < 1). A change in

sales of goods, like wheat and sugar, is likely to be less, to a
proportionate change in income.
58
2. Luxuries have more than proportionate change in sales with a
S
Notes
Activity
change in income (Ei >1). Demand for cars and TV increases
Give___________________
the formula for the cross
elasticity of demand. more than proportionately with an increase in income. It
___________________ means that their demand is highly cyclical or sensitive to
___________________ income.
E
___________________ Uses of Income Elasticity
___________________
(i) Income elasticity for a firm is useful in estimation and
___________________ prediction of demand in the long run. Firms making products
UP
___________________ with high income elasticities are likely to grow rapidly as
incomes rise in an expanding economy and products with low
___________________
income elasticities are likely to experience modest expansion.
___________________ Suppose the elasticity for automobiles is 3, it means that a 1%
___________________ increase in disposable income will lead to a 3% increase in
quantity demanded.
(ii) Income elasticity is also useful in identifying the market for
the product on the basis of the type of product the consumers
are likely to purchase more with an increase in income.
E-
(iii) Income elasticity is helpful in forecasting change in demand
for the good a firm sells in different economic conditions. The
demand for a good with low income elasticity will not fluctuate
much with a recession or boom. But the demand for luxuries
will rise with boom and fall sharply during recession.
CC
Check Your Progress

Fill in the blanks:
1. ................... for a firm is useful in estimation and
prediction of demand in the long run.
2. The demand for a good with ................... income
elasticity will not fluctuate much with a recession or
boom.
Cross Elasticity of Demand (Exy)

(c)
The cross elasticity of demand measures the responsiveness of

demand for good X to a change in price of good Y. It is the ratio of a
percentage change in the demand for good X to a percentage
change in price of good Y, other factors remaining constant. Point
cross elasticity is given by
59
Qx / Qx Qx Py
S
Exy = = Notes
Py / Py Py Qx
___________________
Where Qx and Py refer respectively to the change in quantity
___________________
demanded of good X to a change in the price of good Y.
E
___________________
Arc cross price elasticity of demand is measured with the following
formula: ___________________
Exy =
b
Qx Py 2 + Py 1
=
g
Qx 2 Qx 1 Py 2 + Py 1

___________________
b
Py Qx 2 + Qx 1 g
Py 2 Py 1 Qx 2 + Qx 1 ___________________
UP
___________________
Where subscripts 1 and 2 refer to the original and to the new levels
of income and quantity, respectively, or vice versa. ___________________
The elasticity coefficients give significant results about the type of ___________________
goods. ___________________
(a) If value of Exy is positive the two goods are substitutes (like
Coca cola and Pepsi), because an increase in price of Y (Py)
leads to an increase in quantity of X (Qx) as X is substituted
for Y in consumption.
E-
(b) If Exy is negative, goods X and Y are complementary (like
petrol and cars), because an increase in Py leads to a
reduction in Qx and Qy.
(c) If Exy is zero or close to zero then the two goods are totally
unrelated or independent goods (like books and beer).
CC
The concept is used to anticipate the effect on the sales of a firm to

a change in price of their rivals. For example, the MUL can
measure the effect of a change in the prices of Santro or Matiz on
the demand for Zen.
Uses of Elasticity of Demand for Managerial Decision Making
The analysis of variables that affects demand and numerical

estimates of these variables are essential for the firm to make the
best operating decision and to make plan for its growth. The firm
needs these elasticity estimates in order to determine the
operational policies and the most effective way to respond to the
(c)
policies of competing firms. For taking decisions on a pricing

policy, the businessman has to know the likely effects of price
changes on the demand for his product in the market. It is also
important to know the extent to which a change in the unit price
will affect the demand for the product. He can calculate the
60
increase in the demand for the product and to what extent, if the
S
Notes
prices are lowered and whether it will result in substantial
___________________ increase in the revenue and profit. In the case of elastic demand,
___________________
the total revenue will decrease with the rise in the price, whereas,
in the case of inelastic demand the total revenue will increase with
___________________
the rise the price. If the firm estimated that cross elasticity of
E
___________________ demand for its product with respect to the price of competitor's
___________________
product is very high. It will respond very quickly to the competitor
price reduction, otherwise, the firm would lose a great deal of its
___________________
sale. However the firm would think twice before lowering its price
UP
___________________ for fear of starting a price war. It is important for managers to
___________________
understand the price elasticity of their products and services in
order to set prices appropriately to maximize firm profits and
___________________
revenues.
___________________
Measurement of Elasticity of Demand
There are two approaches of computing elasticity. The choice

between the two depends on the available data and intended use.
E-
(a) Arc elasticity: Arc elasticities are appropriate for analyzing
the effect of discrete, i.e. measurable, changes on price. For
example, a price increases from ` 2 to ` 4 could be evaluated
by computing the arc elasticity. In actual practice, most
elasticity computations involve the arc method. Arc elasticity
measures the incremental changes between two points on a
demand curve. To avoid ambiguity in elasticity coefficients,
CC
arising due to choice of price and quantity, averages of the

original and new quantity and price are used.
Ep =
Q
. 2
b g
P + P1 / 2
b g
P Q 2 + Q 1 / 2
Q Q 1 P2 + P1
= 2 .
P2 P1 Q 2 + Q 1
were subscripts 1 and 2 refer to the original and to the new

values respectively.
(b) Point elasticity: It refers to measurement of elasticity on a

point on a demand curve. Point elasticity helps in measuring
(c)
elasticity where change in price and quantity is

infinitesimally small. As marginal analysis works by
evaluating small changes taken with respect to an initial
decision, it is often useful to measure elasticity w.r.t.
infinitesimally small changes in price. In this case we write 61
S
elasticity as Notes
dQ/Q ___________________
Ep =
dP/P
dQ P ___________________
= .
dP Q
E
___________________
Where dQ/dP is the derivative of quantity w.r.t. price at a ___________________

point on a demand curve and P and Q are the price and ___________________
quantity at that point.
___________________
UP
To measure the point elasticity on a non-linear demand curve, we ___________________
first draw a tangent through the point. For example, to measure
___________________
point elasticity at point R on demand curve Dx, tangent AB is
drawn through the point. The slope of the demand curve and of the ___________________
line is same at that point so that the elasticity of the demand curve ___________________
at point R will be equal to that of the line at this point. The
elasticity of the line at point R can be measured as follows
dQ P
Ep = .
dP Q
E-
The reciprocal of the slope of the straight line AB at point R is NB /
RN. Therefore
dQ NB
=
dP RN
At point R price P = RN and quantity Q = ON. By substituting

CC
these values in the elasticity equation, we get

NB RN NB
Ep = . =
RN ON ON
Geometrically,
NB RB
=
ON RA
Price
(Ep = )
A
Ep > 1
Ep = 1
M
(c)
R Ep < 1
Dx
(Ep = 0)
O
N B
Quantity
Figure 7.1: Point Elasticities of Demand

62
Therefore, it can be said that price elasticity of demand at any
S
Notes point on a linear demand curve is equal to the ratio of lower
___________________ segment to the upper segment of the line. That is
___________________ Lower segment
Ep =
Upper segment
___________________
E
___________________ If we consider similar triangles AMR and RNB then RA/RM =
___________________ RB/NB (from properties of similar triangles) or NB/RM = RB/RA.
___________________
Hence, elasticity = NB/ON can be written as equal to RB/RA. That
is elasticity at point R is the ratio of lower segment of the demand
UP
___________________
curve to the upper segment. If the demand curve were linear, this
___________________
method would be simplified as the tangent to the curve at a point
___________________ would coincide with the curve itself.
___________________
It can be seen from Figure 7.1 that the ratio of RB/RA falls as we
move down the demand curve, since the length of RB decreases
and of RA increases. Due to this reason at mid-point of a linear
demand curve, Ep = 1, as shown at point R. At point A, RA is zero,
E-
therefore, the elasticity is infinite (Ep = infinity). At point B,
elasticity is zero (Ep = 0) since RB is zero. Hence elasticity falls
from infinity to zero as one moves down the linear demand curve.
It follows that at any point to the left of point R, demand is elastic
(Ep > 1), and at any point to the right of point R, demand is
inelastic (Ep< 1).
CC
Price Elasticity and Prediction
Knowledge of price elasticity is important for two reasons:
(i) It helps firms to predict the impact of price change on unit

sales, and
(ii) Guides the firms profit maximization pricing decision.
Managers are concerned with whether a change in price in either

direction will increase or decrease revenue. We know that
elasticity is percentage change in quantity demanded divided by
(c)
percentage change in price. Therefore, if the former is larger, then

the quantity effect is stronger and will more than offset the
opposite price effect. Thus, it can be said that the elasticity
coefficient influences the revenue of the firm. Now what does this
coefficient entail for revenue?
Table 7.1: Price Elasticity and Total Revenue 63
S
Notes
Price elasticity Interpretation Total Revenue (TR)
coefficient ___________________
Price increase Price ___________________
decrease
E
___________________
Perfectly elastic Only one possible TR falls to zero Infinite, Size of
demand E price. Unlimited market ___________________
=infinity quantity sold at that determines TR
price. ___________________
(Figure 7.2 a)
___________________
Elastic demand E Percentage Q is TR decreases TR increases
UP
> 1 (Figure 7.2c) greater than the ___________________
percentage P
___________________
Unitary elastic Percentage Q is TR is unaffected TR unaffected
demand E = 1 equal to percentage by price changes by price change ___________________
P
(Figure 7.2d) ___________________
Inelastic demand Percentage Q is less TR increases TR decreases
E<1 than percentage P
Perfectly inelastic Percentage Q TR increases TR decreases

demand E = 0 remains same to P
E-
If price decreases and, in percentage terms, quantity rises more
than the decrease in price, then total revenue will increase and
vice versa. Economists have classified elasticity coefficients in five
categories. The relationship between various types of elasticity and
total revenue has been summarized in Table 7.1 where Q and P
CC
refer to change in quantity demanded and change in price

respectively.
The five types of price elasticities presented in Table 7.1 are shown
graphically in Figure 7.2. Perfectly elastic and perfectly inelastic
price elasticity of demand is the two extremes on the elasticity
scale. Most of the goods and services fall under the category of
elastic and inelastic demand. Figure 7.2 (c) depicts that when
demand is more elastic (E > 1) a decrease in price results in a
proportionately greater change in demand (QQ2 > PP1). When
demand is less elastic (E < 1), a smaller change in demand takes
(c)
place with a change in price (QQ4 < PP1) as shown in Figure 7.2 (e).
A proportionate change in demand takes place with a change in
price (QQ3 = PP1) when elasticity is unity (E = 1).
64
S
Notes
Activity
Define the advertisement
___________________ Price (a) P (b)
elasticity of demand.
___________________ E = Infinity E=0
___________________
E
P P
___________________ D1 P1
___________________
O O Q
___________________ Quantity Q
UP
___________________ Price (c) (d) (e)
E>1 E=1 E<1
___________________
___________________ P
P1
___________________
D2 D3 D4
O O O
Q Q2 Q Q3 Q Q4
Quantity
E-
Figure 7.2: Types of Price Elasticities of Demand
Check Your Progress

Fill in the blanks:
1. ................... is the ratio of a percentage change in the
demand for good X to a percentage change in price of
good Y, other factors remaining constant.
CC
2. ................... elasticities are appropriate for analyzing

the effect of discrete, i.e. measurable, changes on price.
3. If price decreases and, in percentage terms, quantity
rises more than the decrease in price, then total
revenue will ................... and vice versa.
Advertisement Elasticity of Demand (EA)

Advertisement or promotional elasticity of demand (EA) is the ratio
of percentage change in quantity demanded (Q) to a percentage
(c)
change in advertisement outlay (A).

Q A
EA =
A Q
The greater the promotional elasticity, the more will be the 65
S
incentive to go in for advertising. The advertisement elasticity of Notes
sales varies between zeros to infinity.
___________________
1. If EA = 0, then sales do not respond to the advertisement ___________________
expenditure.
E
___________________
2. When EA < 1 is positive, then sales increase in proportionately
___________________
lesser degree than the increase in advertisement outlay.
___________________
3. Sales increase in equal proportion to advertisement outlay if
___________________
EA = 1.
UP
___________________
4. When EA > 1 then sales increase more than proportionately to
___________________
the increase in advertisement budget.
___________________
Check Your Progress
___________________
Fill in the blanks:
1. ................... is the ratio of percentage change in
quantity demanded (Q) to a percentage change in
advertisement outlay (A).
E-
2. The greater the promotional elasticity, the ...................
will be the incentive to go in for advertising.
Summary
There are various factors influencing the demand for the product
for example price of the product, income of the consumer,
CC
preference and tastes of consumers, price of related goods etc. The

Law of Demand states keeping other factors constant, the quantity
demanded for a product increases with decrease in the price and
vice versa. Veblen effects, Giffen goods, speculative motive etc., are
some exceptions to the Law of demand. The responsiveness of the
quantity demanded to a change in any of the variables of demand
is known as elasticity of demand.
Lesson End Activity

Take any product of your choice and evaluate its cross elasticty
and price elasticity of the demand.
(c)
Keywords
Cross Elasticity of Demand: Measures the responsiveness of
demand for good X to a change in price of good Y.
66
Demand: It is the desire for the product backed by willingness and
S
Notes ability to pay for it.
___________________
Elasticity of Demand: It is the responsiveness of the quantity
___________________ demanded of a good or service to a change in any one variable
influencing demand.
___________________
E
___________________ Income Elasticity: It is the ratio of a percentage change in the
___________________
remaining constant.
___________________
Price Elasticity of Demand: It is the ratio of a percentage
UP
___________________
change in quantity demanded and the percentage in price, other
___________________ factors remaining constant.
___________________
___________________
1. What do you understand by price elasticity of demand? What
are the various ways to measure it?
2. Given is the list of goods. Will their demand be less elastic,
moderate elastic, highly elastic or completely inelastic? Give
reasons to support your answer.
E-
(i) Petrol
(ii) Milk
(iii) Cars
(iv) Salts
(v) Bajra
CC
(vi) Cellular services

(vii) Seasonal vegetables
Further Readings
Maurice- Special Indian, 8th Ed, McGraw Hill Education.
Publication
(c)
Web Readings
en.wikipedia.org/wiki/Price_elasticity_of_demand
en.wikipedia.org/wiki/Elasticity_(economics)
www.mgmtmaterial.com/elasticity_of_demand.html
UNIT 8: Demand Forecasting Concept and Survey Methods
Unit 8
67
S
Notes
Demand Forecasting Concept

___________________
___________________
and Survey Methods
E
___________________
___________________
Objectives ___________________
___________________
UP
topics:
___________________
\ Significance of demand forecasting
\ Demand forecasting methods ___________________
\ Survey methods of demand forecasting ___________________
___________________
Introduction
Forecasting is the prediction of demand for a good or service, for

the forecast period, on the basis of present and past behaviour
E-
patterns of some related events. It is often used to predict the
growth in demand or sales growth, assess the possible market
share and to gather information on proper productmix. These
forecasts help companies to reduce risk and uncertainty associated
with such short run operational decision making. Overproduction
and underproduction can be avoided in the near future by these
CC
measures. Long run production decisions like purchase of plants,

advertising of product, and major capital investments can be made
with the help of forecasts.
A good forecast should be accurate, simple, economical, consistent
and timely. A sound estimate of future demand should be based on
adequate knowledge of relevant past. The forecast should be
simple to understand, made within the allocated budget, and
consistent with the objectives of the firm. It should be made within
the time limit.
Significance of Demand Forecasting

(c)
1. Production planning: Demand forecasting is the

prerequisite for production planning. Expansion of output is
based on the estimates of likely demand for the product. If
produced more than the estimated quantity demanded, it will
result in piling up of stock (inventory), thereby increasing
unnecessary cost of storage and maintenance.
68
2. Sales forecasting: Sales forecasting is based on demand
S
Notes
Activity forecasting. Accordingly advertisement and other sales
State any two points depicting
___________________ promotional activity can be planned out.
the importance of demand
forecasting.
___________________ 3. Control of business: All the activities of the business depend
on demand forecasting. Preparing of budgets, allocating costs,
___________________
E
estimating profits etc., depends on demand and sales forecast
___________________ and price of the product.
___________________
4. Inventory Control: Requirement of inventories, raw
___________________ material, semi materials, spare parts, etc., depends on the
UP
future requirement which can be traced from the estimated
___________________
demand for the product.
___________________
5. Growth and long term investment programmes
___________________
6. Stability
___________________
7. Economic planning and policy making
Check Your Progress

Fill in the blanks:
E-
1. ................... is the prediction of demand for a good or
service, for the forecast period, on the basis of present
and past behaviour patterns of some related events.
2. .................. is based on the estimates of likely demand
for the product.
CC
Methods of Demand Forecasting

Survey Methods of Demand Forecasting
Survey Methods
Opinion Poll Consumer Survey

Methods Methods
(c)
Expert Delphi Complete Sample Survey

Opinion Method Method Enumeration Method Method
Figure 8.1: Types of Demand Forecasting by Survey Methods

The survey methods can be divided into two broad categories. 69
S
Notes
Activity
Opinion Poll Method List the various methods of
___________________
demand forecasting.
The opinion poll methods aim at collecting opinions of those who ___________________
are supposed to possess knowledge of the market, such as sales
E
___________________
representatives, sales executives, professional marketing experts
and consultants. In these methods the expert opinion is surveyed. ___________________
The forecaster identifies the experts on the commodity to be
___________________
surveyed and takes their opinion on the; likely demand for the
commodity. E.g. the future demand of car can be forecasted by ___________________
UP
taking opinions of experts of automobile industry, research ___________________
organizations where such researches are carried, owners of various
___________________
car companies. The opinion poll methods will be discussed in detail
in the following sections. ___________________
___________________
1. Expert-opinion method,
2. Delphi method.
1. Expert-opinion Method: Firms having a good network of

sales representatives can put them to the work of assessing
E-
the demand for the product in the areas, regions or cities that
they represent. Sales representatives, being in close touch
with the consumers or users of goods, are supposed to know
the future purchase plans of their customers, their reaction to
the market changes, their response to the introduction of a
new product and the demand for competing products. The
CC
estimates of demand thus obtained from different regions are

added up to get the overall probable demand for a product.
2. Delphi Method: This method is used to consolidate the

divergent expert opinions and to arrive at a compromise
estimate of future demand. The process is simple.
Under the Delphi method, the experts are provided

information on estimates of forecasts of other experts along
with the underlying assumptions. The experts may revise
their own estimates in the light of forecasts made by other
experts. The consensus of experts about the forecasts
constitutes the final forecast.
(c)
Consumer Survey Method
Demand forecasting by consumer survey methods is done by taking

the view of the consumers directly about their future plans about a
product. Various methods are adopted for surveying the consumer.
70
Forecasting of demand is done by consumer survey methods by
S
Notes
surveying and asking them about the future consumption plan of a
___________________ product. These methods will also be discussed in the following
___________________ sections.
___________________ 1. Complete Enumeration Method: The forecaster undertakes
E
___________________
a complete survey of all consumers whose demand intends to
forecast. In the complete enumeration method, almost all
___________________
potential users of the product are asked about their future
___________________ plan of purchasing the product. The quantities given by the
UP
___________________ consumers about the purchase plan of the product are added
together to obtain the probable future demand of the product.
___________________
The total probable demand can be indicated by the equation.
___________________
D = d1 + d2+ d3+..+dn
___________________
= di
Where di, d2, d3..dn shows demand of individual
consumers 1, 2, 3..n, and D is the probable D.
E-
2. Sample Survey Method: In this method, a sample is selected
to represent the entire population of consumers. The probable
demand of a product expressed by each unit of the sample is
added to get the total demand of the product. The total
demand of the product is estimated by the formula
Df = Cd/Cs(Ct*Qt/Cs)
CC
Where Df = probable forecast, Ct = total number of consumers in

the market, Cs = number of consumers surveyed or sample
consumers, CD = number of consumers reporting future
consumption of the product and Qt = total quantity of the product
to be consumed by the sample.
Check Your Progress

Fill in the blanks:
1. The ................... methods aim at collecting opinions of
those who are supposed to possess knowledge of the
(c)
market, such as sales representatives, sales executives,

professional marketing experts and consultants.
2. Under the ................... method, the experts are provided
information on estimates of forecasts of other experts
along with the underlying assumptions.
Summary 71
S
Notes
The main objective of the demand forecasting is to minimize the
___________________
risk that the firm faces in its decision making process. Data forms
the basis for business forecasting. These can be obtained from ___________________
expert opinion, surveys and market experiments for use in
E
___________________
forecasting. By considering the advantages and limitation of ___________________
different forecasting techniques, business managers can choose
___________________
methods or their combinations that most suitable to the firm.
Forecasting methods range from naive and inexpensive to be ___________________
UP
sophisticated and costly. ___________________
___________________
Lesson End Activity
___________________
Give an example where the survey for the demand of any product ___________________
has been forecasted with the help of opinion poll methods.
Keywords
E-
Delphi Technique: Way of getting repeated opinion of experts

without their face to face interaction.
Forecasting: Forecasting is the prediction of demand for a good or

service, for the forecast period, on the basis of present and past
CC
behavior patterns of some related events.
Group Discussion: Decisions may be taken with the help of

brainstorming sessions or by structured discussions.

1. Why is demand forecasting so significant for the firm?
2. What are different types of forecasting methods? How can the
firm determine the most suitable forecasting method to use?
3. Explain the survey methods of forecasting.
(c)
4. What do you understand by the delphi method of demand

forecasting?
72
Further Readings
S
Notes
___________________ Books
___________________ Managerial Economics by Christopher R Thomas, S Charles
___________________ Maurice- Special Indian, 8th Ed, Mc-Graw Hill Education.
E
___________________ Miller. R.E., and P.D. Blair: Input and Output Analysis;
___________________ Foundations and extensions (Englewood Cliffs., N.J.: Prentice Hall,
1985).
___________________
UP
Granger, C.W.: Forecasting in Economics and Business (New York:
___________________
Academic Press, 1989).
___________________
Himilton, J.D.: Time Series Analysis (Princeton, N.J. Princeton
___________________
University Press, 1994).
___________________
Salvatore, Dominick: Microeconomic Theory and Applications, 3rd
Ed (Reading, Mass, Addison Wesley, 1997).

Publication.
E-
Web Readings
www.adb.org/documents/handbooks/water_supply.../Chap3-r6.PDF
en.wikipedia.org/wiki/Demand_forecasting
CC
(c)
UNIT 9: Statistical Methods of Demand Forecasting
Unit 9
73
S
Notes
Statistical Methods of Demand

___________________
___________________
Forecasting
E
___________________
___________________
Objectives ___________________
___________________
UP
topics:
___________________
\ Statistical methods of forecasting
\ Trend projection methods ___________________
\ Barometric Methods ___________________

\ Econometric methods ___________________
Introduction
In this unit, we provide brief descriptions of forecasting methods
E-
and their application.
Forecasting methods and the relationships between them are
shown in the next section, starting with the primary distinction
between methods that rely on survey and those that require
quantitative data.
Sometimes it is appropriate to forecast demand directly. For
CC
example, a baker might extrapolate historical data on bread sales

to predict demand in the week ahead. When direct prediction is not
feasible, or where uncertainty and changes are expected to be
substantial, marketing managers may need to forecast the size of a
market or product category. Also, they would need to forecast the
actions and reactions of key decision makers such as competitors,
suppliers, distributors, collaborators, governments, and themselves
especially when strategic issues are involved. These actions can
help to forecast market share.
Statistical Methods of Demand Forecasting

(c)
Demand forecasting by statistical methods are more complex than

survey methods. Survey methods are based on opinion of
consumers or experts. Statistical methods are based on data for
74
estimating future demand. The different methods of demand
S
Notes
Activity forecasting by using statistics are given in the chart below.
Identify the various statistical
___________________
methods available for demand
Statistical Methods
forecasting.
___________________
___________________
E
Trend Projection Barometric Econometric
___________________ Methods Methods Methods
___________________
___________________
UP
Graphical Least Squares Regression Simulaneous
___________________
Methods Methods Method Equation Method
___________________
___________________ Figure 9.1: Types of Statistical Methods
___________________
Trend Projection Method
Demand forecasting by trend projection method is based on
analysis of past sales patterns. This method is based on the
assumption that future events are a continuation of the past. Thus,
E-
historical data can be used to predict the future. In projecting
demand for a product, the trend method is applied to time series
data on sales. Firms can get time-series data on sales of a product
from their sales department. New firms can use necessary data
from the older firms of the same industry. Two methods are used
for trend projection based on the basis of time series data. These
methods are described below.
CC
1. Graphical Method: The time series data on the variable (e.g.

sales) under forecast are used to fit a trend line graphically.
For example, the graph below shows the sale of passenger cars
in a country from 1985-2001. Based on the data of sales of
cars, a line or curve is drawn showing sale of passenger cars.
The line can be drawn for the period for which the data is
available. The actual movement of sales of passenger is shown
by dotted lines. The straight line represents the trend line. In
this figure the trend line shows on upward trend.
2. Least Square Method: The trend line can be projected for

knowing the future demand by two methods- linear trend and
(c)
exponential trend.
When the time series data shows a rising trend in the sales,
then a straight line trend equation of the following kind is
used.
S = a + bt
75
S
Notes
Trend
Line ___________________
Actual ___________________
Sales
E
Sales ___________________
($)
___________________
___________________
___________________
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___________________
85 86 87 Time 01
___________________
___________________
Figure 9.2: The Graphical Method of Forecasting
___________________
Where S = annual sales, t = time (in years) a and b are
constants. The parameter b gives the measures of annual
increase in sales. The coefficients of a and b are estimated by
the following two equations:
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S = na + bt
St = at + bL2
Where n is the number of time period (years). Solving such

equations can be learnt from the following example.
Example: Estimation of trend projection by using the linear

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trend equation. Let us consider the following data of sales of

good* by a firm between 2009 and 2010.
Table 9.1
Year Sales of t t2 St
Good* ($)
1991 10 1 1 10
1992 12 2 4 24
1993 11 3 9 33
1994 15 4 16 60
1995 18 5 25 90
1996 14 6 36 84
(c)
1997 20 7 49 140
2008 18 8 64 144
2009 21 9 81 189
2010 25 10 100 250
N=10 S=164 t=55 t2=385 St=1024

By substituting the values in the linear trend equation, we get
76
S = na + bt
S
Notes
___________________ St = at + bt2
___________________ 164 = 10a + 55b ...(1)
___________________
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1024 = 55a + 385b ...(2)
___________________
By solving equations (1) and (2) we get S = 8.26 +1.48t
___________________
Now, we can use the above equation for projecting sales of good *
___________________
for the 11th year, 12th year, 13th year and so on.
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___________________
11th year 2003, S03 = 8.66 +1.48(11) = 24540 units
___________________
12th year 2005, S04 = 8.66 +1.48(12) = 26020 units
___________________
___________________ 13th year 2005, S05 = 8.66 + 1.48(13) = 27500 units
When the sales (variable) have increased over the past years at an
increasing rate, then the appropriate trend equation to be used is
the exponential trend equation of the following form.
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Y = aebT
Or Logey = log a + bT
Where y = sales, T=time and a and b are constants.
Barometric Method
Barometric forecasting, as conducted today, is primarily the result
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of the work conducted at the national Bureau of Economic

Research (NBER) and Conference Board of U. S. The basic
approach of this technique is to construct an index of relevant
economic indicators.
Leading indicator
Coincident indicator
Indicator Level
(Value) Lagging indicator

(c)
0 Peak Date Trough Date Time
Figure 9.3: Business Cycle

Relative Positions of Leading, Coincident and Lagging 77
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Indicators: The economic indicators are time-series that may Notes
1. Precede (lead) changes in the level of general economic ___________________
activity-Leading indicators, or ___________________
2. Move in step or coincide with movements in general economic
E
___________________
activity-Coincident indicators, or ___________________
3. Follow or lag movements in general economic activity- ___________________

Lagging Indicators. ___________________
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The relative positions of leading, coincident and lagging indicators ___________________
in the business cycle are shown graphically in Figure 9.4. ___________________
The index of leading economic indicators is used to forecast or ___________________

anticipate short-term changes in economic activity or turning
___________________
points in business cycle. The leading economic indicators tend to
precede changes in the level of general economic activity, in the
same way as changes in the mercury in a barometer precede
changes in weather conditions.
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It may be noted at the outset that the barometric technique was
developed to forecast the general trend in overall economic
activities. This method can nevertheless be used to forecast
demand prospects for a product, not the actual quantity expected
to be demanded. For instance, development and allotment of land
by the Delhi Development Authority (DDA) to the Group Housing
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Societies (a lead indicator) indicates higher demand prospects for

cement, steel, bricks and other construction materials.
The time series of various indicators are selected on the basis of

the following criteria:
1. Economic significance of the indicator: the greater the

significance, the greater the score of the indicator.
2. Statistical adequacy of time-series indicators: a higher score is

given to an indicator provided with adequate statistics.
3. Conformity with overall movement in economic activities.

(c)
4. Consistency of series to the turning points in overall economic

activity.
5. Immediate availability of the series, and
6. Smoothness of the series.

78
Econometric Methods
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Notes
The econometric models are increasingly used to forecast the firms
___________________
demand and sales of a commodity as well as many other economic
___________________ variables. The characteristic that distinguishes econometric
___________________ models from other forecasting methods is that they seek to identify
E
and measure the relative importance (elasticity) of the various
___________________
determinants of demand or other economic variables to be
___________________ forecasted. By attempting to explain the relationship being
___________________
forecasted, econometric forecasting allows the manager to
determine the optimal policies for the firm. This is to be contrasted
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___________________ with the other forecasting techniques examined in this unit that
___________________ forecast demand, sales, or other economic variables on the basis of
their past patterns or on the basis of some leading indicator alone.
___________________
___________________ Econometric forecasting frequently incorporates or uses the best

features of other forecasting techniques, such as trend and
seasonal variations, smoothing techniques and leading indicators.
Econometric forecasting models range from single-equation models
of the demand that the firm faces for product to large multiple-
equation models describing hundreds of sectors and industries of
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the economy. Although the concern here is with forecasting
demand for a firms product, macro forecasts of national income
and major sectors of the economy are often used as inputs or
explanatory variables in simple single-equation demand models of
the firm. Therefore, we discuss both types of forecasting in this
section.
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1. Single-Equation Models: The simplest form of econometric

forecasting is with a single-equation model. The first step is to
identify the determinants of the variable to be forecasted. For
instance, in forecasting the demand for coffee, the firm will
usually postulate that demand (Q) is a function of or depends
on the price of coffee (P), consumers disposable income (I), the
size of population (N), the price of tea (Ps - a substitute), the
price of milk (Pc - a complement), and the level of advertising
by the firm (A). Thus, we can write the following demand
equation to be estimated:
Q =ao + a1P + a21 +a3N + a4Ps + a5 Pc + a6A + e (9.1)
(c)
Once the model has been estimated (that is, the values of the
as determined) and evaluated, the firm must obtain
forecasted values of the independent or explanatory variables
of the model for the time period for which the dependent
variable is to be forecasted. Thus, to forecast Qt+ 1 (i.e., the
demand faced by the firm in the next period), the firm must 79
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obtain the values for Pt+1, It+l, Nt+1, PSt+l, PCt+1 and At+1, By Notes
substituting these forecasted values of the independent ___________________
variables into the estimated equation, we obtain the
forecasted values of the dependent variable (Qt+1). The ___________________
forecasted value of the macroeconomic variables of the model
E
___________________
(Yt+1 and Nt+1) are usually obtained from the Government
___________________
agencies or from many private firms that specialize in making
___________________
such forecasts. The micro variables in the model not under the
control of the firm (PSt+1 and PCt+1) might be forecasted by ___________________
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time-series analysis or smoothing techniques, and the firm ___________________
can experiment with various alternative forecasted values of
the independent policy variables (Pt+1 and At+1) under its ___________________
control. ___________________
2. Multiple-Equation Models: Although single-equation ___________________
models are often used by firms to forecast demand or sales,

economic relationships may be so complex that a multiple-
equation model may be required. This is particularly the case
in forecasting macro variables such as gross national product
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(GNP) or the demand and sales of major sectors or industries.
Multiple-equation models may include only a few equations or
hundreds of them. To show how multiple-equation models are
used in forecasting, we start with a very simple three-
equation (9.2, 9.3, and 9.4) model of the national economy that
can be used to forecast GNP.
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Ct = a1 + b1 GNPt + m1t (9.2)
It = a2 + b2 pt-1 +, m2t (9.3)
GNPt = Ct + It + Gt (9.4)
Where C = consumption expenditures
GNP = gross national product in year t
I = investment
p = profits
G = government expenditures
(c)
U = stochastic disturbance (random error term)
t = current year
t - 1 = previous year
80 Variables Ct, It, and GNPt (the left hand variables) are called
S
Notes
endogenous variables. These are the variables that the model
___________________ seeks to explain or predict from the solution of the model.
Exogenous variables, on the other hand, are those determined
___________________
outside the model. In the above model, pt-1 and Gt are the
___________________ exogenous variables. Their values must be supplied from outside
E
___________________ the model in order to be able to estimate the model. When (as in
the above model) some of the endogenous variables also appear on
___________________
the right of the equals signs, this means that they both affect and
___________________ are in turn affected by the other variables in the model (i.e., they
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___________________ are simultaneously determined).
___________________ Equations 9.2 and 9.3 are called structural (behavioural)

___________________ equations because they seek to explain the relationship between
the particular endogenous variable and the other variables in the
___________________
system. On the other hand, Equation 9.4 is a definitional
equation or an identity and is always true by definition. Note that
Equation 9.4 has no parameters or coefficients to be estimated. We
will see that, given the value of the exogenous variables pt-1 and Gt,
we can solve the system and estimate the values of the endogenous
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variables. A change in the value of an exogenous variable will
affect directly the endogenous variable in the equation in which it
appears and indirectly the other endogenous variables in the
system. For instance, an increase in pt-l leads to a rise in It directly
(Equation 9.3). The induced increase in It then leads to an increase
in GNPt and, through it, in Ct as well.
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Since the endogenous variables Ct, It, and GNPt of the system are
both determined by and in turn determine the value of the other
endogenous variables in the model we cannot use the ordinary
least-squares technique to estimate the parameters of the
structural equations (the as and the bs in Equations 9.2 and 9.3).
More advanced econometric techniques are required to obtain
unbiased estimates of the coefficients of the model.
By assuming that these coefficients are correctly estimated by the

appropriate estimating technique, we can show how the above
simple macro model can be used for forecasting the values of the
endogenous variables. To do this, we substitute Equations 9.2 and
(c)
9.3 into Equation 9.4 (the definitional equation) and solve. This
will give an equation for GNPt that is expressed only in terms of pt-1
and Gt, (the exogenous variables of the system). Then by
substituting the values of pt (which is known in year t+1) and the
predicted or forecasted value of Gt+1 into the solved equation, we
get a forecast for GNPt+1. That is, substituting Equation 9.2 into 81
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Equation 9.4, we get Notes
___________________
GNP = a1 + b1GNP + It + Gt (9.5)
___________________
By then substituting Equation 9.3 into 9.5, we get
E
___________________
GNPt = a1 + b1GNPt + a2+b2pt-1 + Gt
___________________
GNPt (1-b1) = a1 + a2 + b2pt-1 + Gt (9.6) ___________________
Dividing both sides of Equation 9.6 by 1 b1 we finally obtain ___________________
UP
___________________
GNPt = (a1 + a2)/1- b1 + (b1t-1)/1- b1 + Gt/1- b1 (9.7)
___________________
Equation 9.7 is called a reduced-form equation because GNPt is
___________________
expressed only in terms of pt-1 and Gt (the exogenous variables of
___________________
the model). By substituting into Equation 9.7 the value of pt
(which is known in year t + 1) and the predicted value of Gt+1, we
obtain the forecasted value for GNPt+1. The reduced-form equations
for Ct and It can similarly be obtained.
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While the above simple macro model contains three endogenous
and two exogenous variables, and two structural and one
definitional equations, most large models of the economy contain
hundreds of variables and equations. They require estimates of
tens, if not hundreds, of exogenous variables and provide forecasts
of an even greater number of endogenous variables, ranging from
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GNP to consumption, investment, and exports and imports by

sector, as well as for numerous other real and financial variables.
Firms usually obtain macro forecasts for the entire economy and
its major sectors from firms specializing in making such forecasts
and use these macro- forecasts as inputs in their own specific
forecasting of the demand and sales of the firms product(s).
Check Your Progress

Fill in the blanks:
1. ................... seek to explain the relationship between
the particular endogenous variable and the other
(c)
variables in the system.

2. ................... is an identity and is always true by
definition.
82
Summary
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Notes
Techniques of demand forecasting depend upon information on
___________________
three questions:a. What do people say? b. What do people do? c.
___________________ What have people done?
___________________
E
In consumers opinion survey buyers are asked about their future
___________________ buyingintentions of products, their brand preferences and
___________________ quantities of purchase.
___________________ Future demand level may also be ascertained by experts with the
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help of brainstorming or by structured discussions or even by
___________________
discussing without face to face interaction.
___________________
Demand forecasting may also be done by market experiments
___________________
conducted under controlled or simulated conditions or in real
___________________ markets in which consumers actuallybuy a product without the
awareness of being observed.
Lesson End Activity

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Give an example of the demand forecasting done by the barometric
method.
Keywords
Graphical Method: The time series data on the variable (e.g.
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Least Square Method: The trend line can be projected for

exponential trend.
Single-Equation Models: The simplest form of econometric
forecasting is with a single-equation model.
Multiple-Equation Models: Although single-equation models are
often used by firms to forecast demand or sales, economic
relationships may be so complex that a multiple-equation model
may be required.
(c)

1. Explain the barometric method of demand forecasting.
2. Describe the Econometric method of forecasting.The concept
of elasticity of demand and demand forecasting are versatile
tools of economic analysis. Discuss the validity of this 83
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statement. Notes
3. The concept of elasticity of demand and demand forecasting ___________________

are versatile tools of economic analysis. Discuss the validity of ___________________
this statement.
E
___________________
___________________
Further Readings
___________________
Books ___________________
UP
Managerial Economics by Christopher R Thomas, S Charles ___________________
Maurice- Special Indian, 8th Ed, Mc-Graw Hill Education. ___________________
Miller. R.E., and P.D. Blair: Input and Output Analysis; ___________________
Foundations and extensions (Englewood Cliffs., N.J.: Prentice Hall,
___________________
1985).
Granger, C.W.: Forecasting in Economics and Business (New York:

Academic Press, 1989).
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Himilton, J.D.: Time Series Analysis (Princeton, N.J. Princeton
University Press, 1994).
Salvatore, Dominick: Microeconomic Theory and Applications, 3rd

Ed (Reading, Mass, Addison Wesley, 1997).

Publication.
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Web Readings
www.adb.org/documents/handbooks/water_supply.../Chap3-r6.PDF
en.wikipedia.org/wiki/Demand_forecasting
(c)
84
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Notes
___________________
___________________
___________________
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___________________
___________________
___________________
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___________________
___________________
___________________
___________________
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(c)
Unit 10
85
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Notes
Case Studies
___________________
___________________
E
___________________
Objectives
___________________
___________________
UP
___________________
Case Study 1: Apple Inc.
___________________
In 2010, Apple had to delay the international launch of its iPad
computer for a month, blaming surprisingly strong US demand ___________________
that was higher than the companys ability to produce them. More
___________________
than 500,000 were delivered to retailers and customers in its first
week on sale, but these soon sold out. The company had planned
to launch the touch-screen device internationally at the end of
April, after beginning sales in the USA on 3 April. But the strong
demand meant that it could not hit that date.
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The company said in a statement: We will announce
international pricing and begin taking online preorders on
Monday, May 10. We know that many international customers
waiting to buy an iPad will be disappointed by this news, but we
hope they will be pleased to learn the reasonthe iPad is a
runaway success in the US thus far.
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The news was a disappointment to thousands of people outside

the USA who wanted to get the machines as soon as possible.
The iPad is a touch-screen computer with a 9.7-inch screen, which

uses the same operating system as Apples iPhone and iPod
Touch. It comes in two basic models: one with WiFi wireless
Internet connectivity, and another with both WiFi and 3G mobile
connectivity.
Although Apple announced the iPad in January and gave US

pricing at the timestarting from $499 for the cheapest modelit
repeatedly declined to give any guidance about international
prices. That may be to give it room for manoeuvre and to let it
(c)
raise the price of non-US versions to control demand.
The USA is by far the largest market for Apple products,

generating about half its revenues. Analysts have estimated that
Apple could sell between 2.5 million and 6 million iPads this year,
which would make it by far the largest seller of tablet computers
Contd.
86 in the world. It is estimated that about 1.25 million non-Apple
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Notes tablets will be sold in 2010.
___________________ Questions
___________________ 1. What factors do you think influenced the demand for the
iPad? How might these factors change over time?
___________________
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___________________
2. Do you think Apple was simply lucky with the iPad?
___________________
3. What effect might the delayed launch have on sales of the
iPad?
___________________
4. The delay gave the company time to think about the
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___________________ international price of the product. What factors might
___________________ determine how much the company could increase the price
outside the USA?
___________________
Source: http://www.oup.com/uk/orc/bin/9780199586547/9780199586547_ch03.pdf
___________________
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(c)
Case Study 2: Demand for Cars in China 87
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The demand for cars in China has grown very rapidly in recent Notes
years. With around 5 million cars sold each year, China is already ___________________
the third largest car market in the world after the USA (17
___________________
million cars sold per year) and Japan (around 9 million). At the
same time, the Chinese government has spent heavily on the road
E
___________________
network. By the end of 2004, the country had 21,000 miles of
___________________
motorways, more than double the 2000 figure. In 1987, it had
none! Only the USA now has more motorways than China. ___________________
Chinas total road network is now the third longest in the world. ___________________
UP
China is aiming to put the car industry at the heart of its ___________________
economy. In bigger cities, consumers have gone straight from
___________________
bicycles to cars, missing out motorbikes, because these were
banned or the use of them was severely restricted. A big boost ___________________
occurred when China joined the World Trade Organization (WTO)
___________________
in 2001. This opened up its markets to trade, allowing foreign
profits into the country, and car prices fell rapidly. Demand has
also been boosted by cheap borrowing from state banks (in the
past, banks did not lend to individuals) and by social change.
Many state-owned factories have been sold off; these have then
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been closed or shifted to suburban areas. Employees now have to
travel much further to work and therefore need a car.
Questions
1. The above highlights how the Chinese government is

intervening in the economy to influence decisions, but that
there is a free market as well. Would you describe such an
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economy as free market, mixed, or planned?
2. If the government invests more into roads, what might the

opportunity cost be?
3. What do you think are the main factors affecting demand for
new cars? Do these differ from the main factors affecting
demand for other products?
(c)
88
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Notes
___________________
___________________
___________________
E
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
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CC
(c)
UNIT 11: Supply Analysis
89
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Notes
___________________
___________________
E
___________________
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
BLOCK-III
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CC
(c)
90
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Notes
UNIT 11: SUPPLY ANALYSIS
___________________ UNIT 13: PRODUCTION
z Introduction z Introduction
___________________
z Supply Function z Production and Production Functions
___________________
E
z The Law of Supply z Technological Progress
___________________
z Movements and Shifts in Supply
UNIT 14: SUPPLY & DEMAND AS MARKET
___________________
z Elasticity of Supply FORCES
z
___________________
Managerial Uses of Supply Elasticity z Introduction
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___________________ z Concept of Demand
UNIT 12: COST
___________________ z Types of Demand
z Introduction
___________________ z Demand Function and Demand Curve
z Cost Concepts
z Meaning and Determinants of Supply
z ___________________
Short Run Cost Functions
z The Supply Curve
z Total Cost Functions
z Long Run Cost Functions UNIT 15: CASE STUDY
z Economies of Scale
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(c)
Unit 11
91
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Notes
Supply Analysis
___________________
___________________
E
___________________
Objectives
___________________
topics: ___________________
\ Supply Function ___________________
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\ The Law of Supply ___________________
\ Determinants of Supply
___________________
___________________
Introduction
___________________
A detailed review of the inputs and outputs of a process that is
employed to assess how the available quantity of a product is affected
by changes in demand, input factors and production techniques.
Supply analysis is often used to make key policy decisions by
E-
manufacturing business managers since it gives them insight into
how shifts in production are likely to influence market supply.
Like the law of demand, the law of supply demonstrates the
quantities that will be sold at a certain price. But unlike the law
of demand, the supply relationship shows an upward slope. This
means that the higher the price, the higher the quantity supplied.
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Producers supply more at a higher price because selling a higher

quantity at a higher price increases revenue.
Supply Function
Supply of a good or service refers to the quantities that the seller(s)

is willing to and able to offer for sale at various prices within a
given time period, other factors held constant. The foregoing
discussion on production and cost analysis and the objectives of the
firm have thrown light on the determinants of supply. The amount
of a good supplied depends on a number of factors that can be
(c)
stated in terms of a supply function as follows.
Sx = f (Px, Py, C, T, O, F, W, N)
1. Product Price (Px): The quantity supplied varies directly to

price of the good, other factors held constant. Generally,
92
producers tend to supply more at a higher price to earn
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Notes
Activity greater profits. Higher revenues from sales are necessary to
What are the factors of the
___________________ induce producers to increase supply of a good or service.
supply function?
___________________ 2. Prices of Related Products (Py): Just as from consumers
___________________ standpoint, substitutes or complements influence demand for
E
a good or service, so also prices of goods related in production
___________________
influence firms supply goods and services. For example,
___________________ suppose the sellers of pizza notice that the price of hot dogs
___________________ increases substantially. They may reduce the amount of
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resources devoted to the selling of pizza in favour of hot dogs.
___________________
This will decrease the supply of pizza. If the sellers were
___________________ already selling two (or more) goods, the change in market
___________________ conditions would prompt them to reallocate their resources
towards the more profitable ones.
___________________
The price of a complementary good is expected to affect the

supply of the good under consideration in a direct manner. For
instance, if the price of computer hardware increases, other
things remaining constant, the supply of software would
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increase and vice versa. This is due to the reason that, an
increase in price of computer hardware increases its supply
that results in an increase in supply of software.
3. Costs and Technology (C and T): The two factors can be

treated as one as they are closely related. Costs refer to the
cost of factors used in production. Increase in factor prices,
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other things remaining constant, increases production cost

that leads the firm to restrict supply. For instance, an
increase in price of color picture tubes (CPT) will increase the
price of CTVs.
Technology refers to technological innovations or

improvements introduced to reduce the unit cost of production
or increase factor productivity. A reduction in total cost lowers
the total cost curve which leads to an increase in supply.
4. Objectives of the Firm (O): The amount of a good or service

supplied is influenced by the objectives of the firm. For
(c)
instance, a sales maximiser would supply more than the profit

maxi miser to gain greater market share.
5. Future expectations (F): Like consumers expectations

influence their demands, sellers expectations influence
supply. Future expectations of prices, costs, sales and the
general macroeconomic conditions influence supply. For 93
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example, if sellers anticipate a rise in price, they may choose Notes
Activity
to hold back current supply to take advantage of the higher State the law of supply.
___________________
prices in future, thus decreasing market supply. A likely glut
___________________
in future would have a reverse impact. Similarly, sellers
E
expectations of change in future production costs in ___________________
comparison to current input prices would influence their ___________________
current supplies. A shortage of raw materials in future may
___________________
restrict supply and vice versa.
___________________
6. Weather conditions and other short-term factors (W):
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Floods, droughts, strikes, lockouts and other short-term factors ___________________
have adverse temporary impact on supply. ___________________
Supply of geysers and room heaters tends to increase in ___________________
winters, as there are few buyers in other months and carrying ___________________
costs of inventory. Floods and droughts will reduce supply of
agricultural goods. Similarly, strikes and lockouts have
negative effect on supply of industrial goods.
7. Number of sellers (N): The number of sellers has a direct
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impact on supply. The more sellers, the greater is the market
supplies. If sellers are in collusion, they would tend to restrict
supply. Sellers under rivalry are most likely to increase supply
to capture larger market share.
Check Your Progress

CC
Fill in the blanks:

1. The quantity supplied varies ................... to price of the
good, other factors held constant.
2. ................... refer to the cost of factors used in
production.
3. ................... refers to technological innovations or
improvements introduced to reduce the unit cost of
production or increase factor productivity.
The Law of Supply

(c)
The law of supply states that quantity supplied is related directly

to its price, other factors held constant. That is, as the price of a
good or service increases, its supply expands, and contracts with a
decrease in price. (Note that the law depicts relation only between
the supply of the good or service and its price, while other
94
determinants are taken as constant). This is so for the reason that,
S
Notes
firstly, a higher price generally implies higher profits that induces
___________________ the producers to supply more. Secondly, new producers may enter
___________________ the industry due to higher profits leading to an increase in
production and supply. The law can be shown in form of a supply
___________________
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schedule and supply curve.
___________________
A supply schedule depicts various quantities of a good or service
___________________
the firm will sell at different prices at a given point of time. Market
___________________ supply or industry supply is the aggregate of supply of individual
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___________________ firms at different prices. Table 11.1 shows firm and market or
industry supply schedules for A grade newsprint.
___________________
___________________
Supply curve is a diagrammatic representation of supply schedule.
It shows the maximum amount of a good the firm is willing to sell
___________________
at each possible price of a good. Figure 11.1 depicts the market
supply curve of newsprint.
Table 11.1: Market Supply of Newsprint
Price (`/kg.) Firm A Firm B Market Supply

E-
(A + B)
10 50 0 50
20 130 100 230
30 120 230 350
40 200 300 500

CC
50 250 350 600

(c)
Figure 11.1: Market Supply of Newsprint

95
Check Your Progress
S
Notes
Activity
Fill in the blanks:
Graphically depict
___________________ the
1. A ................... depicts various quantities of a good or movement and shift in supply.
___________________
service the firm will sell at different prices at a given
point of time
E
___________________
2. ................... is a diagrammatic representation of supply ___________________

schedule. ___________________
___________________
Movements and Shift in Supply
UP
___________________
As we have movements and shifts in demand so also there are
___________________
movements and shifts in supply.
___________________
1. Changes in price result in changes in the quantity supplied.
These are called as movements along a supply curve. The ___________________
quantity supplied expands with an increase in price as shown

by a movement from B to B2 along supply curve S in
Figure11.1. On the other hand, at a lower price contraction of
supply takes place depicted by a movement along supply curve
E-
S from B to B1.
2. Changes in non-price determinants result in changes in the

supply. Shifts in the supply curve represent such shifts.
Increase in supply is shown by a downwards shift in the
supply curve to the right, while a decrease in supply by a shift
in the supply curve to the left. In Figure 11.1, though the price
CC
is constant, an increase in supply shifts the supply curve from

S to S1 thereby increasing supply from PB to PC. The supply
curve S2 shows a decrease in supply from PB to PA as an effect
of non-price determinants.
Check Your Progress

Fill in the blanks:
1. ................... is shown by a downward shift in the supply
curve tyo the right, while a decrease in supply by a shift
in the supply curve to the left.
(c)
2. Changes in price result in changes in the quantity

supplied are known as ...................
96
Elasticity of Supply
S
Notes
Elasticity of supply is the degree of responsiveness of quantity
___________________
supplied to a given change in price. It can be stated as follows:
___________________
Proportionate change in quantity supplied
___________________ Es =
E
Proportionate change in price
___________________
Q/Q
___________________ Es =
P/P
___________________
In case of zero elasticity or perfectly inelastic supply the quantity
UP
___________________
supplied remains fixed irrespective of changes in price as shown by
___________________ supply curve S1 in Figure 11.2. In case of consumer perishables like
___________________ milk, supply remains almost fixed as they have to be sold at
whatever price they can fetch. Infinite elasticity (S2) is another
___________________
extreme case where nothing is supplied at lower prices. Figure 11.2
depicts that the producers are willing to supply any amount at
price OP but nothing below it.
Price
E-
S 1 (Es = 0)
S 5 (Es < 1)
S3 (Es = 1)
P S 2 (Es = Infinity)
S 4 (Es > 1)
CC
O Q
Quantity
Figure 11.2: Elasticity of Supply

Supply curve S3 depicts elastic supply which shows that the supply
changes in same proportion as the change in price.
Any straight line passing from the origin, irrespective of its slope
has unit elasticity. Supply is said to be elastic when the quantity
supplied changes more than proportionately to the change in price.
When the supply curves cuts the vertical axis it is relatively elastic
(c)
as shown by S4. On the other hand, if the change in price leads to a

less than proportionate change in quantity supplied, the supply
tends to be inelastic. The supply curve cutting the horizontal axis
like S5 is inelastic.
Managerial Uses of Supply Elasticity 97
S
Activity
Notes
The concept of supply elasticity explains why a given change in List the various managerial
price tends to have greater effect on the amount supplied as uses___________________
for elasticity of supply.
one moves from a market period (very short time period) to a ___________________
short-run and finally to a long run. The supply in the market
E
___________________
period tends to be perfectly inelastic as the use of any input
___________________
cannot be changed readily. In short run, some factors of
___________________
production can be changed; therefore, supply is relatively
___________________
elastic. As in the long run use of all factors can be changed, the
UP
supply curve in the long run, is highly elastic. For this reason, ___________________
elasticity of supply helps to make adjustments in supply to a ___________________

higher price in the long run. ___________________
___________________
Check Your Progress
Fill in the blanks:
1. ................... depicts elastic supply which shows that the
supply changes in same proportion as the change in
E-
price.
2. Any straight line passing from the origin, irrespective
of its slope has ................... elasticity.
3. Supply is said to be elastic when the quantity supplied
changes more than proportionately to the change in
...................
CC
Summary
Supply of a good or service refers to the quantities that the seller(s)
is willing to and able to offer for sale at various prices within a
given time period, other factors held constant. Elasticity of supply
is the degree of responsiveness of quantity supplied to a given
change in price.
Lesson End Activity

(c)
Give an example of supply for any product and give the graphical
representation of the supply for that product.
98
Keywords
S
Notes
Costs: It refers to the cost of factors used in production.
___________________
___________________ Product Price: The quantity supplied varies directly to price of

the good, other factors held constant.
___________________
E
___________________ Technology: It refers to technological innovations or
improvements introduced to reduce the unit cost of production or
___________________
increase factor productivity.
___________________
UP
___________________
___________________
1. Discuss the shape of supply curve.
___________________
2. Describe the supply function.
___________________
3. Describe the factors affecting the supply.
4. Explain the concept of technological progress.
Further Readings
E-
Books
Maurice- Special Indian, 8th Ed, Mc-Graw Hill Education.
CC
Publication
Web Readings
en.wikipedia.org/wiki/Production_function
economicsconcepts.com/production_function.htm - United States
www.jeffsims.net/flash/production.html
(c)
UNIT 12: Cost
Unit 12
99
S
Notes
Cost
___________________
___________________
E
___________________
Objectives
___________________
topics: ___________________
\ Relevance of cost concepts in decision-making ___________________
UP
\ Behaviour of costs in the short run and long run ___________________
\ Reasons for the emergence of economies of scale
___________________
___________________
Introduction
___________________
It means to ascertain the cost of a specified thing or activity. cost
can be termed as the amount of resource given up in exchange for
goods or services" In production, research, retail, and accounting,
a cost is the value of money that has been used up to produce
E-
something, and hence is not available for use anymore.
In business, the cost may be one of acquisition, in which case the
amount of money expended to acquire it is counted as cost. In this
case, money is the input that is gone in order to acquire the thing.
This acquisition cost may be the sum of the cost of production as
incurred by the original producer, and further costs of transaction
CC
as incurred by the acquirer over and above the price paid to the
producer. Usually, the price also includes a mark-up for profit over
the cost of production.
Cost Concepts
Cost distinctions help the manager to decide amongst the
alternative courses of action. Knowledge of various cost concepts is
crucial for managerial decisions.
1. Economic Cost: Opportunity cost or economic cost is the

amount of subjective value foregone in choosing one activity
(c)
over the next best alternative. It is an indirect cost or an

imputed cost. Opportunity costs are incurred when budgetary
resources are allocated to one department instead of the other.
A firm cannot retain a hired input if it is paid a lower price for
it than another firm. Opportunity cost includes the cost of
inputs owned by the firm as well of those hired from outside.
100
To illustrate this, consider a firm of readymade garments,
S
Notes
Activity which produces 2 million shirts by employing the resources of
Explain the concept of
___________________ production.
opportunity costs.
___________________ Factors hired Cost (` Crores)
Cloth 1,200
___________________
E
Labour 3,250
___________________
Machinery 6,000
___________________ Electricity 4,550
___________________ Miscellaneous 1,000
UP
Sub Total 16,000
___________________
Factors owned
___________________ Managerial ability 1,350
___________________ Building 7,000
Total 24,350
___________________
The economic cost of manufacturing 2 million shirts is

` 24,350 crores. The cost of self-owned resources has to be
imputed on the basis of their opportunity costs.
E-
When a factor of production has no alternative use, its
opportunity cost is zero. For example, if a firm receives an
export order when its capacity is not fully utilized the
opportunity cost of using the plant for export production will
be nil. This is so because the unutilized capacity of the plant
has no alternative use.
Actual costs mean the actual expenditure incurred for

CC
producing a good or service. In this example the cost of factors

hired, ` 16,000 crores is known as the actual cost or outlay
cost or absolute cost.
2. Explicit and Implicit Cost: Explicit costs or out of pocket

costs involve an actual payment to hire labour or purchase
inputs required in production. They include the wages to hire
labour, the interest on capital, rent on buildings and
equipment and cost of raw material and semi finished goods.
Implicit costs refer to the value of inputs owned and used by
the firm in its production process. The amount, which a firm
could earn by selling or hiring these inputs, is the implicit cost
(c)
or the book cost. In the aforementioned example, ` 16,000

crores is the explicit cost and ` 8,350 crores is the implicit
cost.
3. Sunk and Incremental Costs: Sunk costs are expenditures

made in the past or that may be made in future as part of
UNIT 12: Cost
contractual agreement. The costs for inventory and future 101
S
rental payments on a warehouse and contractual commitment Notes
to labour unions that must be paid as a long-term lease are ___________________
sunk costs. They are not affected by decision making
___________________
therefore, they are regarded as irrelevant for short run
E
analysis. ___________________
___________________
Marginal or incremental costs play a major role in decision
making. Marginal cost is the change in the total cost for a unit ___________________
change in output. It helps in making short run decisions about ___________________
UP
profit maximizing rates of output. While incremental cost is a
___________________
broader concept and refers to the change in total cost from
implementing a particular management decision such as ___________________
introduction of new product line, undertaking a new ___________________

advertising campaign, adding a new machine, changing the
___________________
distribution channel and replacing the old machine.
Since incremental costs can be avoided by not bringing a

change in the activity they are also called avoidable or
escapable costs.
E-
4. Historical Cost and Replacement Cost: The historical cost
of an asset refers to the actual cost incurred at the time of the
purchase of an asset. Replacement cost means the price to be
paid to purchase an asset today. Suppose, the price of a PC in
1980 was ` 30,000 and the present cost is ` 50,000. The
original cost of `30,000 is the historical cost and ` 50,000 is
CC
the replacement cost. The balance sheets show assets at their

historical costs. But due to variation in prices over time
replacement costs are relevant for managerial decisions.
5. Fixed and Variable Costs: Fixed costs remain constant

irrespective of a change in the volume of output, up to a
certain level of plant capacity. They are incurred even when
output is nil. On the other hand variable costs vary in direct
proportion to changes in output. The distinction between fixed
cost and variable costs is important in forecasting the effect of
short run changes in volume of output, costs and profits.
(c)
6. Short Run and Long Run Costs: Short run costs are the
costs incurred on the variable inputs in the short run. They
vary with the variation in output within a given plant
capacity. Long run costs are the costs incurred on the fixed
inputs. They are costs across all possible capacities.
Knowledge of short run costs is useful for pricing and output
102
decisions and long run costs provide information for planning
S
Notes
the growth and investment policies of the firm.
___________________ 7. Private and Social Costs: Private costs relate to costs
___________________
incurred by the firm as a production unit. While social costs
are borne by the society but generated by productive activity
___________________
E
of the firm. The cost incurred by expansion of output is private
___________________ cost but pollution, traffic congestion, and accidental hazards
___________________ are external to the firm, thus known as social costs.
Development of dams, rose garden, amusement parks and the
___________________
like are benefits to the society by the productive activity of the
UP
___________________ firm. Taxes and subsidies are private costs to be borne solely
___________________ by the firm.
___________________ 8. Shutdown and Abandonment Costs: Shutdown costs are

___________________ incurred when there is temporary cessation of business
activity, which could be saved if production continues. They
include sheltering of plant and equipment lay off expenses etc.
Abandonment costs are the cost of retiring a fixed asset from
use. Permanent cessation of production raises the problem of
E-
disposal of assets.
9. Separable and Common Costs: Costs that can be attributed

to a product, a department, or a process are the separable
costs and the rest are common costs. For example, in a multi
product firm, raw material can be separated product wise. But
the managerial cost is a common cost. The distinction between
CC
the two is also called as direct and indirect cost respectively.
10. Inventory Costs: Inventories are generally referred to as the

stocks held by a firm. Costs incurred to hold inventories are
called as inventory costs that comprise capital tied up in the
inventory, the carrying costs and the ordering costs of
inventories. Carrying costs are the costs of holding materials
in the stores. They include the cost of storage space, bins,
protection of assets, interest on blocked funds, insurance, and
costs of spoilage/obsolescence. Ordering costs comprise the
costs of placing orders, inspection, checking and handling of
goods, the cost of floating tenders, stationery, fax, etc. The
(c)
inventory costs are minimized when the carrying costs and

ordering costs are balanced and the resulting order quantity is
called the economic order quantity/economic lot size.
Holding of inventories gives rise to capital costs. Capital cost

primarily is the opportunity cost of capital tied up in form of
UNIT 12: Cost
raw materials, intermediate goods and finished goods. The 103
S
opportunity cost is the productive opportunities of the assets Notes
tied up in inventories. ___________________
11. Information Costs: Globalization of economic activity has led ___________________

to internationalization of production and consumption. The
E
___________________
manager must be aware of the latest developments in the
___________________
industry in which he operates so as to make better decisions.
He may have to make inventory capacity decisions, modify ___________________
product line, and customize products to local tastes, and so on. ___________________
UP
With the advent of information economy creation of value is
___________________
increasingly based on knowledge and communications rather
than on natural resources and physical labour as in the past. ___________________
For instance, computeraided design (CAD) and computer- ___________________

aided manufacturing (CAM) has increased producers ability
___________________
to produce several products for different markets. Spread of
computer networks and IT speed up delivery of goods,
decrease inventory, cuts wastes and generally increases
productivity. Thus, in the present Age of Information, a
E-
manager has to incur costs
(i) To acquire an information source that can help in

forecasting, or
(ii) Acquire information that influences forecasts.
The decision maker should acquire the additional source or

CC
information only if its expected value (in making better

decisions) exceeds its costs.
Check Your Progress

Fill in the blanks:
1. Globalization of economic activity has led to ..................
of production and consumption.
2. ................... are generally referred to as the stocks held
by a firm.
3. ................... are the costs of holding materials in the
(c)
stores.
4. ................... comprise the costs of placing orders,
inspection, checking and handling of goods, the cost of
floating tenders, stationery, fax, etc.
104
Short Run Cost Functions
S
Notes
To price intelligently, management should know how costs change
___________________
with a change in production. Cost functions depict relationship
___________________
between the cost and the output rate. They show the minimum
___________________ costs of producing various levels of output on the assumption that
E
___________________
the firm uses the optimal or least cost combination to produce each
level of output.
___________________
The short run curves are derived from the short run production
___________________
curves given the factor prices. They depict variations in cost over
UP
___________________
output for plant of a given capacity. The short run costs may
___________________ exceed the long run costs for this reason. Table 12.1 shows short
___________________
run costs of a firm. These schedules are plotted in Figure 12.1
where Q refers to the output that a firm produces in the short
___________________
run.
Table 12.1: Short Run Costs
Quantity TFC TVC TC AFC AVC ATC MC
0 60 0 60 - - - -
E-
1 60 20 80 60 20 80 20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
CC
Total Cost Functions

As discussed earlier, short run is a time period during which some
of the firms inputs are fixed. Total fixed costs (TFC) are the total
costs per period of time incurred by the firm for the fixed inputs.
They include:
(a) Interest payment on borrowed capital,
(b) Contractual rent,
(c) Depreciation of machinery and building,

(c)
(d) Property taxes, and
(e) Salaries of administrative staff and/or salaries fixed by

contract.
UNIT 12: Cost
105
S
Notes
___________________
___________________
E
___________________
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
E-
Figure 12.1: Short Run Cost Curves
These costs have to be incurred despite negligible output by the

firm. In the example, the firm has to incur TFC of ` 60 even though
CC
output is zero, in order to remain in business. At zero output, the

TC of the firm is equal to fixed costs. The TFC curve shown in
Figure 12.1 is a horizontal line parallel to X-axis.
The costs incurred for variable inputs are the total variable costs
(TVC). They include:
(a) Payment for raw materials,
(b) Fuel and power used,
(c) Depreciation by use of plant and equipment,
(d) Wages for direct labour and/or temporary employees, and

(c)
(e) Excise taxes.
Running expenses like routine maintenance and ordinary repairs

are also included in variable expenses. The TVC increases with the
increase in output of the firm, since a larger output requires more
variable inputs. In Figure 12.1, the TVC increases at a decreasing
106
rate initially till the point of inflexion (point G) and then at an
S
Notes increasing rate. This is due to the operation of law of diminishing
___________________ returns as shown in Figure 12.2.
___________________
___________________
E
___________________
___________________
___________________
UP
___________________
___________________
Figure 12.2: Relation between TVC and TP Curves
___________________
___________________ In the Figure, the TP curve shows increasing returns to variable

input (labour) till L and then decreasing returns. The input level L
corresponds to the output level Q. The TVC curve increases at a
decreasing rate up to Q and at an increasing rate beyond Q.
Total cost (TC) is the sum of TFC and TVC. The TC curve is
E-
parallel to the TVC due to fixed costs in the short run. They differ
from the TVC by the fixed cost of ` 60.
Average Variable Cost Functions

Average variable cost (AVC) is the variable cost per unit of output
produced. It can be derived from the TVC.
CC
TVC
AVC =
Q
The AVC decreases initially and eventually rises because of

diminishing returns to variable input. If the firms production is
nil, these costs will not be incurred. They are affected by the per
unit cost of each variable input in production (for example, hourly
wage rates of workers), the productivity of inputs and the
production technology available to the firm. Suppose, labour is the
only variable input in production then TVC per output level (Q)
equals wage rate (w) multiplied by the number of labourers used.
Thus,
(c)
TVC wL w w
AVC = = = =
Q Q Q/L APL
Since average product of labour (APL) usually rises first reaches

maximum and then falls so also the AVC curve first falls reaches a
UNIT 12: Cost
minimum and then rises. This relationship is shown 107
S
diagrammatically in Figure 12.3. Notes
___________________
___________________
E
___________________
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
E-
Figure 12.3: Per Unit Cost Curves and Productivity Curve
The AVC is important for short run decisions when the price
received for producing output is so low that the firm may choose
not to produce. A firm will shut down when it cannot earn
revenues sufficient to pay its AVC. The firm has no choice
regarding fixed cost in short run since these must be paid whether
CC
or not the firm shuts down. Therefore, fixed costs have no effect on
firms short run decisions. For a perfectly competitive firm,
shutdown point occurs where MC = AVC (i.e., where AVC is
minimum). At any price below this point revenues earned from
operations will fail to cover the cost of operations. The firm will
generate losses if it operates and it should shutdown.
Average fixed cost (AFC) is the ratio of total fixed cost to the
output (Q) produced by the firm.
TFC
AFC =
Q
(c)
The AFC declines continuously with increase in output since the

TFC is spread over as additional units of output produced in the
short run. For this reason the AVC curve is a rectangular
hyperbola.
Average total cost (ATC or AC) measures the total economic costs
of production per unit produced in the short run. It includes the
108
opportunity cost of capital employed, that is, the normal risk
S
Notes adjusted rate of return on capital. Therefore, a firm operating at its
___________________ AC earns zero economic profit. Economic profits are a signal for
entry and exit from the industry. The ATC represents a
___________________
benchmark curve in the short run for predicting whether entry or
___________________ exit will occur.
E
___________________
AC in the short run consists of average variable cost (AVC) and
___________________ average fixed cost (AFC).
___________________ ATC or AC = AVC + AFC
UP
___________________
We are aware that fixed costs of production do not vary with level
___________________ of output and are fixed in the short run. Therefore, the AC (fixed
___________________ cost per unit produced) decreases as the quantity produced
increases (AVC decreases). Thus, the typical AC curve is U-shaped
___________________
representing decreasing costs per unit initially as more units are
produced but reaching a minimum and then rising as output rises
per period.
Marginal Cost
E-
Marginal cost is the addition to the total cost resulting from the
addition to the last unit of output. It can be derived from the
change in TVC or TC, per unit change in output. Thus MC does not
depend on TFC. It should be noted that MC is always plotted
halfway between the various levels of output.
A firms decision to produce a certain level of output is influenced

CC
by its marginal cost. The U shape of MC can be attributed to the

law of variable proportions.
This can be proved as follows:

TC TVC (wL) w(L) w w
MC = = = = = =
Q Q Q Q Q/ L MPL
Since the marginal product of labour (MPL or Q/L) rises initially

reaches a maximum and then falls, it follows that the MC curve
first falls, reaches a minimum and then rises. Thus, the rising
portion of the MC curve reflects the law of diminishing returns.
(c)
Relationship between AC and MC

1. When MC falls, the AVC and AC curves must be falling. The
rate of fall in MC is greater than that of AC because the cost
of producing the last unit (the MC) is less than the AC of all
UNIT 12: Cost
the preceding units produced and this pulls down the AC 109
S
curve. Notes
2. When the MC curve lies above the AVC and AC curves, it ___________________
pulls them up since the cost of the last unit exceeds the ___________________
average of the previous units produced and adding any
E
number to an average which exceeds the average must force ___________________
the average value to rise. ___________________
3. MC intersects AC at its minimum point. When AC is at its ___________________

minimum, it is neither increasing nor decreasing, it is
___________________
constant. It follows that, when AC is constant AC = MC. This
UP
is because MC can be defined as the addition either to TC or ___________________
TVC resulting from one more unit of output. ___________________
The rate of change in MC is greater than that in AVC which ___________________

results the MC to be minimum at an output lower than at which
___________________
AVC is minimum (in Figure 12.2 Q2 > Q1). The ATC falls for a
larger range of output than AVC, hence ATC is minimum at a
larger output than minimum AVC (in Figure 12.2 Q3 > Q2).
The AC and MC curves indicate the optimum level of output for a

E-
given size of plant in the short run. The minimum level of AC is
where AC = MC. Output less than or more than this level will be
non-optimal. It should be noted that the intersection point shows
only the optimal output but not the maximum output.
Check Your Progress

Fill in the blanks:
CC
1. The TVC increases with the increase in ................... of

the firm.
2. The TVC increases at a .................... rate initially till
the point of inflexion (point G) and then at an
.................... rate.
Long Run Cost Functions

Quite often, managers have to make long run production decisions
with respect to change in the scale of plant (all inputs of the firm)
and hence the firms cost of production. Since all inputs are
(c)
variable in the long run, there are no fixed costs in the long run.
Ability to vary all inputs allows the firm to produce at lower costs
in the long run than in the short run. In brief, flexibility is
valuable.
110
Given the factor prices and a specific production function, we can
S
Notes
draw an expansion path, which gives the least costs associated
___________________
with various levels of output i.e. the long run total cost (LTC)
___________________ schedule. The LTC gives the least cost for various level of output
when all the factors of production are variable. The shape of the
___________________
E
LTC curve is due to returns to scale, factor prices given. The LAC
___________________ and LMC are derived from the LTC.
___________________ LTC LTC
LAC = LMC =
Q Q
___________________
UP
___________________ A hypothetical example is taken in Table 12.2 to explain the shape
___________________
of the long run cost curves plotted in Figure 12.3. Shapes of the
LAC and LMC shown in the figure are derived from the LTC. They
___________________ are U-shaped curves that have significant implications for long run
___________________ cost decisions.
Table 12.2: Long Run Costs
Production Total Product LTC LMC LAC

scale (Q)
A 10 50 5 5.00
E-
B 20 90 4 4.50
C 30 120 3 4.00
D 40 150 3 3.75
E 50 200 5 4.75
F 60 260 6 4.33
CC
(c)
Figure 12.4: Long Run Cost Curves

UNIT 12: Cost
Figure 12.4 shows that as output increases the total cost increases, 111
S
but not at a constant rate. The rate of change in the LTC is Notes
reflected in the LMC. The LMC curve first decreases, then it is
___________________
constant, and finally increases over the range of output. The
reason for this behaviour of the firms LMC (or LTC) pertains to ___________________
returns to scale. There is a direct relationship between the returns
E
___________________
to scale in production and the long run total cost function of the
firm, factor prices given. ___________________
(a) When returns to scale are increasing, LTC increases at a ___________________

slower rate than the increase in the output. ___________________
UP
(b) When returns to scale are constant, LTC and output move in ___________________
the same direction and in same proportion.
___________________
(c) When returns to scale are decreasing, LTC increases at a ___________________
faster rate than does the output.
___________________
The long run cost curves depict some significant relationships.
1. The LMC is minimum at the point of inflexion (point A) on

LTC.
E-
2. LAC is minimum at the point of kink (point B) on LTC.
3. LAC is least when LMC = LAC.
4. LAC is falling when LMC < LAC.
5. LAC is rising when LMC > LAC.
LAC as the Envelope Curve and Decision Making Tool

CC
Though the firm can choose any capacity plant in the long run, it
has to operate at a particular level of capacity. Once the plant has
been built, the firm operates in the short run and plans for the long
run. For example, before the IBM Corporation makes the decision
to add a new product to its line, the firm is in a long run situation.
The firm can choose among a wide variety of types and size of
equipment to produce the product. But once the investment is
made, IBM is confronted with a short run situation since the type
and size of equipment is, to a considerable extent, frozen.
Therefore, we can say that the firm operates in the short run and
plans for the long run. The long run is referred to as planning
(c)
horizon because the firm can build a plant that minimizes cost of
producing any anticipated level of output.
Suppose there are six SAC curves representing different scale or

size of plants as shown in Figure 12.5. The firm will choose plant A
to produce output till 12 units. The firm is indifferent between
112
plant A and B to produce 12 units of output. If the demand is
S
Notes expected to increase beyond 12 units of output in future than the
___________________ firm may choose plant B rather plant A. The same rule applies for
22 units of output. Plant B will be preferred to plant C for 20 units
___________________
of output. The average cost per unit for plant B (QR) will be less
___________________ than plant C (PR). PQ is the per unit loss if plant C is chosen. For
E
___________________
production between 12 and 22 units firm will operate on plant B.
___________________ For outputs less than the optimal scale, it is more economical to
underutilize a slightly larger plant operating at less than its
___________________
minimum costoutput level than to overutilise a smaller plant.
UP
___________________ Conversely, at output beyond the optimum level i.e. when the firm
___________________
experiences decreasing returns to scale, it is more economical to
overuse a slightly smaller plant than to underuse a slightly larger
___________________ one. To produce output less than ON, the firm will construct the
___________________ relevant plant and operate at less than its full capacity i.e., at less
than its minimum average cost of production. At output beyond
ON, the firm will operate the plant beyond its maximum capacity.
Only plant C is fully utilised and ON is the optimal output
(corresponding to plant C) since it is the minimum point of LAC.
Other plants are either underutilized or overutilise.
E-
Thus, the LAC curve is called the planning curve since it assists
the manager in using plants of various sizes to produce a specific
level of output at the minimum AC of production. Therefore LAC is
called the planning curve and the long run is referred to as the
planning horizon. Note that till the minimum optimum point (point
N), the firm operates on the decreasing portion of the relevant SAC
CC
curve while to the right on the rising portion.

(c)
Figure 12.5: LAC vs SAC

UNIT 12: Cost
To draw LAC, we assume infinite SAC curves each representing a 113
S
particular size of plant. We draw a smooth Ushaped curve Notes
Activity
tangent to the SAC curves. No point on the SAC curve can be Define the economies of
___________________
below the LAC curve. The LAC curve outlines the lowest per unit scale.
costs that the firm will incur over the range of output. As such it ___________________
envelopes the SAC curves for different capacity levels and is
E
___________________
typically assumed to be Ushaped. The U shape of LAC implies
___________________
increasing returns to scale or lower AC till the optimal scale
followed by decreasing returns to scale or high AC. Till the ___________________
optimum point (point N) there are economies of scale and
___________________
diseconomies thereafter. The LAC curve never cuts a SAC because
UP
average cost in long run is lower than short run at any level of ___________________
output. ___________________
1. ................... curve outlines the lowest per unit costs that

the firm will incur over the range of output.
2. The U shape of LAC implies ................... returns to
E-
scale or lower AC till the optimal scale followed by
decreasing returns to scale or high AC.
Economies of Scale
Now we will answer the question, why a large plant initially
experiences decrease in per unit costs and after a certain point,
CC
production results in higher average costs. We are aware that in

the long run, the law of diminishing returns is not applicable as it
assumes only one input as variable. The economies and
diseconomies of scale explain the U-shape of the LAC curve.
Economies of scale refer to a situation where output grows

proportionately faster than the use of inputs. With prices
remaining constant, this leads to lower costs per unit. Thus, the
primary reason for scale economies, in the long run, is the
increasing returns to scale in the firms long run production
function. This is reflected in the declining portion of the LAC.
While under decreasing returns to scale, output increases at a
proportionately slower rate than the increase in inputs. With input
(c)
prices constant, this leads to higher costs per unit. The rising
portion of LAC depicts this change. The lowest point on the LAC
curve occurs at the output level at which the forces for increasing
returns to scale are just balanced by the forces of decreasing to
scale.
114
Economies of scale arise because of technological and financial
S
Notes reasons, also referred as economies at plant level and firm level
___________________ respectively. Figure 12.6 depicts the major factors that give rise to
economies of scale.
___________________
___________________
E
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
Figure 12.6: Economies of Scale
Scale economies at the plant level arise because of increase in the

scale of operations. Greater division and specialization of labour
can take place with more specialized and productive machinery.
Each worker is assigned task in accordance to his skill and
E-
qualification. This division of labour leads to specialization in a
task due to repetitive work, which increases his proficiency. As
Prof. Marshall has stated learning by doing saves time lost in
moving from one activity to another.
It has been observed that per unit costs decline with large plant
size. Certain plants and equipment are indivisible in smaller
CC
units/sizes, like tractors and computers. Small firms cannot employ

such sophisticated machines and are, therefore unable to earn
benefits of updated technology. Thus, by increasing scale, the firm
may be able to use new production methods that are not feasible in
smaller outputs. It is also regarded that a machine that costs twice
as much as a smaller one will typically produce more output i.e., its
productivity/price is more. Large firms need fewer supervisors and
spare parts and smaller inventories per unit of output as the scale
of operation increases.
At the firm level the economies of scale arise due to financial

reasons. Due to bulk purchases large firms receive quantity
discounts for raw materials and components that result in lower
(c)
average cost. The cost of capital per unit of output is often found to
vary inversely with the size of firm. Large firms are able to raise
funds in the capital markets at lower costs than smaller firms.
Large firms usually sell bonds and stocks more favorably and
receive bank loans at lower interest rates than smaller firms.
UNIT 12: Cost
115
Large firms are able to secure quantity discounts even in securing
S
Notes
space and time in various advertising media. They can afford to
initiate promotional schemes to increase sales. Besides, the ___________________
promotional cost is spread out, which decreases the burden per ___________________
unit of output on larger firms, than smaller ones. For instance, a
E
___________________
30-second television advertisement represents the same fixed cost
to a large fast food chain and a small chain alike. But this expense ___________________
comprises a much lower cost per burger for the large chain. The ___________________
same can be said about innovations. Large firms are in a better
___________________
position to carry out R and D and thereby adopt latest methods of
UP
production and sales, and material procurement, than their small ___________________
counterparts. Large firms enjoy benefits of top caliber management ___________________
personnel.
___________________
Diseconomies of scale arise primarily due to decreasing returns to
___________________
management. As the size of the firm increases, firms planning and
coordinating activities become difficult. Additional bureaucratic
layers separate managers from the market and their customers. If
the consumers preferences change rapidly or if rivals introduce a
E-
new product, larger firms may be disadvantaged by their lack of
flexibility and slow adjustment to market. An interesting example
has been the reorganization of IBM. In early years of computer
industry, there were no independent suppliers of computer chips
and peripherals. Computer manufacturers had to be vertically
produced those inputs. But as the industry grew, so did
independent suppliers who could specialize in product components
CC
efficiently. As this occurred, change in technology, and factor costs

decreased the minimum efficient scale for computer
manufacturing. Even though IBMs separate divisions were as
efficient as their competitors, the internal pricing and cost
information did not reflect the efficiency. The organisation had to
be restructured so that divisions could operate as separate
companies to be closer to the market.
Per unit transportation costs rise as a firm increases the

production capacity. These involve delivery of goods, handling
expenses, insurance and security expenses, and inventory costs.
Thus, managerial inefficiencies and transportation costs more than
(c)
offset the fall in per unit costs due to economies of scale.

Till now we discussed factors that give rise to internal economies
and diseconomies of scale, which are a result of expansion of the
firm. External economies may arise due to the expansion of the
industry as a whole. Provision of training facilities and skill
formation, improved transportation and communication facilities,
116 and lateral and vertical integration may result in a reduction in
S
Notes per unit costs of industry as a whole. Excessive expansion may give
___________________ rise to external diseconomies, like environmental pollution.
___________________
Check Your Progress
___________________
E
Fill in the blanks:
___________________
1. Scale economies at the plant level arise because of
___________________ increase in the ....................
___________________
2. At the firm level the economies of scale arise due to
UP
___________________ ....................
___________________
___________________ Summary
___________________ Opportunity Cost is the value of a resource in its next best
alternate use. Declining long run average cost curve over the lower
part of the range of possible output is usually attributed to the
Economies of Scale. Rising long run average cost curve at higher
level of output are usually attributed to the Diseconomies of Scale.
E-
Lesson End Activity
Draw the graphical representation of LAC and SAC curves.
Keywords
CC
Actual costs mean the actual expenditure incurred for producing

a good or service.
Average fixed cost is the ratio of total fixed cost to the output
produced by the firm.
Average variable cost is the variable cost per unit produced.
proportionately faster than the use of inputs.
Expansion path of the firm represents the least cost combination
of inputs for different levels of output.
Fixed costs are the total costs per period of time incurred by the
(c)
firm for the fixed inputs.

Implicit costs refer to the value of inputs owned and used by the
firm in its production process.
addition to the last unit of output.
UNIT 12: Cost
Questions for Discussion 117
S
Notes
1. What are opportunity costs? Explain with the help of
___________________
examples. What problems are faced in measuring these costs?
___________________
2. Explain the concept of total cost and marginal cost.
E
___________________
3. What are the salient features of the LAC curve? What is its ___________________
usefulness in managerial decision making?
___________________
4. What role is played by economies of scale in determining the
efficient size of the firm? ___________________
UP
___________________
Further Readings ___________________
___________________
Books
___________________
Maurice- Special Indian, 8th Ed, Mc-Graw Hill Education.
Publication
E-
Managerial Economics by Karampal and Surender Kumar, Ist
Web Readings
CC
(c)
118
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Notes
___________________
___________________
___________________
E
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
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CC
(c)
UNIT 13: Production
Unit 13
119
S
Notes
Production
___________________
___________________
E
___________________
Objectives
___________________
topics: ___________________
\ Production and production function ___________________
UP
\ Technological progress ___________________
___________________
Introduction ___________________
A manager is faced with a choice problem of how to produce? He ___________________

has to make a decision about the combination of fixed and variable
quantities that should be employed to produce a good most
efficiently. That is, he has to decide about the input combination.
This requires, firstly the engineering or technological information
E-
on production possibilities (the production function) and, secondly
economic data on prices of inputs and output (cost analysis). In this
unit we will discuss the operating efficiency, i.e., the relation
between physical input and output. In fact, prudent decisions
about optimal output and optimal prices to be charged require an
understanding of relationship between output rate of the firm and
costs. Managerial decisions with respect to quotation of prices,
CC
efficacy of a product line, change in volume of output, and use of

excess capacity depends on the cost analysis. Efficient resource
combinations to produce a specific output rate can be translated
into cost data.
Production and Production Functions

Production in economics refers to the process by which man
utilizes or converts the resources of nature, working upon them, so
as to satisfy human wants. In other words, production is an
economic activity that transforms inputs or resources into output
(c)
of goods and services, thus creating or adding utility. Utility is the

want satisfying power of a good or service. Processes of production
create utility by conferring form utility, place utility and time
utility. Manufacture of copper wires is utility of form as copper ore
is transformed into wires. Export of mangoes to Middle East is
utility of place as it provides satisfaction to greater number of
120
people. Canning of seasonal fruits and storing of seasonal
S
Notes
Activity vegetables in cold storage creates time utility as they are made
Explain the term production.
___________________ available during off-season. Managers are interested in
productivity that is simply a ratio of output to input.
___________________
___________________ A production function is a purely technical or physical relation
E
between inputs and maximum output that can be produced, within
___________________
a given period of time, with a given level of technology. It can be
___________________ presented in form of an equation, table and graph. Output (Q) is a
___________________
function of combination of inputs namely; land (LD), labour (L),
capital (K), managerial ability or management (M) and technology
UP
___________________
(T). The relationship is generally expressed in the form of an
___________________ equation as follows:
___________________ Q = f (Ld, L, K, M, T)
___________________
A two input production function can also depict significant results
and can be easily generalized for any number of inputs. Therefore,
a production function takes the following form:
Q = f (L, K)
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Labour and capital are taken as two inputs since they are regarded
as inevitable inputs to produce any quantity of a good. They are
taken as substitutes in production. A production function is based
on following assumptions:
(i) Perfect divisibility of both inputs and output,

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(ii) Limited substitution of one factor for the other,
(iii) Technology is constant, and
(iv) Inelastic supply of fixed factors in the short run.
It should be noted that the relationship between inputs and

outputs exists for a specific time period. In other words, quantity is
not a measure of output accumulated overtime. It is believed that
at any moment of time, the firm is producing the maximum output
with the best available production technology. Further profit
maximisation by managers assumes that production is technically
efficient, that is, neither inputs nor outputs are wasted or misused.
Technology is also taken as constant since technological
(c)
innovations result in a change in the relationship between inputs

and output.
Technological change or advance of technology may involve

introduction of new methods of producing existing products,
improvements or cost reduction of existing products (due to process
UNIT 13: Production
innovation), or new techniques of organisation, marketing and 121
S
management. It may also result in availability of new products due Notes
to product innovation. A manager should be aware that technique ___________________
of production refers to production process employed by a firm
___________________
whether labour intensive or capital intensive.
E
___________________
Let us take a hypothetical example to describe a production
function. Suppose a firm supplies specialty part to an automobiles ___________________
manufacturer. Figure 13.1 shows a production function with the ___________________
quantities of output (specialty part) that can be produced by using
___________________
different combinations of labour and capital. The table shows that
UP
52 units of output can be produced by five combinations of labour ___________________
(L) and capital (K), specifically (8L, 2K) (6L, 2K) (4L, 3K) (3L, 4K) ___________________
and (2L, 6K).
___________________
How to produce?
___________________
Short run Long run

One variable input
Law of Variable Proportions
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VI Q
Two variable inputs All inputs variable
Isoquant analysis Returns to scale
2 inputs Q all inputs Q
Figure 13.1: Production Decisions
Production Functions
CC
We know that a production function expresses an engineering

relationship between inputs and outputs. There are several forms
of production functions, but we will focus on the five most common
forms.
1. Linear Production Function: A linear production function

can take the form
Q = aL + bK + c
Where a, b, and c are coefficients that must be estimated from

the data. Due to linearity each inputs marginal product is
constant: MPL = a and MPK = b. Constant marginal
(c)
productivity may be an accurate approximation over a limited

range of input use. Further, linearity implies that the inputs
are perfect substitutes for each other.
122
2. Fixed Proportion Production Function: A fixed proportion
S
Notes
production function, also called as Leontief function, is the
___________________
opposite extreme from linear production. Instead of perfect
___________________ substitutability, fixed proportions production allows no
___________________ substitutability. Output is produced with a given proportion of
E
inputs. Simple examples include a taxi and its driver or a
___________________
construction crane and its operator. In both cases, the
___________________ required mix of labour to capital is one to one. An excess of
___________________ either input a machine without an operator, or vice versa
does no good. Expansion of production requires balanced
UP
___________________
increases in the necessary inputs. Like linear production,
___________________ fixed proportions should be thought of as an extreme case.
___________________ As a result of fixed proportions in case of an increase in the
___________________ price of an input, the firm cannot economize on its use, that is,
substitute away from it. Thus, a petrochemical firm that uses
fixed proportions of different chemicals to produce its specialty
products has to hire them at the prevailing market prices.
3. Quadratic Production Function: The variables in this

E-
production function are raised to positive integer powers. A
quadratic function can be expressed as follows
Q = a LK bL2K2
Where a and b are positive coefficients. It is easy to check that

each input shows diminishing returns. For example, MPL =
CC
Q/L = aK 2bK2L, which declines as L increases. The

elasticity of production declines with increase in input.
4. Cubic Function: A cubic function can take the following form
Q = aLK + bL2K + cLK2 dL3K eLK3
Where all coefficients are positive. This function shows

increasing returns for low levels of output and then decreasing
for high output levels. The marginal product of an input (say
labour) takes the form
MPL = Q/L = (aK + cK2 eK3) + 2bKL 3dKL2

(c)
The marginal product is a quadratic function in the amount of

labour, that is, it is a parabola that rises, peaks, and then
falls. Thus, this production function includes an initial region
of increasing marginal productivity followed by diminishing
returns. The elasticity of production varies at each point along
the curve.
UNIT 13: Production
5. Power Functions: A power function can be expressed as 123
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follows Notes
Q = aXb ___________________
Where output Q is a function of input X. If one input is ___________________

increased while all others are held constant, marginal product
E
___________________
will decline. Exponents (like b) in such a function are
___________________
elasticities of production. The equation can be written in
logarithmic form ___________________
Log Q = log a + b log X. ___________________
UP
Cobb Douglas production function is the most popular form. It ___________________
is expressed as follows ___________________
Q = AK La b
___________________
Where Q is the total output; A is a positive constant; K and L ___________________

are capital and labour respectively; a and b are positive
fractions. The Cobb Douglas production function is often used
in the form
Q = AKa L1-a
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The Cobb Douglas production is a power function with several
properties.
1. In its general form, it is multiplicative type and is non-linear.
The function can be changed into its log-linear form as
log Q = log A + a log K + b log L
CC
It is easier to compute Cobb Douglas function when expressed

in this form.
2. The power functions are homogeneous. Fractions a and b
represent the degree of homogeneity. When (a+b) = 1, the
production function is homogeneous of degree one which
implies constant returns to scale. If (a + b) > 1, it is
homogeneous degree greater than one, that is increasing
returns to scale and vice versa.
3. a and b represent the elasticity coefficients of output for
capital and labour inputs respectively. The output elasticity
coefficient (Ek) in respect of capital can be defined as
(c)
proportional change in output as a given change in capital

keeping labour constant. Thus
Percentage change in factor quantity ratio
Ek =
Percentage change in factor price ratio
124
Q / Q Q K
S
Notes Ek = =
K / K K Q
___________________
By differentiating the production function Q = AKa Lb with
___________________ respect to capital; we get
___________________ LM K OP = a
E
E k = a AK a 1Lb
___________________ N AK L Q
a b
___________________ Substituting the values for Q and DQ/DK in the first equation,
we get
___________________
LM K OP = a
UP
E k = a AK a 1Lb
___________________ N AK L Q
a b
___________________ Thus output elasticity coefficient for K is a. The same

___________________ procedure may be adopted to show that b is the elasticity
coefficient of output for L.
___________________
4. a and b represent the relative shares of capital and labour
respectively. The share of K in Q is given by
Q
K
K
E-
Similarly the share of L in Q may be obtained as
Q
L
L
The relative share of K in Q can be obtained as
Q 1 aAK a1 Lb . K
K = =a
L Q AK a Lb
CC
Similarly it can be shown that b represents the relative share

of labour in total output.
5. In its general form Q = Ka L1the Cobb Douglas means that at
zero cost, production will be zero.
Some concepts used in production analysis can easily be
derived from the Cobb Douglas production function as shown
below.
(a) Average Product (AP) of L and K
APL = A (K/L)1 a
APK = A (L/K)1
(c)
(b) Marginal Product of L and K

MPL = a . A (K/L) a = a (Q/L)
MPK = (a1) A (L/K)a = (1-a) Q/K
UNIT 13: Production
125
(c) Marginal Rate of Technical Substitution
S
Notes
MRTS LK =
MPL LM a K OP
N a1 af L Q
___________________
MPK
___________________
Constant Elasticity of Substitution Production Function (CES
E
___________________
function) has constant elasticity rather than unity elasticity
assumed by Cobb Douglas production function. The general form of ___________________
CES function is ___________________
X = [KC + (1 K) L-] v/ ___________________
UP
Subject to ( > 0, 0 < K<1, > -1) ___________________
Where X refers to output, C to total capital input and L to labour ___________________
input. ___________________
X, C and L are variables included in the production function and , ___________________

K, a and are parameters.
1. denotes efficiency and depicts scale effect. Like the
parameter A in Cobb Douglas function, it indicates the state of
technology and organisational aspects of production. The
E-
higher the value of g, higher will be the output given the same
inputs.
2. is the capital intensity factor coefficient or distribution

parameter. (1 K) is the labour intensity coefficient. The
value of K indicates the relative contribution of capital input
(C) and labour input (L) to total input (X).
CC
3. is the substitution parameter. The elasticity of substitution

is derived with the help of the percentage .
Check Your Progress

Fill in the blanks:
1. ................... is an economic activity that transforms
inputs or resources into output of goods and services,
thus creating or adding utility.
2. ................... is a purely technical or physical relation
between inputs and maximum output that can be
(c)
produced, within a given period of time, with a given

level of technology.
3. ................... are taken as two inputs since they are
regarded as inevitable inputs to produce any quantity
of a good.
126
Technological Progress
S
Notes
Activity
Explain the term technological
___________________ Technological progress leads to increase in output for a given
progress.
amounts of capital and labour. It shifts the entire production
___________________
function and Isoquant map. Technical improvements may arise
___________________ from the use of more productive inputs or better methods of
E
___________________ economic organization. It can have many dimensions:
___________________ z Larger quantities of output

___________________ z Better products
UP
___________________
z New products
___________________
z A larger Variety of products
___________________
Suppose that the production function is
___________________
q = A (t) f (k, l)
Where A(t) represents all influences that go into determining q
other than k and l. Changes in A represents technical progress
over a period of time. The determinant of technological progress in
E-
modern economics is the result of firms research and development
activities. Spending on Research and development depends on the
fertility of the research process and appropriability of research
results.
Check Your Progress

CC
Fill in the blanks:

1. ................... leads to increase in output for a given
amounts of capital and labour.
2. The determinant of technological progress in modern
economics is the result of firms ................... activities.
Summary
Production refers to the transformation of resources into output of
goods and services. Production function refers to the physical
relationship between a firms inputs of resources and its output of
(c)
goods and services per unit of time, leaving process aside. The
marginal rate of substitution measures how one factor of
production is substituted for another while keeping the output
constant. Law of variable proportions states that as equal
increments of one inputs are added, the input of other productive
UNIT 13: Production
services being held constant, beyond a certain point, the resulting 127
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increments of product will decrease. An Isoquant curve shows all Notes
the possible combinations of the inputs capable of producing same ___________________
level of output. Output can be increased by changing all factors of
___________________
production. It can change in more than proportion, equal
E
proportion or less than proportion. ___________________
___________________
State the properties of the Coub Douglas Production Function. ___________________
UP
___________________
Keywords ___________________
___________________
Average product is the total output produced per unit of input
used. ___________________
Marginal product is the change in the total product resulting

from a unit change in a variable input.
Marginal rate of technical substitution is the rate at which

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one input can be substituted for the other to maintain the same
level of output.
Production function is a purely technical or physical relation
between inputs and maximum output that can be produced, within
a given period of time, with a given level of technology.
Isocost line is the locus of alternative combinations of labour and

CC
capital that a firm can purchase with a given monetary cost outlay.
Isoquant depict physical relationship of all combinations of two

inputs, say labour and capital input rates that will produce the
same level of output.
Law of diminishing returns states that as additional units of
variable input are combined with a fixed input, the additional
output (i.e., marginal product) initially increases at an increasing
rate, then diminishing rate, eventually leading to a decline in the
total product.
(c)

1. What is the law of Diminishing Returns? Why does it operate?
How does it help in short run business decision making?
2. State and illustrate the Cobb Douglas Production Function.

128
3. What is the effect of an increase in the price of an input on the
S
Notes production function of a firm? With two inputs, how does it
___________________ affect the firms choice of inputs?
___________________ 4. A firms production function is Q = L2 + 10LK + K2, where Q
represents the output and L stands for labour and K for
___________________
E
capital. The price of L and K are ` 5 and ` 20 respectively. The
___________________ firm has a fixed budget of ` 1150. Determine the equilibrium
___________________ quantity of Q, L and K if the firm has to maximize profits.
___________________
UP
___________________ Further Readings
___________________
Books
___________________
___________________ Maurice- Special Indian, 8th Ed, Mc-Graw Hill Education.
Publication
E-
Web Readings
CC
(c)
UNIT 14: Supply & Demand as Market Forces
Unit 14
129
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Notes
Supply & Demand as Market

___________________
___________________
Forces
E
___________________
___________________
Objectives ___________________
___________________
UP
topics:
___________________
\ Meaning of demand
\ Demand function & demand curve ___________________
\ Meaning of supply ___________________
___________________
Introduction
Supply and demand are the most frequently used words in
economic analysis. And for good reason, they provide a good off-
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the-cuff answer for any economic question. For example,
Why are onions and mangoes so expensive? Supply and demand.
Why are interest rates falling? Supply and demand. Why cant I
find decent woolen socks any more? Supply and demand.
The importance of interplay of supply and demand makes it only
natural that early in any managerial economics course, one learns
CC
about supply and demand. We will start with demand.
Concept of Demand
In Managerial Economics we are concerned with demand faced by the
firm for a commodity faced by the firm. This depends upon the size of
the total market or industry demand for the commodity, which in
turn is the sum of the demands for the commodity of the individual
consumers in the market. Thus we begin by examining the theory of
consumer demand in order to learn about the market demand on
which the demand for the product faced by a particular firm depends.
(c)
Demand is one of the crucial requirements for the existence of any

business enterprise. A firm is interested in its own profit and/or
sales, both of which depend partially upon the demand for its
product. The decisions which management takes with respect to
production, advertising, cost allocation, pricing, etc., call for an
analysis of demand.
130
Demand for a commodity refers to the quantity of the commodity
S
Notes
Activity which an individual household is willing to purchase per unit of
List___________________
the various types of time at a particular price.
demand.
___________________ Demand for a commodity implies:
___________________ Desire to acquire it
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___________________
Willingness to pay for it, and
___________________
Ability to pay for it.
___________________
Demand has a specific meaning. Mere desire to buy a product is
UP
___________________
not demand. A misers desire for a car and his ability to pay for a
___________________ car is not demand because he does not have the necessary will to
pay for it. Similarly, a poor mans desire for a car and his
___________________
willingness to pay for a car is not demand because he lacks the
___________________ necessary purchasing power. One can also conceive of a person who
possesses both the will and purchasing power to pay for a
commodity, yet this is not demand for that commodity if he does
not have desire to have that commodity.
Demand for a commodity has to be stated with reference to time,

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its price and that of related commodities, consumers income and
taste, etc. Demand varies with fluctuations in these factors.
Further it also depends on quality because if the quality changes it
can be deemed as another commodity.
Check Your Progress

Fill in the blank:
CC
1. Demand for a commodity refers to the quantity of the

commodity which an individual household is willing to
purchase per unit of time at a particular price.
...................
Types of Demand
For a purposeful demand analysis for managerial decisions, it is
necessary to classify the large number of goods and services
available in every economy. Policy decisions are also facilitated by
(c)
an understanding of demand at various levels of aggregation. A

classification in these respects is as follows:
1. Consumer goods and producer goods: Goods and services

used for final consumption are called consumer goods. These
include those consumed by human beings, animals, birds, etc.
Producer goods refer to the goods used for production of other 131
S
goods, like plant and machines, factory buildings, services of Notes
employees, raw materials, etc. ___________________
2. Perishable and durable goods: Perishable goods become ___________________

unusable after sometime, the rest are durable goods. To be
E
___________________
precise, perishable goods are those which can be consumed
only once while in the case of durable goods, their services ___________________
only are consumed. Durable goods pose more complicated ___________________
problems for demand analysis than do non-durables. Sales of
___________________
non-durables are made largely to meet current demands
UP
which depend on current conditions. In contrast, sales of ___________________
durable goods go partly to satisfy new demand and partly to ___________________
replace old items. Further, the latter set of goods are generally
___________________
more expensive than the former set, and their demand alone
is subject to preponement and postponement, depending on ___________________
current market conditions vis--vis expected market
conditions in future.
3. Autonomous and derived demand: The goods whose

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demand is not tied with the demand for some other goods are
said to have autonomous demand, while the rest have derived
demand. However, there is hardly anything whose demand is
totally independent of any other demand. But the degree of
this dependence varies widely from product to product. Thus,
the autonomous and derived demand varies in degree more
than in kind.
CC
4. Individuals demand and market demand: Market

demand is the summation of demand for a good by all
individual buyers in the market. For example, if the market of
good X has, say, only three buyers, then individual and
market demand (monthly) could be as follows:
Table 14.1: Demand of X in Litres
(c)
This has been shown by a graphically in Figure 14.1 where

D1D1 represents demand curve of buyer 1, D2 D2 of buyer 2, D3
D3 of buyer 3 and DD that of all three of them called the
132
market demand curve. The market demand curve is thus the
S
Notes horizontal summation of individual demand curves.
___________________
___________________
___________________
E
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
Figure 14.1: Demand of X In Litres at Different Prices
A firm would be interested in the market demand for its

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products while each consumer would be concerned basically
with only his own individual demand.
5. Firm and industry demand: Goods are produced by more

than one firm and so there is a difference between the demand
facing an individual firm and that facing an industry. (All
firms producing a particular good constitute an industry
CC
engaged in the production of that good). For example, demand

for Hyundai car alone is a firms demand and demand for all
kinds of cars is industrys demand.
6. Demand by market segments and by total market: If the

market is large in terms of geographical spread, product uses,
distribution channels, customer sizes or product varieties, and
if any one or more of these differences were significant in
terms of product price, profit margins, competition, seasonal
patterns or cyclical sensitivity, then it may be worthwhile to
distinguish the market by specific segments for a meaningful
(c)
analysis. In that case, the total demand would mean the total
demand for the product from all market segments while a
particular market segment demand would refer to demand for
the product in that specific market segment.
133
Check Your Progress
S
Notes
Activity
Fill in the blanks:
Graphically represent the
___________________
1. Goods and services used for final consumption are demand curve.
___________________
called ....................
E
___________________
2. ................... goods become unusable after sometime, the
___________________
rest are durable goods.
___________________
3. The goods whose demand is not tied with the demand
for some other goods are said to have .................... ___________________
UP
___________________
Demand Function and Demand Curve
___________________
The demand for a commodity arises from the consumers ___________________
willingness and ability to purchase the commodity. The demand
theory postulates that the quantity demanded of a commodity is a ___________________
function of or depends on not only the price of a commodity, but

also income, price of related goods both substitutes and
complements taste of consumer, price expectation and all other
factors. Demand function is a comprehensive formulation which
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specifies the factors that influence the demand for the product.
Dx = f (Px, Py, Pz, B, A, E, T, U)
Where, Dx = Demand for item x
Px = Price of item x
Py = Price of substitutes
CC
Pz = Price of complements
B = Income of consumer
E = Price expectation of the user
T = Taste or preference of user
U = All other factors
Socio-psychological determinants of demand like tastes and

preferences, custom, habits, etc., defy any theoretical explanation.
Demand curve considers only the price demand relation, other

(c)
factors remaining the same. The inverse relationship between the

price and the quantity demanded for the commodity per time
period is the demand schedule for the commodity and the plot of
the data (with price on the vertical axis and quantity on the
horizontal axis) gives the demand curve of the individual.
134
Table 14.2: An Individuals Demand Schedule for Commodity X
S
Notes
___________________ Price x Quantity of x demanded
(per Unit) Px (in Units) Dx

___________________
2.0 1.0
___________________
E
1.5 2.0
1.0 3.0
___________________
0.5 4.5
___________________
___________________ The Demand curve is negatively sloped, indicating that the
UP
individual purchases more of the commodity per time period at
___________________
lower prices (other factors being constant).
___________________
The inverse relationship between the price of the commodity and
___________________ the quantity demanded per time period is referred to as the Law of
___________________ Demand.
A fall in Px leads to an increase in Dx (so that the slope is

negative) because of the substitution effect and income effect.
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Price of X
CC
Figure 14.2: Demand Curve
The first reason for the validity of downward sloping demand curve
is that the lower prices bring in new buyers. Secondary, when the
price of a commodity declines, the real income or purchasing power
of the consumers increases which induced them to buy of this
commodity. This is known as the income effect. Thirdly, when the
price of a commodity falls while prices of all other goods remain
(c)
constant, the commodity becomes relatively cheaper. This induces

the consumers to substitute this commodity in place of other
commodities which have been relatively dearer. This is known as
substitution effect.
Individual Demand and Market Demand 135
S
Notes
To study a market, there are a number of buyers. The change from
an individual to a market demand schedule can be done easily by ___________________
summing up the quantities demanded by each consumer at various ___________________
possible prices.
E
___________________
P P P ___________________
___________________
___________________
UP
___________________
D1 D2 D3 ___________________
Q Q Q
35 39 26
___________________
P
___________________
E-
D(Total)
Q
100
Figure 14.3: Market Demand Curve
Total demand curve can similarly be derived by summing

individual demand curves horizontally.
CC
A market demand curve tells us two things:
1. The maximum quantity that could be demanded at a given

price.
2. The maximum price obtainable for a given quantity.
Shifts in the Demand Curve

If any of the components held constant in drawing a demand curve
change, there is a shift in the demand curve. It is of two types.
1. Increase in Demand: The demand curve shifts upward or to

the right, so that the individual demands more of the commodity
(c)
at each commodity price if the price of a substitute commodity

increases or the price of a complimentary commodity falls, and if
the consumers taste for the commodity changes.
2. Decrease in demand: With opposite changes in factors

affecting demand, the demand curve shifts to dx2.
136
It is important to clearly distinguish between a movement along a
S
Notes
given demand curve (as a result of change in price) from a shift in
___________________
demand (as a result of change in income, price of related
___________________ commodities and tastes). The first is known as a change in
___________________ quantity demanded and the second is known as a change in
E
demand.
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
Figure 14.4: Increase in Demand

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Analysis of historical demand, supply movements and future
projects help determine the cycle position. There are four major
phases of the cycle.
CC
Figure 14.5: Decrease in Demand
1. Falling market: When the market is moving down, prices

are typically decreasing, stock levels are rising and demand is
decreasing. For example combined with past construction,
(c)
new space is becoming available that is no longer necessary,

thus leading to an oversupply situation.
2. Oversupplied market: Around the bottom of a cycle, signals

are usually mixed i.e., the rate of decrease in prices is slowing
but the future direction of demand is uncertain.
3. Rising market: Once the market's upward movement has 137
S
been confirmed through steady increases in demand (with Notes
strong future expectations of continued demand, robust ___________________
economic growth coupled with slow response of new supply),
___________________
prices being to increase steadily.
E
4. Supply response: The market anticipates the peak of the ___________________
cycle. Demand for stock begins to slow, large supply of new ___________________
stock is nearing completion and prices continue to climb until ___________________
demand is satisfied.
___________________
UP
Movement along a demand curve is different from shift in demand
___________________
curve. Movement along a demand curve is the change in a point on
the demand curve. Shift in the demand curve means the change in ___________________
the whole demand curve. In the figure below, movement from D1 to ___________________
D2 is "expansion" demand and from D1 to D3 is "contraction" of ___________________
demand. The contraction and expansion along a demand curve
depends on the change in "quantity demanded".
P
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D
P3
P1
Price
P2
D
Q
CC
D1 D2
Quantity
Figure 14.6: Movement Along A Demand Curve
Six Things to Remember when Considering a Demand Curve

A demand curve follow the law of demand: when a price rises,
quantity demanded falls, and vice versa.
The horizontal axis quantity has a time dimension.
The quantities are of the same quality.
The vertical axis price is a relative price.
(c)
The curve assumes that everything else is held constant.

Effects of price changes are shown by movements along the
demand curve. Effects of anything else on demand (shift
factors) are shown by shifts of the entire demand curve.
138
Meaning and Determinants of Supply
S
Notes
Activity
List ___________________
the determinants of Meaning
supply.
___________________ The term supply must also be qualified with the price, the
___________________
quantity supplied at that price and the time period.
E
___________________ Supply means the quantity of a good a firm or an industry is
willing to supply at a given price during a given period of time.
___________________
Any factor that influences price and cost of the product influences
___________________ the supply of the product. The difference between revenue and
UP
___________________ costs is profit. For that matter anything that influences the profit
position is the determining factor.
___________________
___________________ Determinants
___________________ The main determinants are:
1. Own price of the product: If the cost remains unchanged
and the price rises, the profits rise. This induces the firms to
supply more. There is thus a direct relation between price and
supply.
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2. Technology: Technology refers to the combination of inputs
used to produce the product. There are constant
improvements in the technology used. The criterion of
improvement is that per unit cost falls. If price of the product
remains the same, and the per unit cost falls, profits rise and
the firms are induced to supply more.
CC
3. Input prices: The change in the price of an input directly

affects the cost of production. The per unit cost may rise or fall
depending upon whether price of the inputs falls or rises. If
the per unit cost falls, price of the product remaining the
same, profits rise. This induces the producers to supply more.
4. Prices of the related products: Firm normally produces
more than one product. Suppose a readymade garment firm
produces shirts and jeans both. Suppose price of jeans is
rising. This means that the relative profitability of producing
jeans is increasing. This induces the firm to divert some
resources from production of shirts to the production of jeans.
There is thus an inverse relation between the prices of the
(c)
related products and the supply of the given product.
The Supply Curve

The shape of supply curve is determined by the cost behaviour. The
cost behaviour in turn is determined by the changing trend of
prices in the input market. If producing higher quantity of a 139
S
product leads to higher per unit cost, the firm would be willing to Notes
Activity
supply more only at a higher price. This means a direct relation Graphically represent the
___________________
supply curve.
between price and supply and an upward sloping supply curve.
___________________
If producing higher quantity leads to lower per unit cost, the firm
E
___________________
may be willing to supply more even at a lower price. This means a
downward sloping supply curve. If the per unit cost remains the ___________________
same, the supply curve may also be parallel to the X-axis. ___________________
A distinction is made between supply curves in the short run and ___________________
UP
long run. Short run supply curve is taken to be upward sloping.
___________________
The long run supply curve can be of any shape depending upon the
behaviour of the input markets. But, generally, a typical long run ___________________
supply curve is also taken to be upward sloping. ___________________
___________________
Shift of Supply Curve
The term shift signifies change in supply due to factors other than
the own price of the product. Graphically it is called shift of
supply curve. When supply changes due to own price it is called
E-
movement along the supply curve.
Shift is also denoted as change in supply. The movement along

the supply curve is also denoted as change in quantity
supplied.
CC
(c)
Figure 14.7: Shift of Supply Curve (Change in Supply)

140
S
Notes
___________________
___________________
___________________
E
___________________
___________________
___________________
UP
___________________
___________________
Figure 14.8: Movement along the Supply Curve
___________________ (Change in Quantity Supplied)
___________________ The change in supply, if positive, is sometimes called increase,
and if negative, is called decrease. The change in quantity
supplied; if positive, is called extension and if negative, is called
contraction. The two situations are shown graphically in Figures
14.7 and 14.8.
E-
Check Your Progress
Fill in the blanks:
1. A movement along a given supply curve (as a result of
change in price) is also known as
CC
2. A shift in supply (as a result of factors other than price)

is also known as ...................
Summary
The communication between buyers and sellers may be any means
to settle the terms and conditions of transactions. The demand
function is a mathematical expression of the relation between
quantity demanded of commodity and the various determinants of
demand. A change in demand is reflected in a shift of the demand
curve to a new position due to change in any one of the
determinants of demand.
(c)
Lesson End Activity

With the help of the demand & supply curve, determine the
market price.
Keywords 141
S
Notes
Autonomous Demand: The goods whose demand is not tied with
___________________
the demand for some other goods are said to have autonomous
demand. ___________________
Complementary Goods: COMPLEMENTS are products that tend
E
___________________
to be used jointly, e.g., cars and gasoline, hamburgers and French ___________________
fires, tapes and tape players.
___________________
Individual Demand: The quantity of the commodity which an
___________________
individual household is willing to purchase per unit of time at a
UP
particular price. ___________________
Perishable Good: Perishable goods are those which can be ___________________

consumed only once while in the case of durable goods, their ___________________
services only are consumed.
___________________
Substitute Goods: Goods that can be used in place of another
good are called substitutes, e.g., a bus ride substitutes for a train
ride, ball pens for fountain pens.
E-
1. Explain determinants of demand by a consumer and market
demand.
2. Distinguish between Shift of demand curve and movement
along a demand curve.
CC
3. Explain determinants of supply.

4. Distinguish between Shift of Supply Curve and movement
along a supply curve.
Further Readings
Books
Dornbusch, R., Stanley fisher and Richard Startz (2001),
Microeconomics, New Delhi: Tata McGraw Hill.
Petersen, H. Craig and Lewis, W. Cris (20010, Managerial
Economics, Pearson Education Asia, New Delhi.
(c)
Koutsoyanis, A Modern Microeconomics (1979), Macmillan

Publishing Company, New York.
Web Readings
en.wikipedia.org/wiki/Supply_and_demand
142
S
Notes
___________________
___________________
___________________
E
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
E-
CC
(c)
UNIT 15: Case Study
Unit 15
143
S
Notes
Case Study
___________________
___________________
E
___________________
Objectives
___________________
After analyzing this case, the student will have an appreciation of the
___________________
UP
___________________
Case Study: Market and Sales Performance FY05-06 (Total
Automotive Scenario of India) ___________________
Introduction ___________________
The Indian car industry is a key driver of economic growth ___________________

contributing 4-5% in GDP growth. Rupee one invested in the auto
sector gives back `2.24 to the economy. There has been a
remarkable transformation of the car industry after 1991. It is set
to become the third largest automobile market by 2030 behind
E-
China and U.S. It is the second largest small car market after
Japan. The auto policy of government of India has a vision to
establish a globally competitive automotive industry in India and
to double its contribution to the economy by 2010.
Total Automobile Sales in India
14000
CC
Sales Volumes (in ,000s
12000 Three Wheelers
10000 LCVs
8000
Medium & HCVs
8527 9717
6000
Two Wheelers
4000
Passenger Vehicles
2000
1228 1319
0
2004-05 2005-06
% Market share across OEMs

Contd
(c)
144
S
Notes 60.0
50.0
___________________
40.0
___________________
30.0
___________________
E
20.0
___________________
10.0
___________________ 0.0
___________________ MUL Hyundai Tata Honda Ford HM GM Skoda Toyota Daimler Fiat
UP
2004-05 54.5 16.0 16.4 4.0 2.8 1.6 1.8 0.8 1.2 0.2 0.6
___________________
2005-06 55.1 16.6 15.9 4.3 2.9 1.6 1.2 1.1 1.0 0.2 0.1
___________________
___________________ The domestic car and UV industry is poised for strong growth.
The passenger cars market is likely to reach 2-8-3.0 million units
___________________
by 2015. The various demand drivers for passenger cars may be
listed as:
Increase in Affordability
z Growth in income leads to rapid expansion in the addressable

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market
z Lower EMIs
z Decline in excise duty and import duty
z New offerings
z Increase in dealerships and reach of financing

CC
z Reduction in holding period and increase in demand for

second car Compact car owners to upgrade
z Compact car owners to upgrade
z Adult/Population ratio
z Population density
z Urbanization
z Road density
Contd
(c)
UNIT 15: Case Study
145
S
Notes
___________________
Luxury Cars
___________________
C onsum er U pgradation
E
___________________
Mid size Cars
___________________
___________________
Small Cars ___________________
UP
___________________
___________________
Two wheelers
___________________
___________________
Passenger Car and UV Demand Growth (Units)
CAGR
Particulars 2004-05 2009-10 (5 year)
(%)
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Total passenger cars 819688 1736923 16.2
(Domestic)
Utility Vehicles 243875 399956 10.5
(Domestic)
Total cars and UVs 1063563 2136879 15
(domestic)
Exports 166410 412169 19.9
(cars and UVs)
Total
CC
1229973 2549048 15.7
Passenger Car and UV Demand Growth (Units)
3000000
2500000
2000000
2004-05
1500000
2009-10
1000000
500000
(c)
0
Total Utility vehicles Total Exports Total
passenger (domestic) cars and (cars and
cars UVs UVs)
(domestic) (domestic)
The impact of FDI has been remarkable FDI infused new

technology and management skills in the auto industry. It
Contd
146 increased the domestic capital efficiently. Demand for passenger
S
Notes cars tripled in size in the period 1985 to 2005. Still only about
12% of household in India can afford a car. This is well below the
___________________
levels of penetration seen in other countries at similar level of
___________________ economic development. Thus the Indian car industry is a large
___________________ market and provides an interesting area for study of demand
E
supply interplay.
___________________
Question
___________________
Analyse and summarise the case.
___________________
UP
___________________
___________________
___________________
___________________
E-
CC
(c)
UNIT 16: Market Equilibrium
147
S
Notes
___________________
___________________
E
___________________
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
BLOCK-IV
E-
CC
(c)
148
S
Notes
UNIT 16: MARKET EQUILIBRIUM
___________________ z Monopoly
z Introduction z Perfect Competition versus Monopoly
___________________
z Concept of Market Equilibrium z Price Discrimination
___________________
E
z Applications of Demand and Supply
___________________ UNIT 19: PRICING METHODS
UNIT 17: MARKET STRUCTURES & THEIR z Introduction
___________________
PRICING - I
z Multi Product Pricing
z Introduction
___________________
UP
z Price Discrimination
z Market Structure
___________________
z Pricing Methods in Practice
z Perfect Competition
___________________
___________________ UNIT 20: CASE STUDIES

UNIT 18: MARKET STRUCTURE & THEIR
PRICING - II
___________________
z Introduction
E-
CC
(c)
Unit 16
149
S
Notes
Market Equilibrium
___________________
___________________
E
___________________
Objectives
___________________
topics: ___________________
\ Concept of market equilibrium ___________________
UP
\ Applications of market demand & supply ___________________
___________________
Introduction ___________________
A situation in which the supply of an item is exactly equal ___________________

to its demand. Since there is neither surplus nor shortage in the
market, price tends to remain stable in this situation. In this unit,
we will study the concept of market equilibrium and its working in
the market.
E-
Concept of Market Equilibrium
The market for a good is said to be in equilibrium when at a price
market demand equals market supply. Market demand is the
sum of demands of all the individual consumers. Graphically, it is
CC
the horizontal sum of the demand curves of all the individual

consumers of the good. Market supply is the sum of supplies by all
the producers of that product. Graphically, it is the horizontal sum
of supply curves of all the individual producers of the product.
The price at which the market demand equals market supply is

called the equilibrium price. The quantities at this price are
called equilibrium demand and equilibrium supply.
Refer to the Figure 16.1. The equilibrium is at E, the intersection
of the demand and supply curves. The equilibrium price is OP and
the equilibrium quantity OQ. At any other price, market demand
and market supply will not be equal to each other.
(c)
For example, at price P1, market supply exceeds market demand

by A1B1. It is called the excess supply situation. At price P2, the
market demand exceeds market supply by A2B2. This is called
excess demand situation.
150 Y
S
Notes
Activity
Define the term market
___________________ S
equilibrium.
___________________ A1 B1
P1
___________________
E
P E
___________________
P2 A2 B2
___________________
D
___________________
UP
___________________ X
O Q
___________________
Figure 16.1: Market Equilibrium
___________________
When the demand and supply forces are free to operate neither the
___________________
excess supply situation not the excess demand situation will stay.
The market will correct itself and reach equilibrium again through
the interaction of the forces of demand and supply. How?
Suppose there is excess supply. It means that the firms will not be
E-
able to sell all what they want to sell at the given price. To clear
the stocks they will offer lower price to the consumers. The offer
produces two effects. Since the price is now lower, consumers start
demanding more. The consumer moves along the demand curve
downwards. Since the firm supply less at a lower price, they start
supplying less. The firms move along the supply curve downwards.
The price continues to fall and both the consumers and the firms
CC
continue to move along the curves till the price reaches equilibrium
(E) once again.
Now suppose there is excess demand. It means that the consumers
will not be able to buy all what they want to buy at the give price.
The consumers start offering higher price to the firms. It also
produces two effects. First, the consumers start demanding less.
Second, the firms start supplying more.
Both start moving along the curves upwards till the equilibrium
price is reached again.
The Effect of Shifts

(c)
The market equilibrium analysis is based on the assumption that

the factors other than the own price of the product remain
unchanged. If they change, the demand curve or the supply curve
or both may shift. Any shift will result in new equilibrium price
and quantity.
Given downward sloping demand curve and the upward sloping 151
S
supply curve, a rightward shift of demand curve (increase in Notes
demand) will lead to rise in price and rise in quantities. A leftward ___________________
shift will have the opposite effects. (Figure 16.2). A rightward shift
___________________
of supply curve will lead to fall in price and rise in quantities. A
leftward shift will have the opposite effects (Figure 16.3). The
E
___________________
effect of the simultaneous shifts of both the supply curve and the ___________________
demand curve will depend upon two things: (1) the direction of the
shifts and (2) the relative magnitudes of the shifts. The net result ___________________
may be that price rises, or falls or may remain same. One such ___________________
UP
possibility is shown in the Figure 16.4.
___________________
Y ___________________
S ___________________
Price
___________________
P1 E1
P
E-
E
D1
P2 E2
D
O D2
CC
Q2 Q Q1
Figure 16.2: Shift of Demand Curve
Y
S1
Price
S
P1 E1
P S2
E
P2 E2
(c)
O
Q1 Q Q2
Figure 16.3: Shift of Supply Curve

152
Y S1
S
Notes
Price S
___________________
P E
___________________ E1
___________________
E
D1 D
___________________
O X
___________________ Q1 Q QTY
___________________
UP
___________________ Figure 16.4: Shift of both Demand & Supply Curves

___________________ 1. The price at which the market demand equals market
supply is called the ...................
2. When the market supply exceeds market demand, it is
called the ................... situation.
E-
3. When the market demand exceeds market supply, it is
called the ................... situation.
Applications of Demand and Supply

How do Prices Allocate Resources?
CC
Prices, without use of any adjective, are the prices determined by

free interaction between the forces of demand and supply. Such a
mechanism is called market system, or simply price system.
Price system, in an economy, performs two functions:
1. Serves as price rationing device: Rationing here is not

used in the usual sense of the term. It has nothing to do with
government intervention in the market where it fixes the
maximum quantity a person can buy. Rationing here simply
means a distribution system. When the distribution system
operates through the price system, it is called price
rationing. So, price rationing is nothing but distribution of
(c)
goods and services in an economy through the automatic

functioning of the forces of demand and supply.
Price system eliminates shortages and surpluses. It amounts

to that price system automatically rations whatever is
available in the market. Suppose the market of a product is
already in equilibrium at A (Figure 16.5). Further suppose, 153
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due to one reason or the other, the producers are now willing Notes
to supply less at each price. This shifts supply curve to the
___________________
left. This creates shortages of the good at the existing price
OP1. The consumers demand P1A while firms are willing to ___________________
supply only P1B. The shortage is BA. Now, since demand falls
E
___________________
short of supply at price OP1, all consumers willing to pay OP1
___________________
will not be able to get the good. The consumers start offering
higher price and upward movement starts along the demand ___________________
curve. When price starts rising, the suppliers are now willing ___________________
UP
to supply more, and an upward movement also starts along
___________________
continue till C where market demand once again becomes
equal to market supply. A new equilibrium is reached at price ___________________
OP2 and quantity OQ2. The shortage is eliminated through
___________________
price rationing.
___________________
Price rationing raises the prices of goods in shortage. As a
result, goods go to the people who are rich. The poor suffer. As
a result government tries alternative rationing
mechanisms, e.g. price ceiling, queuing, favored customers,
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ration coupons, etc. Such mechanisms are justified on three
grounds.
i. Price-gouging, i.e. charging exorbitant prices is bad.
ii. Income is unfairly distributed.
iii. Some goods are necessities, and everyone should be able

to buy them at a reasonable price.
CC
Alternatives are justified if implemented honestly. The

practical problem is that black marketing emerges. This is
nothing but backdoor entry of the price rationing. It may
make the final distribution more unfair than that which
would result from simple price rationing.
S2
S1
C
P2
B A
(c)
P1
X
O Q2 Q1
Figure 16.5
154
2. Determines allocation of resources: The price system
S
Notes determines allocation of resources and the ultimate
___________________ combinations of things produced. Any change in the market
causing shift of demand and supply curves, causes price
___________________
changes. The chain of happenings follows:
___________________
E
(i) Suppose demand curve shifts rightwards.
___________________
(ii) This raises the price.
___________________
___________________ (iii) Rise in price causes profits to rise.
UP
___________________ (iv) Profits attract capital.
___________________ (v) Higher capital raises marginal product of labour and
___________________ wage rate.
___________________ (vi) Higher wage encourages workers to acquire skills.
(vii) For imparting skill new educational and training

institutions open.
(viii) In this way supply, demand and prices in input and

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output markets determine the allocation of resources and
ultimate combination of goods and services to be
produced.
An Application: Effect of an Oil Import Tax

We can show that an import tax reduces imports, reduces domestic
demand and raises domestic supply.
CC
A B
Po
D
(c)
X
O Q1 Q
2
Figure 16.6
155
Y
S
Notes
S
___________________
___________________
C D
E
P1 ___________________
A B
___________________
Po
D ___________________
___________________
UP
___________________
X
O Q1 Q3 Q4 Q2
___________________
___________________
Figure 16.7
___________________
Let P0 = World price of oil.
OQ1 = Domestic supply at OP0.
OQ2 = Domestic demand at OP0.

E-
Q1Q2 = AB = Excess demand gap filled by imports.
An import tax is imposed. This raises price of imported oil to

OQ3 = Domestic supply at (increased)
OQ4 = Domestic demand at (reduced)

CC
Q3Q4 = CD = Excess demand gap filled by imports (decrease)
Check Your Progress

Fill in the blanks:
1. When prices are determined by free interaction
between the forces of demand and supply, the
mechanism is called ...................
2. When the distribution system operates through the
price system, it is called ...................
(c)
Summary
In a market economy, the demand and supply forces constitute the
market mechanism that acts as the allocative device of resource
allocation. We use the term demand in the broad sense to refer to
the quantities of a commodity that buyers are willing and have
156 ability to buy at different prices. The term quantity demand refers
S
Notes to specific amount that buyers are willing and able to buy at
___________________ particular price with reference to point or over a period of time. A
market is a place that allows buyers and sellers to carry our any
___________________
transaction.
___________________
E
___________________
Lesson End Activity
___________________
With the help of the internet, find out another application of
___________________ demand & supply.
UP
___________________
___________________ Keywords
___________________ Equilibrium Price: The price at which the market demand
___________________ equals market supply is called the equilibrium price.
Producer Goods: Refer to the goods used for production of other

goods, like plant and machines, factory buildings, services of
employees, raw materials, etc.
E-
Market Demand: It is the summation of demand for a good by all
individual buyers in the market.
Supply: Quantity of a good a firm or an industry is willing to
supply at a given price during a given period of time.

CC
1. Determine the market equilibrium according to market

demand and market supply forces.
2. Suppose the government levies a tax on electricity. With the
help of demand and supply curves, show the deadweight loss
and government revenue. Would the deadweight loss and
government revenue be larger in the first few months and
after one year?
3. Consider a market in which the supply and demand functions

are given by the following equations:
(c)
P = 100 0.2 Q (demand)
P = 40 + 0.1 Q (supply)
(a) Determine the equilibrium quantity and price and

compute the price elasticity of supply at the equilibrium
point.
(b) Determine the effect of a ` 50 price ceiling on the price 157
S
and quantity traded. Notes
4. What do a supply schedule and supply curve show? What is ___________________

the usual shape of the supply curve? Why? ___________________
E
___________________
Further Readings
___________________
Books ___________________
___________________
Dornbusch, R., Stanley fisher and Richard Startz (2001),
UP
Microeconomics, New Delhi: Tata McGraw Hill. ___________________
Petersen, H. Craig and Lewis, W. Cris (20010, Managerial ___________________

Economics, Pearson Education Asia, New Delhi. ___________________
Koutsoyanis, A Modern Microeconomics (1979), Macmillan ___________________

Publishing Company, New York.
Web Readings
E-
en.wikipedia.org/wiki/Supply_and_demand
CC
(c)
158
S
Notes
___________________
___________________
___________________
E
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
E-
CC
(c)
UNIT 17: Market Structures & their Pricing - I
Unit 17
159
S
Notes
Market Structures & their

___________________
___________________
Pricing - I
E
___________________
___________________
Objectives ___________________
___________________
UP
topics:
___________________
\ Concepts of market structure
\ Features of different market structures prevalent in an economy ___________________
___________________
Introduction ___________________
Today, it remains true that economics is better equipped to discuss

markets (i.e., the market analytic) than to discover them. Although
much progress has been made regarding the latter, which is crucial
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to MSA.
The strategic role of product substitutability and market definition
plays a significant role in economics. Product substitutability is
linked to market definition, which, in turn, is integral to market
structure. It also calls attention to the importance of market
structure to competitive economic behavior.
CC
In attempting to determine market boundaries, economists use

product cross elasticity measures [going back to the pioneering
work of Smits,1958]. A market may be defined to include only a
single good or a group of goods according to the following criteria:
(1) a single good has a "low" cross elasticity with respect to all
other goods and thus constitutes a market by itself, or (2) some
group of goods have "high" cross elasticities among themselves, but
"low" cross elasticities with respect to all other goods and thus
collectively define a market.
This approach works best when analyzing markets which
(c)
approximate the market structure "end points" of perfect

competition and monopoly. However, it is more challenging to
identify the market boundaries of markets well within these end
points. Of issue is what constitutes appropriate criteria for
differentiating between "close" substitutes within a market and
160 "distant" substitutes outside the market. Marketing MSA may be
S
Notes
Activity of some help in dealing with this issue.
Identify the characteristics of
___________________
perfect competition. Market Structure
___________________
___________________ The competitive environment or the market structure in which an
E
industry operates plays a decisive role in price and output
___________________
decisions of a firm. Of the three factors of pricing, namely,
___________________ customer, cost, and competition, two have already been examined;
___________________ the role of consumer demand and significance of production costs.
UP
Consumer demand sets the ceiling or the upper limit to the price
___________________
that a company can charge. Demand schedule depicts the different
___________________
levels of demand for each price set by the company while
___________________ elasticities of demand show the responsiveness of demand to a
___________________
change in demand determinants. Cost of production sets the floor
or the lower limit of price to be set. A company wants to set a price
that covers the cost borne by the firm in production. Competitive
environment helps the firm decide where the prices might be set.
Figure 17.1 presents a complete model of the contribution of
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customer, cost, and competition in the pricing of a product.
Perfect Competition
It should be noted that competition has different interpretations in
economics and business. Businessman regards competition as a
process of rivalry where firms try to gain advantage through
pricing decisions, advertising, R and D, product quality and other
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means. In economics, however, when there is perfect competition,

firms cannot engage in rivalrous behaviour because they are price
takers in the market.
Characteristics of Perfect Competition
The main features of perfect competition are discussed here. They

are necessary for a firm to be a price taker.
1. The competitive market is composed of a large number of

sellers and buyers, each of which is small in relation to the
total market.
(c)
2. Outputs of the firms in such a market are regarded as perfect

substitutes for one another or are so perceived by the buyers.
All firms produce a standard, homogenous and
undifferentiated product.
161
3. Buyers have perfect information about cost, price, and quality
S
Notes
of competing goods. Consumers will not pay a higher price
___________________
than necessary for the product. Summation of individual
demand schedules and supply schedules will give industry ___________________
demand curve (ID) and market supply curve (IS) for the
E
___________________
industry's product. The equilibrium price (P) is established by
___________________
the intersection of these curves. At price OP, firms may sell
and buyers purchase any quantity of product in the market. ___________________
Thus, each firm has an infinitely elastic demand curve at the ___________________
UP
price set by the industry. We, therefore, have P = AR = MR.
___________________
Price differences are quickly eliminated and a single price ___________________
prevails throughout the market for the product. If the price is
___________________
raised above OP by a firm, its sales will decrease. Consumers
will instead purchase a good (a perfect substitute) from a ___________________
competitor at the market price. There is no reason to sell
below price OP as the firm can sell any amount at the market
price. A lower price will give losses. From the viewpoint of
industry, a price above the equilibrium level will result in
E-
excess supply which will pull down the price to the
equilibrium point E. Similarly, a price lower than the
equilibrium level (OP) will give rise to excess demand that
will push the prices till point E.
A firm has to adjust its production and sales policies to the

given market price. Since the seller has no control over the
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price at which he sells, his AR and MR schedules are infinitely

elastic AR = MR because every unit is sold at the same market
price irrespective of the quantity sold. Sales can be increased
at the same price and more revenue can be earned with
increase in sales.
(c)
Figure 17.1: Demand Curve of A Perfectly Competitive Firm

162
4. Perfect competition assumes easy entry and exit from an
S
Notes
Activity industry. If a price is above cost, resulting in economic profit,
Describe the price and output
___________________ resources can be mobilized to create new firms or to expand
determination of Perfect
Competition.
the production capacity of firms already in the industry. If
___________________
profits are below average, resources like raw material, labour
___________________ and capital can easily be transferred from the industry and
E
___________________ used to produce other products at higher profit rates. There
are no patents or copyrights, and vast amounts of capital are
___________________
not necessary to enter the market. Already established firms
___________________ do not have any lasting cost advantage over entrants because
UP
___________________ of experience or size.
___________________ 5. There is perfect mobility of resources. The workers and inputs

can easily move from one job to another and can respond very
___________________
quickly to monetary incentives.
___________________
Stock market is closest to perfect competition. Agricultural
commodities like wheat and vegetables fall under perfectly
competitive market structure.
Price and Output Determination

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Short run: In short run, a firm has to decide about the output it
should produce at the market price so that profit is maximum.
Some inputs of production are fixed in the short run, which gives
rise to fixed costs. These costs should be incurred whether the firm
produces or not. A firm may stay in business to cover these costs
even if it incurs losses. Thus, a firm may try to maximize profits or
CC
minimize losses in the short run. The cost functions of firms are
different as factors of production are not homogeneous. Therefore,
each firm has different profit levels.
In Figure 17.2 firm I takes market price P and produces quantity

where MC = MR. Per unit profit is BC (AR AC, i.e., BQ1 CQ1)
and total profit is DPBC. At output Q1 average cost is CQ1.
Equilibrium price and output decisions can be explained by the
total revenue and total cost approach as well. The total cost is
ODCQ1 (CQ1 OQ1), since TC = AC Q. Similarly, total revenue
TR = OPBQ1 (BQ1 OQ1) since TR = AR Q. Therefore, profit is
DPBC (OPBQ1 ODCQ1) since profit = TR TC. This is defined as
(c)
supernormal profit or economic profit. Normal profit is defined as

the rate of return on capital which is just sufficient to attract the
investment necessary to set up and operate a firm. Normal profit is
included as a part of economic costs. Thus, profit which is more
than whatever is included as cost becomes above normal profit.
Firm II minimizes losses and continues to operate in the short run. 163
S
At Q2 quantity the firm incurs a loss of DT per unit and APTD in Notes
total. If the firm stops production, it will earn greater loss of DN ___________________
per unit. The firm will cover variable costs OMNQ2 and fixed costs
___________________
partly (TPMN) if it operates. Point H is the shut-down point of the
firm because P = AVC at this point. Below point H the firm will not
E
___________________
even cover its variable costs, and, therefore, the firm will limit ___________________
losses equal to its fixed costs partly. Hence, as long as TR > TVC
___________________
(or on per unit basis P > AVC), it is better to operate than shut
down. ___________________
UP
___________________
___________________
___________________
___________________
E-
CC
Figure 17.2: Price and Output Determination
Firm III is neither incurring losses nor earning profits, therefore, it

can be said that it is breaking even. It produces optimal output
OQ3 at the equilibrium price OP.
Firm IV is not able to cover the TVC resulting in negative

contribution margin (P1PCA). The total loss is greater than fixed
cost that it would incur. The firm will be better off by shutting
down its operations.
(c)
Analysis of short run price and output determination indicates

that
z If AR > AC the firm will earn supernormal profits,
z If AR < AC the firm will incur losses but operate,

164
z If AR = AC the firm will break even, and
S
Notes
z If AR < AVC the firm will shut down.
___________________
___________________
The rising portion of the marginal cost curve of the firm above the
AVC curve or shut down point is the short run supply curve of a
___________________
perfectly competitive firm. This is so because the perfectly
E
___________________ competitive firm always produces where P = MR = MC as long as P
> AVC. Given the constant prices, the perfectly competitive market
___________________
supply curve (in Figure 17.2) is horizontal summation of the
___________________ individual firms' supply curves.
UP
___________________
Long run: Economic profit earned by firm I will be wiped out in
___________________ the long run. In the long run, this profit will attract new firms or
___________________ lead to an expansion by existing firms or both. This will increase
industry supply that brings down the market price till all profits
___________________
are eliminated. On the other hand, increase in input price, due to
entry of more firms, may increase production costs as well. This
may shift the cost upwards and reduce supernormal profits.
In the long run, all inputs are variable. Therefore, best level of
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output is where P = LMC. In Figure 17.2 firm III produces output
Q3 which is the minimum point of LAC. Therefore at point R,
P = MR = LMC = min LAC.
If the price is below AC, the firms will not have incentive to stay in
business and shut down in the long run. The exit of some firms will
increase profits of the remaining firms and thus eliminate their
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losses. Due to free entry and exit, all profits are eliminated so that
P = LMC = min. LAC. Thus in the long run, all firms are efficient
but break even and earn normal profits i.e. total revenue of the
firm just covers all costs (explicit and implicit).
Evaluation of Perfect Competition

Firms hardly observe long run equilibrium in real world as the
market demand curve changes with a change in tastes, technology,
and prices of inputs of production. Nevertheless, the long run
analysis helps in explaining entry and exit reasons of firms. The
analysis is a yardstick to assess how resources are allocated
(c)
efficiently in the long run for three reasons. First, the tendency to
move towards long run equilibrium leads to the optimal scale of
plant and the best level of output of the firm. Second, when capital
resources flow in competitive industry due to economic profits, a
lower rate of return than the normal rate of return resources will
force firms to leave the industry until the remaining resources
earn a normal rate of return. Third, production occurs at minimum 165
S
cost in long run, since long run equilibrium is at minimum LAC. Notes
Given the technology available to the firm, entry of new firms ___________________
results in cost cutting amongst competitors so as to survive in the
___________________
long run. Moreover, the threat of new entry promotes efficiency by
E
forcing existing firms to minimize costs or be driven out of the ___________________
market. Thus, economic forces in perfect competition require ___________________

producers to minimize per unit cost of production.
___________________
The other two marklet types are explained in the following unit. ___________________
UP
1. The ................... is composed of a large number of ___________________
sellers and buyers, each of which is small in relation to ___________________

the total market.
2. The ................... is in which an industry operates plays
a decisive role in price and output decisions of a firm.
E-
3. Consumer demand sets the ................... to the price
that a company can charge.
4. ................... depicts the different levels of demand for
each price set by the company while elasticities of
demand show the responsiveness of demand to a
change in demand determinants.
CC
Summary
Market structure is best defined as the organisational and other
characteristics of a market. We focus on those characteristics
which affect the nature of competition and pricing but it is
important not to place too much emphasis simply on the market
share of the existing firms in an industry.
Perfect competition market is that market where large numbers of
buyers and sellers producing homogenous (similar) product exist
but the size of the individual sellers and buyers is relatively so
(c)
small that they cannot change the demand and supply of the
product. In this market, the price of the commodity is determined
by the industry and the firm is merely a price taker. Equilibrium
conditions in this market are when (a) MR is equal to MC and (b)
MC curve should cut MR curve from below.
166
Lesson End Activity
S
Notes
Find out few examples of a perfect competition market and
___________________
evaluate their characteristics.
___________________
___________________ Keywords
E
___________________ Market Structure: An industry which operates plays a decisive
___________________ role in price and output decisions of a firm.
___________________ Perfect competition: Where firms cannot engage in rivalrous
UP
behaviour because they are price takers in the market.
___________________
___________________ Questions for Discussion

___________________
1. "In a perfectly competitive market no one transaction can
___________________ influence the price of a commodity." Do you agree with this
statement? Explain with the help of examples.
2. (a) What is the best level of output of a perfectly competitive
firm in the long run?
E-
(b) What is the optimal scale of a plant of a perfectly
competitive firm in long run equilibrium?
(c) If a competitive firm is in short run equilibrium, must it
also be in long run equilibrium?
Further Readings
CC
Books
Maurice - Special Indian, 8th Ed, McGraw Hill Education.
Publication
Web Readings
en.wikipedia.org/wiki/Market_structure
(c)
tutor2u.net/economics/.../a2-micro-market-structures-
summary.html
www.bized.co.uk/sites/bized/files/docs/structure.ppt
www.scribd.com/.../Different-Types-of-Market-Structure
Comparison.
UNIT 18: Market Structures & their Pricing - II
Unit 18
167
S
Notes
Market Structures & their

___________________
___________________
Pricing - II
E
___________________
___________________
Objectives ___________________
___________________
UP
topics:
___________________
\ Concept of Monopoly
\ Features of monopoly ___________________
\ Price and output determination of monopoly ___________________

\ Price discrimination ___________________
\ Degrees of price discrimination
Introduction
E-
The long term impacts of electric utility restructuring will largely
depend on the degree to which the industry can be restructured to
provide for effective competition without market power abuses.
While other factors, such as technological advancements, may
influence electricity costs, the structure of the market will
ultimately determine whether the market is truly competitive and
whether anticipated competitive benefits can be realized by
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consumers. If market power abuses cannot be checked effectively,

the benefits of restructuring may be reduced or eliminated.
In this unit, we will study the monopoly and price discrimination
market and its pricing.
Monopoly
In monopoly, there is a single seller in the market with no close
substitutes. The firm is industry, for example defence and
railways. Prior to its break-up in 1984, American Telephones and
Telegraph Company (AT and T) were considered as one of the
largest monopolies in the world. In India, monopoly exists in
(c)
railways, post and telegraph and other public utilities.
Features of Monopoly
1. There is only one seller of a good or service in the market.
2. The product supplied is unique with no close substitutes.
168 3. There are legal, technical and economic restrictions to entry.
S
Notes
Activity
List the features of a 4. The monopoly firm has considerable price control. The optimal
___________________
monopoly market. price policy of the firm depends on the market and cost
___________________ conditions.
___________________
E
5. The monopolist is assumed to maximize profits in the long run
___________________ by producing sub-optimal output.
___________________
Sources of Monopoly
___________________
Barriers to entry describe the disadvantages of potential entrants
UP
___________________ relative to established firms in an industry. They play important
___________________ role in determining the structure of an industry, such as the
number of firms and the size of distribution. Joe Bain (1956)
___________________
mentioned economies of scale, product differentiation, absolute cost
___________________ advantage of established firms and capital requirements as the
main sources of barriers to entry and, therefore, monopoly power.
1. Economies of scale: Operation of scale economies over

sufficiently large range of outputs leaves only one firm
supplying the entire market. Such a firm is called a 'natural
E-
monopoly'. The potential entrant would have to build a large
plant in order to compete with such established firm. Bain
argued that large-scale entry was thus more risky and
difficult to finance. Figure 18.1 depicts a large existing firm,
producing output OQE at per unit cost of BQE. The firm will
have lower average costs than a new firm attempting to enter
CC
the industry on a small scale and high cost such as AQN.
Figure 18.1: Natural Monopoly

(c)
2. Product differentiation: Product differentiation may confer

advantages to established firms because entrants would have
to compete in marketing the product in addition to producing
it. Entrants may also need to overcome consumer loyalty to
establish brands and this would increase costs and risks of
entry. The new firm may be forced to sell the product at a
lower price that may not generate adequate profit or may be 169
S
forced to sell at higher costs due to large advertisement Notes
budget. ___________________
3. Absolute cost advantage: Established firms in the industry ___________________
can obtain resources at a lower cost than potential entrants.
E
___________________
This advantage occurs when established firms have access to
important inputs, or unique assets (such as prime location or ___________________
manufacturing process) which allow them to produce at a ___________________
lower cost than potential entrants. Under these conditions,
established firms would be able to charge prices above their ___________________
UP
marginal costs and earn economic profits without attracting ___________________
entry.
___________________
4. Capital requirements: In some industries (automobiles, ___________________
defence, oil refining and deep sea drilling) the capital
___________________
requirements of production are enormous. In others,
(chemicals, pharmaceuticals and electronics) large investment
in R&D is necessary. Entry becomes risky when large sunk
costs of this kind are required.
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5. Control over inputs: Control over the entire supply of raw
material like mineral deposits, oil supplies and even scientific
talent can also lead to monopoly power. Till World War II,
Alcoa, the Aluminum Company of America controlled supply
of bauxite and, therefore, had monopoly in production of
aluminum. Other examples of monopoly based on resource
control are French Champagne, De Beers (diamonds) and
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OPEC (crude oil).
6. Legal restrictions: Patents held by existing firms make it

virtually impossible for other firms to produce a comparable
product or use a particular production process. Xerox had
monopoly on copying machines and Polaroid on instant
cameras when they were produced first.
Exclusive franchises granted by the government are another

form of legal restrictions. A firm is set up as the sole producer
and distributor of a product or service but is subject to
government regulations. For example, post offices set up by
government.
(c)
7. Strategic barriers: A monopoly firm may exercise limit

pricing, that is, keep price below monopoly levels to
discourage new entry. For the same reason, it may engage in
extensive advertising and brand proliferation, not because
this is profitable in itself, but to raise the cost of entry of new
170
competitors. This is generally called as retaliation pricing. The
S
Notes firm may intentionally create excess capacity, as a warning
___________________ that it can quickly expand capacity should a new firm attempt
to enter.
___________________
___________________ Price and Output Determination
E
___________________ The ability to set price by a monopolist is limited by the demand
___________________
curve for its product. He can control both price and quantity but
only one variable at a single point of time. The downward sloping
___________________ demand curve implies that the monopolist must decrease price to
UP
___________________ increase sales, while an increase in output will require the firm to
sell at a lower price. This means that the firm is the price maker.
___________________
___________________ The effect of output changes on total revenue depends on the MR

curve. If MR is positive, an increase in output increases the total
___________________
revenue. If MR is negative, increasing output reduces TR. The cost
curves of a monopoly firm are similar to perfect competition
because factors of production are hired from the same market. The
AR curve is the demand for the monopolist since he charges single
price for all units he can sell (AR/unit = P). In Figure 18.2 (a) the
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best level of output is Q1 where MC = MR. If the output is
increased beyond this point then MC > MR and profits will be
reduced by increasing output. The price P1 at this level of output is
given by the demand curve. AB is the profit per unit and P1ABC
total profit. Note that P > MR at best level of output under
monopoly as demand curve lies above MR curve.
CC
A monopolist can break even if AC = P at the equilibrium output.

In Figure 18.2 (b) at point G, price P2 is equal to the average cost.
Therefore, the monopolist is breaking even. He will incur losses
when AC > P at the best level of output as shown in Figure 18.2 (c).
It pays for the monopolist to stay in business in the short run if he
incurs losses, as long as P > AVC. The excess of price over AVC can
be used to cover the fixed cost of the monopolist. In the long run,
he will go out of business when he incurs losses larger than the
fixed costs. Thus aim of the monopolist like perfect competitor in
short run is to maximize profits or minimize losses.
Long run: In the long run, all inputs are variable, therefore, the
monopolist adjusts the scale of plant and sets price in order to
(c)
maximize profits. Since entry is blocked, the monopolist can

produce at sub-optimal scale where profits are maximum. Figure
18.2 (a) shows that the monopolist does not produce at the lowest
point on its LAC curve (point M) like a perfect competitor. Even if
he does in an unusual situation, he would still charge a price
higher than his long run average cost and earn profits in the long 171
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run. Notes
___________________
___________________
E
___________________
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
Figure 18.2: Pricing Under Monopoly

E-
A change in government policies or the market environment may
attract new firms in the long run due to high rate of return. The
demand curve of the monopolist will become more elastic and
represent a smaller share of the total market sales and they have
smaller effect on price. New entrants will capture some economic
profit. The market structure may evolve into an oligopoly or
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monopolistic competition. If the monopoly position is a result of

control over scarce resources, patents, unique managerial talent or
a choice location, entry by other firms may be impossible and the
firm will maintain monopoly position.
Evaluation of Monopoly
res of In most cases, it has been observed that the monopolist charges a
ation high price by supplying less than desired in the market. The
socially desirable output is when P = MC. The price (P) depicts the
money that the society is willing to pay and marginal cost (MC)
shows the cost incurred in the production of the last unit of the
good. Downward sloping demand curve results in the price being
(c)
higher than the MC (P > MC). Thus, it is often said that the
monopoly price is higher than the competitive price. It is further
stated that monopoly restricts consumer choice. The consumer has
to purchase what is offered for sale in such a market situation, as
there is a single seller of the good.
172
Despite these drawbacks, monopoly markets are regarded as a
S
Notes
Activity significant part of the economy as the monopolist is considered to
Give the distinctive features of
___________________ invest in R&D due to supernormal profits earned by him. They also
perfect competition in relation
to monopoly market.
do not indulge in wasteful expenditure in the form of advertising,
___________________
etc., that is essential in monopolistic competition and oligopoly.
___________________
E
Check Your Progress
___________________
Fill in the blanks:
___________________
1. In ..................., there is a single seller in the market
___________________
with no close substitutes.
UP
___________________
2. In the long run, all inputs are ..................., therefore,
___________________
the monopolist adjusts the scale of plant and sets price
___________________ in order to maximize profits.
___________________
Perfect Competition versus Monopoly
Large numbers of sellers exist under perfect competition. As a
result, individual firms do not have any control over price. The
firm is a price-taker as the forces of demand and supply establish
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market price. The firm has to decide about the output, it should
produce at the going price. On the contrary, single firm is the sole
producer of a good under monopoly. Thus, the firm is the industry.
The industry supply curve is similar to the supply curve of the
individual firm. Therefore, a monopolist is a price-maker.
The long run price under perfect competition is driven down to the
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lowest sustainable level, where economic profits are zero. As a

result, a competitive market delivers maximum benefit to the
consumers. On the other hand, monopolist sets a high price by
restricting output below the competitive level. Comparisons
between the two can be made graphically. In Figure 18.3
equilibrium takes place where MR = MC. EP and EM are the
equilibrium levels of a perfectly competitive market and monopoly
respectively. PP is the market price of a perfect competitor and PM
is the price set by the monopolist. The diagram shows that the
perfectly competitive price is increased till it becomes equal to
marginal cost, i.e. PP = MC. But monopolist restricts output,
therefore PM > MC. For this reason, the price set by the
monopolist is said to be higher than the socially desirable level.
(c)
Hence competition is regarded to deliver output at a minimum

price.
173
S
Notes
Activity
Identify the main features of a
___________________
price discrimination market.
___________________
E
___________________
___________________
___________________
___________________
UP
___________________
Figure 18.3: Perfect Competition Versus Monopoly
___________________
The monopoly output QM is lower than the competitive output of QP
___________________
or the socially desirable output. Output produced in the
competitive market (QP) corresponds to the minimum point of long ___________________
run average cost (QP = min. LAC) while monopoly output is less
(QM < min.LAC), i.e., lower than the optimal output. Thus, we have
the following summary comparison of perfect competition and
monopoly:
E-
PM > PP
QM < QP
We also know that goods produced under competitive market are

homogeneous but unique under monopoly. There are no entry
barriers under perfect competition and exit is also easy. Due to less
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capital requirements, no product differentiation and absence of

strategic and legal barriers, investors can enter perfectly
competitive market with ease. On the other hand, presence of the
aforementioned barriers under monopoly restricts entry and exit
also becomes difficult.
Price Discrimination
Price discrimination occurs when the same product or service is
sold at more than one price that does not reflect a proportional
difference in costs. An airline may sell tickets on a particular flight
at a higher price to businessmen than to college students.
(c)
Companies engage in such practice to enhance profits.

A firm can engage in price discrimination, when following
conditions are fulfilled.
1. The firm must have some control over the supply of the
product or service. A perfectly competitive seller has no
174
control over price; therefore, he cannot discriminate between
S
Notes different classes of buyers and charge different prices.
___________________
2. The different segments of buyers are separable at moderate
___________________ cost and are unable to transfer products easily from one class
___________________ to another.
E
___________________ 3. The different markets/buyers should have different price
elasticity of demand. This may be due to difference in income
___________________
levels, tastes or availability of products.
___________________
From, consumers, viewpoint those in lower price market may
UP
___________________
benefit compared to situations where a uniform price is charged.
___________________ However, consumers in the higher-price markets are at a
___________________ disadvantage. The extent to which a seller can separate the market
and discriminate between buyers, gives rise to three types of price
___________________
discrimination.
First Degree Discrimination

It is assumed that the firm is aware of each consumer's demand
curve for the commodity and fixes the price accordingly. The curve
E-
indicates the maximum price that can be charged for successive
units of output. Figure 18.4 (a) shows that Q1 can be sold for a
maximum price of P1, the second could be offered for a maximum of
price P2 and so on. The profit maximizing output is QD where
maximum price obtained for the product is equal to the marginal
cost of production. Any attempt to offer more will reduce the profits
CC
because price would be less than the marginal cost. A lawyer or

doctor may charge different fees based on the income of the clients
and patients respectively. Different rates are taken for electricity
services for industrial use and residential demand.
First Degree Second Degree

Price (a) Price (b)
P1 A P0
P2 B
C P1
P3
MC=AC P2 DS
DA
(c)
O O
Q1 Q2 Q3 QD Qo Q1
Output Output
Figure 18.4: Price Discrimination

Second Degree Discrimination 175
S
Notes
Under this type of price discrimination, differential prices are
charged for different amounts of goods and services. The second ___________________
degree price discrimination is mostly applicable to the goods and ___________________

services whose consumption is metered like electricity. In Figure
E
___________________
18.4 (b) for output less than Qo, price Po is charged. Medium price
P1 is charged for quantities purchased between Qo and Q1, and a ___________________
low price P2 for purchases beyond Q1. ___________________
Third Degree Discrimination ___________________
UP
___________________
This type of discrimination is most common. The monopolist
segregates the customers into different markets and charges ___________________
different prices in each segment. Market segmentation can be ___________________
based on location, age, product use or income. Different locations
are priced differently even though the cost of offering in each ___________________
location is same. A theatre varies its seat prices according to

audience preferences for different locations. Railways and buses
charge half-ticket for children below 14 years.
E-
Price
Market A Market B MC
PA C
PB
M E
DT
DB
MRA DA MRB MRT
O O O
QA QB QT
CC
Output
Figure 18.5: Third Degree Price Discrimination
Suppose a company operates in two markets A and B. Demand is

less elastic in market A and more elastic in B as shown in the
Figure 18.5. Combined marginal cost curve MC is drawn for the
firm as a whole because the product sold is considered to be
homogenous. Optimal combined output will take place where MC =
MRT. The firm could have charged uniform price C, but it increases
profit by differentiating prices in the two markets. Next, the firm
allocates output in two markets which is maximized by equating
MC to corresponding MR of each market i.e., MC = MRA = MRB.
(c)
This is done by drawing a horizontal line from the point of

intersection (MR = MC) in the two markets. The price charged in
each market is found by drawing a vertical line at the
corresponding quantity to the demand curve. It indicates that QA
will be sold in market A at price PA and QB in market B at price PB.
176
Note that the discriminating monopolist charges a higher price in
S
Notes market A where demand is less elastic.
___________________
International Price Discrimination
___________________
Very often products going to the export market are priced lower
___________________ than those sold domestically, as the price elasticity of demand is
E
___________________ greater in the foreign market. This is often referred to as
international price discrimination or dumping. The price elasticity
___________________
of demand for the product of the monopolist is higher abroad
___________________
because of competition from other nations in the foreign market. In
UP
___________________ the domestic, market import tariff and other trade barriers restrict
___________________ foreign competition. Import restrictions separate the foreign
market from the domestic market. In the last decade, Japan was
___________________
accused of dumping steel, television and computer chips in the
___________________ United States.
Check Your Progress

Fill in the blanks:
E-
1. Large numbers of sellers exist under ...................
2. In ..................., individual firms do not have any control
over price.
3. The long run price under perfect competition is driven
down to the lowest sustainable level, where economic
profits are ....................
CC
Summary
Monopoly is a market where there is only one producer of a goods
or service. There is also no close substitute of the goods or services.
In the short run the monopolist can increase or decrease its
production only by increasing or decreasing its variable factors. He
will be in equilibrium when MC=MR and MC cuts MR from below.
In the long run the monopolist will be in equilibrium at the point
where LMR will be equal to its LMC. Monopolist determines its
price at which he gets abnormal profits.
(c)
Monopolist charges different prices from different customers for

the same product, such situation is known as price discrimination.
Discrimination of First degree is said to exist when the firm
charges a separate price for each separate unit of the commodity
from the same consumers of the product. Discrimination of second 177
S
degree exist when consumption of a good is divided into various Notes
blocks, a separate price is charged from each block but for each ___________________
block a uniform price is charged. Third degree discrimination is the ___________________
most commonly observed discrimination. In this discrimination
E
___________________
consumers are divided into various groups. According to their price
___________________
elasticities, different prices are charged from different consumer
groups. ___________________
___________________
UP
Find out some examples of price discrimination and also for ___________________
monopoly markets. ___________________
___________________
Keywords

E-
difference in costs.
Product market is a meeting place between buyers and sellers
where individuals demand goods and services to satisfy
consumption desires by bidding and firms anxious to earn profits
supply them.
CC

1. Can a monopolist incur losses in the short run? Why?
2. Why are first and second degree price discrimination less
common than third degree price discrimination?
3. Under what conditions would it not be useful to charge
different prices in different markets even if possible?
4. Is price discrimination socially desirable?
5. Can a monopolist earning short run profits increase those
profits in the long run? Why?
(c)
6. Would a monopolist ever operate in the inelastic portion of

demand curve it faces? Why?
178
Further Readings
S
Notes
___________________ Books
___________________ Managerial Economic by Christopher R Thomas, S Charles
___________________ Maurice - Special Indian, 8th Ed, McGraw Hill Education.
E
___________________ Managerial Economics by Atmanand, 2nd Edition, Excel Books
___________________ Publication
___________________ Managerial Economics by Karampal and Surender Kumar, 1st
UP
___________________
___________________ Web Readings

___________________ en.wikipedia.org/wiki/Market_structure
___________________
tutor2u.net/economics/.../a2-micro-market-structures-
summary.html
www.bized.co.uk/sites/bized/files/docs/structure.ppt
www.scribd.com/.../Different-Types-of-Market-Structure-
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Comparison...
CC
(c)
UNIT 19: Pricing Methods
Unit 19
179
S
Notes
Pricing Methods
___________________
___________________
E
___________________
Objectives
___________________
topics: ___________________
\ Concept of Pricing ___________________
UP
\ Methods of Pricing ___________________
\ Multi-product Pricing
___________________
___________________
Introduction
___________________
The microeconomic principle of profit maximisation suggests
pricing by the marginal analysis that is by equating MR to MC.
However, in the pricing methods followed in practice, firms rarely
follow this process. Uncertainty with regard to demand and cost
E-
functions and the deviation from the objective of short run profit
maximisation are the two main reasons for this.
Determination of profit maximisation requires an accurate
knowledge of the demand and cost conditions facing the firm. It is
not easy to get a good estimate of the true demand function, for one
faces difficulties with regard to the specification of the function,
data availability and limitations of the estimation method.
CC
Besides, there is a problem of product interdependence among rival

firms, which is rather significant in an oligopolistic market.
Similar problems are witnessed with regard to the cost function.
There is no unique theory of firm behaviour. Profit is certainly an
important variable for which every firm cares, but maximisation of
short run profit is not a popular objective of the firm today. Firms
seek maximum profit in the long run. The problem is dynamic and
its solution requires accurate knowledge of demand and cost
conditions over time, which may be impossible.
In view of these problems, economic prices are a rare phenomenon.
Instead, firms set prices for their products through several
(c)
alternative means which are being discussed below.
Multi Product Pricing

Most modern firms produce a variety of products rather than a
single product. This requires that we expand our simple pricing
180
rule and consider demand and product interdependencies.
S
Notes Normally in the case of a firm which is producing multiple
___________________ commodities, the demands for its various products are separable
but the costs are not quite divisible, product-wise. Thus, while
___________________
there are separate demand functions for all products of a multiple
___________________ product firm, there is only one cost function for all products. In the
E
livestock industry, meat and wool are produced together where
___________________
sheep are reared. Crude oil and natural gas may be found together
___________________ in oil exploration. In these joint products, costs also are joint. In
___________________ most cases, joint products come in fixed proportions.
UP
___________________ In joint products, the profit maximizing prices will be given by the
point at which the combined marginal revenue of the products
___________________
equals the marginal costs as shown in Figure 19.1.
___________________
The line CMR denotes the combined marginal revenue. It is
___________________ obtained by summing MR1 and MR2 vertically. The CMR equals
MC at point E. A horizontal line passing through point E
determines the prices and quantities of the two commodities. It is
assumed that the demand functions of different commodities are
independent of one another. The profit-maximizing prices are OP1
E-
and OP2 and the quantities are OQ1 and OQ2 of commodities 1 and
2 respectively. The prices in the case of more than two joint
products can also be determined in the same manner.
CC
Figure 19.1
Price Discrimination
Price discrimination occurs when variation in prices for a product
in different markets does not reflect variation in costs. It is
(c)
designed to increase the total profit. Three conditions must be

fulfilled before a firm successfully practises price discrimination.
a. The firm must have at least some control over price.
b. It must be possible to group different markets in terms of the
price elasticity of demand in each.
181
c. The firm's markets must be separable, meaning that products
S
Notes
cannot be purchased in one market and then resold in
another. ___________________
___________________
Generally, price discrimination is identified to be of the following
three types.
E
___________________
___________________
First Degree Discrimination
___________________
This type of discrimination involves charging the maximum price
___________________
possible for each unit of output. Figure 19.2 shows the demand
UP
curve of a monopolist. The curve indicates the maximum price that ___________________
can be obtained for successive units of output. For example, the ___________________
first unit Q1 can obtain maximum price P1 and so on. It is assumed
___________________
that marginal cost is constant and equal to average cost.
___________________
First degree price discrimination charges the maximum price
possible for each unit of output. The consumer willing to pay the
highest price P1 is identified and so on for P2, P3, etc. The profit
maximizing output rate is where the marginal cost and demand
curves intersect (QD). The maximum price that can be obtained for
E-
the product is just equal to the marginal cost of production at QD.
Selling more than QD units would reduce profits because price
would be less than marginal cost, and vice versa. This type of
discrimination is most profitable scheme for a firm and also the
most extreme form. It is, however, not common because it requires
complete knowledge of the market demand and willingness of
consumers. A possible example may be selling of government bonds
CC
by asking buyers to submit tenders.

(c)
Figure 19.2
182
Second Degree Discrimination
S
Notes
Instead of setting different prices for each unit, here pricing is
___________________
done on the basis of quantities of output purchased by individual
___________________ consumers. For each buyer, refer Figure 19.3, the first Q1 units
purchased are priced at P1, the next Q2 Q1 units are priced at P2
___________________
E
and all additional units are priced at P3. Examples are found in
___________________
cases where services are metered, e.g., electricity, telephone, gas,
___________________ second refills of food items, etc.
___________________
UP
___________________
___________________
___________________
___________________
E-
Figure 19.3
Third Degree Discrimination

This is the most common type. It separates consumers or markets
on the basis of their price elasticity of demand. This segmentation
may be based on factors like geographic separation of markets,
nature of use (business, residential), personal characteristics of
CC
consumers (age - adult and child), etc.
Figure 19.4 shows the marginal revenue curves of two individual

markets as MR1 and MR2. It is assumed that the marginal costs
are equal and constant in both. The combined demand curve of the
two is the sum of the demands in each of the markets at each price.
Similarly the marginal revenue curve is the sum of two individual
curves. The optimal total output is at point QT where MRT = MC.
P Market-I P Market-II P Combined Market

(c)
P1 P2
D2
D1 DT
e1 MC e2 MC MC
MR2 MRT
MR1
O Q O Q O Q
Q1 Q2 QT
Figure 19.4
Since marginal costs are constant, the decision rule for allocating 183
S
output is that the marginal revenue should be equal in the two Notes
markets. Thus, the extra revenue obtained from selling an
___________________
additional unit in the first market should be the same as that
received from selling one more unit in the second market. If the ___________________
two are not equal, the firm could increase its revenue and profit by
E
___________________
allocating additional output to the market with greater marginal
revenue. Thus Q1 units of output should be sold at a price of P1 in ___________________
market 1 and Q2 units at price of P2 in market II. A higher price is ___________________

charged in market 1, where demand is relatively less elastic. The ___________________
UP
consumers here are thus, less sensitive to price, i.e. higher prices
___________________
can be charged.
___________________
International Price Discrimination and Dumping
___________________
International price discrimination is called dumping or even
___________________
persistent dumping. Under this type of dumping the monopolist
sells the commodity at a higher price at home. The reason is that
the market demand curve may be less elastic at home. The price is
less abroad where the monopolist faces competition from other
E-
nations and the market demand curve for the monopolist's product
is more elastic. Predatory dumping is the temporary sale of a
commodity at below cost or at a lower price abroad in order to drive
s of foreign producers out of business, after which prices are raised
ods?
abroad to take advantage of the newly acquired monopoly power.
Sporadic dumping is the occasional sale of the commodity at below

CC
cost or at a lower price abroad than in the domestic market in

order to unload an unforeseen and temporary surplus of a
commodity without having to reduce the domestic prices.
However, it is often difficult to determine the type of dumping and

domestic producers invariably demand protection against any form
of dumping.
Check Your Progress

Fill in the blanks:
1. ................... is the practice of selling two or more
products together for a single price.
(c)
2. ................... occurs when variation in prices for a

product in different markets does not reflect variation
in costs.
184
Pricing Methods in Practice
S
Notes
Activity
What are the three types of
In the practical market, different types of pricing methods are
___________________
cost-based pricing methods? followed. The common ones are discussed below:
___________________
___________________
Cost Based Pricing Methods
E
___________________ Cost based pricing methods have three types: Full cost or break-
even pricing, cost plus pricing and the marginal cost pricing. In full
___________________
cost pricing, price just equals the marginal (total) cost. In the
___________________ second type, some mark up is added to the average cost in arriving
UP
at the price. In the last type, price is set equal to the marginal cost.
___________________
Cost oriented pricing is quite popular. It has several strengths as
___________________ well as limitations. Its strengths are its simplicity, acceptability
___________________ and consistency with a target rate of return on investment and the
price stability in general. Its limitations are difficulties in getting
___________________
accurate estimates of cost, particularly of the future cost rather
than the historic cost, volatile nature of the variable cost, and its
ignoring of the demand side of the market completely.
Penetration Pricing
E-
While introducing new products or entering a new market, firms
may deliberately set a relatively lower price in the hope of
"penetrating" into the market. The motive is to establish market
share first and then gradually move to a more profitable price.
This requires that the demand be highly price elastic and the
nature of product differentiation be such that many consumers are
in a position to get attracted by the low price.
CC
Penetration pricing is the reverse of the skimming policy in which

the price is lowered only as short run competition forces it.
The passive skimming policy has the virtue of safeguarding some

profits at every stage of market penetration. But it prevents quick
sales to the many buyers who are at the lower end of the income
scale or the lower end of the preference scale and who, therefore,
are willing to pay any substantial premium for product or
reputation superiority. The active approach in probing possibilities
for market expansion by early penetration pricing requires
research, forecasting and courage.
(c)
A decision to price for market expansion can be reached at various

stages in a product's life cycle: before and at birth, in childhood, in
adulthood or in senescence. The chances for large volume sales
should at least be explored in the early stages of product
development research, even before the pilot stage, perhaps with a
more definitive exploration when the product goes into production
and price and distribution plans are decided upon. And the 185
S
question of pricing to expand the market, if not answered earlier, Notes
will probably arise once more after the product has established an ___________________
elite market.
___________________
Quite a few products have been rescued from premature
E
___________________
renascence by pricing them low enough to tap new markets. The
___________________
reissues of important books in the low-priced pocketbook category
illustrate this point particularly well. These have produced not ___________________
only commercial but intellectual renascence as well to many ___________________
UP
authors. The pattern of sales growth of a product that had reached
___________________
stability in a high price market has undergone sharp changes
when it was suddenly priced low enough to tap new markets. ___________________
The following conditions generalize and indicate the desirability of ___________________
an early low-price policy: ___________________
z A high price elasticity of demand in the short run, i.e. a high

degree of responsiveness of sales to reductions in price.
z Substantial savings in production costs as the result of greater

E-
volume - not a necessary condition, however, since if elasticity
of demand is high enough pricing for market expansion may
be profitable without realizing production economies.
z Product characteristics such that it will not seem bizarre

when it is first fitted into the customer's expenditure pattern.
A strong threat of potential competition.

CC
This threat of potential competition is a highly persuasive reason

for penetration pricing. One of the major objectives of most low-
pricing policies in the pioneering stages of market development is
to raise entry barriers to prospective competitors.
Price Skimming
This is also a variation of price discrimination, not over two
markets, but over a period of time. The firm starts with a high
price for customers who are willing to pay for a better quality or
prestige value. The price is gradually decreased or "skimmed" to
(c)
increase the number of customers. But there is danger in letting

the price drop beyond a point because of the perceived correlation
between quality and price. Firms quite often do not undertake such
tactics and set the desirable price straight away on some other
basis.
186
For products that represent a drastic departure from accepted
S
Notes
ways of performing a service, a policy of relatively high prices
___________________
coupled with heavy promotional expenditures in the early stages of
___________________ market development and (lower prices at later stages) has proved
___________________ successful for many products. There are several reasons for the
E
success of this policy:
___________________
z Demand is likely to be more inelastic with respect to price in
___________________
the early stages than it is when the price is fully grown. This
___________________ is particularly true for consumer goods. A novel product such
UP
___________________ as the electric blanket is not yet accepted as a part of the
expenditure pattern, consumers are still ignorant about its
___________________
value compared to conventional alternatives. Moreover, at
___________________ least in the early stages, the product has so few close rivals
___________________ that cross elasticity of demand are low.
z Launching a new product with a high price is an efficient

device for breaking up the market into segments that differ in
price elasticity of demand. The initial high price serves to
skim the cream of the market that is relatively insensitive to
E-
price. Subsequent price reductions tap successively more
elastic sectors of the market. This pricing strategy is
exemplified by the systematic succession of editions of a book,
sometimes starting with a high priced limited personal edition
and ending up with a low-price pocketbook.
This policy is safer, or at least appears so. Facing an unknown

CC
elasticity of demand, a high initial price serves as a "refusal"

price during the stage of exploration.
z Many companies are not in a position to finance the product

floatation out of distant future revenues. High cash outlays in
early stages result from heavy costs of production and
distributor organizing, in addition to the promotional
investment in pioneer product. High prices are a reasonable
financing technique for shouldering these burdens in the light
of many uncertainties about the future.
Loss Leader Pricing

(c)
Suppose a firm produces a high value item, X, which requires a low

value but high volume item Y, and also produces Y. The sale of X is
less than Y but use of Y is more (e.g., X-razor, Y-blades). Thus the
loss on X can be more than compensated by sale of Y if the firm is
able to produce both the part and consumable in right proprietary
or dedication. So the customer does not buy the replacements from
another competitor. Thus the so-called loss-leader is really a profit 187
S
leader and the firm gets profit after its total sale. Notes
___________________
Transfer Pricing
___________________
It refers to the determination of the price of the intermediate
E
___________________
products sold by one semiautonomous division of the same firm. It
is essential in determining the optimal output of each division and ___________________
of the firm as a whole and in evaluating divisional performance
___________________
and determining divisional rewards. The correct transfer price for
an intermediate product for which there is no external market is ___________________
UP
the marginal cost of production. When a perfectly competitive ___________________
external market for the intermediate product exists, the transfer
___________________
price for intracompany sales of the intermediate product is given
by the external competitive price for the intermediate products. ___________________
When an intermediate product can be sold in an imperfectly ___________________
competitive market, the transfer price of the intermediate product
is given at the point where the net marginal revenue of the
marketing division of the firm is equal to the marginal cost of the
production division at the best total level of output of the
E-
intermediate product and the price charged in the external market
is given on the external demand curve.
Ramsey Pricing
A firm's common costs are those that cannot be assigned to any
single product or service. The use of fully distributed costs can lead
to poor pricing decisions. A product can be profitably produced if its
CC
price exceeds incremental costs of supplying the product. Ramsey

pricing is the second best alternative that can be used when
marginal cost pricing is not feasible. A simple version of Ramsey
pricing specifies that price deviations from marginal cost should be
inversely related to the elasticity of demand. The reason is that if
demand is elastic, increasing the price causes a substantial
reduction in the quantity demanded.
Peak-Load Pricing
Peak-load pricing can be used to reduce costs and increase profits
if the same facilities are used to provide a product or service at
(c)
different periods of time, the product or service is not storable or

the demand characteristics vary from period to period. The theory
of peak-load pricing suggests that peak period users should pay
most capacity costs, while off-peak users may be required to pay
only variable costs. An example is followed in pricing of telephone
services.
188
Product Bundling
S
Notes
Bundling is the practice of selling two or more products together
___________________
for a single price. When the products are only available as a
___________________ package, the pricing strategy is referred to as pure bundling. If at
least some products can also be purchased separately, then the
___________________
E
firm is using mixed bundling. Examples are complete meals offered
___________________ in some restaurants, cars sold with air conditioners, antilock
___________________ brakes, cassette decks at "no-extra" price, season-tickets packages
with ticket for a popular game and a not so popular one, etc. Some
___________________
advantages of product bundling which has made it a common
UP
___________________ practice are:
___________________ z Firms can reduce their production and marketing costs by
___________________ packaging goods and services in this way,
___________________ z It allows firms to increase their profits by extracting

additional consumer surplus,
z It requires less information about tastes and preferences of

customers.
E-
Prestige Pricing and Psychological Pricing
A perception on the part of the firm or producer that charging a
higher price will increase the quantity of the product sold because
of the prestige achieved by the customer, is known as prestige
pricing. The basis for this seeming contradiction is that either the
customers are not well informed about the quality of the various
products or that the producer has succeeded in creating a special
CC
snob appeal for its product.
The practice of charging ` 9.95/- or ` 9.99/- instead of ` 10/- for a

product in the belief that such pricing will create the illusion of
significantly lower price to the customer is referred to as
psychological pricing. However, this may be a temporary
phenomenon with most consumers, and over an extended period of
time such pricing would appear to have limited application.
Value Pricing
Value pricing refers to the selling of quality goods at much lower
prices than previously. This is an old fashioned price-cutting but
(c)
with manufacturers redesigning the product to keep or enhance

quality while lowering costs so as to still earn a profit. It is actually
offering more for a lot less. Value pricing is likely to spread in the
future as companies cater to increasingly sophisticated but bargain
conscious consumers.
Government's Control on Pricing 189
S
Notes
The government has from time to time introduced price control for
certain commodities. Two categories of commodities have been ___________________
brought under price control. Necessities of various kinds such as ___________________
edible oils, drugs and textiles fall into the first category. The
E
___________________
second category consists of certain basic goods such as cement and
steel which are intermediate inputs in the production of other ___________________
commodities. The Tariff Commission of India and the Bureau of
___________________
Industrial Costs and Price (BICP) have been involved in
determining fair prices for commodities under price control. ___________________
UP
___________________
This approach to price fixation has led to a great deal of
controversy in India. Questions have been raised as to what ___________________
constitutes a reasonable rate of return. The argument is that the
___________________
rates of return assumed by the Tariff Commission and similar
price fixing agencies fall below what investors would consider ___________________
reasonable. As a result, it is claimed that resources may not flow
into industries under price control, thereby impairing the long run
interests of consumers. If excess demand conditions exist,
contradiction of supply of the goods in question will have an
E-
adverse effect on consumer interests. Price control calls for a
careful balancing of the interests of consumers and producers,
which is an inherently difficult task to perform.
Check Your Progress

Fill in the blanks:
1. In ..................., the selling of quality goods at much
CC
lower prices than previously.

2. ................... can be used to reduce costs and increase
profits if the same facilities are used to provide a
product or service at different periods of time, the
product or service is not storable or the demand
characteristics vary from period to period.
3. ...................refers to the determination of the price of
the intermediate products sold by one semiautonomous
division of the same firm.
(c)
4. A perception on the part of the firm or producer that

charging a higher price will increase the quantity of the
product sold because of the prestige achieved by the
customer, is known as ...................
190
Summary
S
Notes
There is no unique theory of firm behaviour. Profit is certainly an
___________________
important variable for which every firm cares, but maximisation of
___________________ short run profit is not a popular objective of the firm today. Firms
___________________ seek maximum profit in the long run. The problem is dynamic and
E
its solution requires accurate knowledge of demand and cost
___________________
conditions over time, which may be impossible.
___________________
In view of these problems, economic prices are a rare phenomenon.
___________________
Instead, firms set prices for their products through several
UP
___________________ alternative means like price discrimination, different pricing
___________________ methods or techniques etc.
___________________
Lesson End Activity
___________________
List the various pricing methods and find out how they are used in
practice.
Keywords
E-
Product Bundling: Bundling is the practice of selling two or more
Price Discrimination: Price discrimination occurs when
variation in prices for a product in different markets does not
reflect variation in costs. It is designed to increase the total profit.
Value Pricing: The selling of quality goods at much lower prices
CC
than previously.
Prestige Pricing: A perception on the part of the firm or producer

that charging a higher price will increase the quantity of the
product sold because of the prestige achieved by the customer, is
known as prestige pricing.
Peak load Pricing: Peak-load pricing can be used to reduce costs
and increase profits if the same facilities are used to provide a
product or service at different periods of time, the product or
service is not storable or the demand characteristics vary from
period to period.
(c)
Transfer Pricing: It refers to the determination of the price of the

intermediate products sold by one semiautonomous division of the
same firm.
Cost plus Pricing: Some mark up is added to the average cost in
arriving at the price.
Questions for Discussion 191
S
Notes
1. State and explain the factors which you would normally
___________________
consider while pricing a new product.
___________________
2. We can apply the equi-marginal principle in the context of
multi-product pricing. True or False. Explain.
E
___________________
3. Explain the principles involved for the success of price ___________________
discrimination. Do you think that price discrimination is anti- ___________________

social?
___________________
UP
4. A seller sells his commodity in two markets I and II and their ___________________
demand schedules are as follows:
___________________
Market I Market II
___________________
Px Dx Px Dx ___________________
10 80 12 120
8 120 10 160
6 180 8 220
E-
4 200 6 280
The seller wants to maximize profits by selling just 280 units.

What prices will he set in the two markets?
5. Given two isolated markets supplied by a single monopolist,

the two corresponding demand functions being
CC
P1=12Q1 and P2=203Q2
Suppose the total cost function for the monopolist is

C=3+2(Q1Q2)
What will prices, sales and marginal revenues be in the two

markets, under regime of price discrimination and what profit
will the monopolist earn?
Further Readings
Books
(c)
Grubel, Harbert G (1977); International Economics (Homewood).
S K Agarwala, Microeconomics, First Edition, New Delhi, 2007

192
S
Notes
Publication
___________________
___________________
___________________
E
___________________
Web Readings
___________________ en.wikipedia.org/wiki/Pricing
___________________ www.stat.fi/voorburg2005/kenessey_1.pdf
UP
___________________
www.norcron.com/documents/pricing_methods.pdf
___________________
www.sedi.org/DataRegV2-unified/capnet.../pricing% 20methods.pdf
___________________
___________________
E-
CC
(c)
Unit 20
193
S
Notes
Case Studies
___________________
___________________
E
___________________
Objectives
___________________
___________________
UP
___________________
Case Study 1: Oil and New Economy
___________________
You cannot get more old economy than to fret about the price of
oil. Although the oil price is hard to miss when you come to refuel ___________________
your car, economy watchers with any sophistication are
___________________
encouraged at every turn to pay little attention. For instance,
measures of "underlying" inflation exclude the oil price - too
volatile, the argument goes, and no longer all that significant, one
is led to suppose. Yet theory and empirical evidence suggest that
the price of oil remains a fundamental driver of the business
E-
cycle. In all likelihood cheap oil has played a big role in creating
the appearance of a "new economy" and dear oil, if the price stays
up, may do more harm than many believe.
In Britain, the leading advocate of the view that oil still matters
has been Andrew Oswald, a professor at Warwick University. In
an article in the Financial Times last year he went so far as to
CC
claim that the so-called new paradigm is almost entirely an

illusion caused by a prolonged period of extremely cheap oil. Now
that the price has soared and assuming that it stays relatively
high, he fears that the result will be a marked slowdown in the
world economy.
Mr. Oswald is therefore a doubly unusual fellow: an easy-money

new-economy sceptic. Most new-economy skeptics want monetary
policy in the United States tightened faster (because they believe
the surge in labour productivity will not last and that inflationary
pressures are building). Mr. Oswald, in contrast, though a
trenchant critic of the new economy, believes that monetary policy
should be on recession watch in both Britain and America.
(c)
Mr. Oswald, along with Alan Carruth of the University of Kent

and Mark Hooker of the Federal Reserve, published an article in
1998 which helps to makes the case for this view. The starting
point is the chart, which repays careful study. The association
between changes in the price of oil and, after a delay, changes in
Contd.
194 American unemployment is impressively close. And the
S
Notes underlying model which Mr. Oswald and his collaborators adduce
is persuasive and simple. They concentrate on the supply side
___________________
(that is, labour-market) implications of oil, rather than on the
___________________ demand side effects. Dear oil raises producers' costs and squeezes
___________________ their profit margins. To restore those margins, employers strive to
E
cut labour costs. At the aggregate level and for any given pressure
___________________
of demand, higher unemployment is the result: in effect, only with
___________________ more people on the dole are workers willing to accept lower
wages. Mr. Oswald and his colleagues showed that a forecasting
___________________
model based on this version of the "efficiency wage" theory of
UP
___________________ labour markets fits the data very well. From the late 1970s to the
___________________ mid-1990s, oil played a stronger and statistically more significant
role in driving American unemployment than interest rates. In
___________________
forecast extending beyond the sample period used in the study, a
___________________ stern test of any model, Mr Oswald's approach easily outperforms
its rivals, including consensus predictions of commercial
forecasters.
The paper makes no attempt to test and reject the view that new
technologies have changed the structure of the American economy
E-
in the late 1990s. New economy optimists may therefore be
untroubled by these findings. But that would be a mistake. Mr.
Oswald's point is that there is no need to posit a new economy to
account for the behaviour of the American economy since the mid-
1990s. The boom has all the standard features of an oil price
shock, except that, compared with the more familiar cases of
1973-74 and 1979-80 and the not-so-noticed case of 1990-91, this
CC
one happened in reverse. Profit margins widened dramatically as

the price of energy fell; inflationary pressure subsided even as
demand gained strength (under the influence of rising stock
market wealth and other forces); the rate of unemployment
consistent with stable inflation (the so-called natural rate)
appeared to fall to an amazing low.
Lawrence Summers, America's treasury secretary, attracted

attention recently when he likened the new technology boom to a
positive supply side shock, the converse of the oil price shocks of
the 1970s. And yet, Mr. Oswald argues, the more natural parallel
to draw between then and now is that for most of the 1990s there
has been a "good" oil price shock. Even if you do not accept Mr.
(c)
Oswald's new economy skepticism in full, it is undeniable that oil

was (rightly) given most of the blame for what went wrong in
those earlier periods, but none of the credit for what has gone
right more recently.
Contd.
195
It seems highly likely, Mr. Oswald's scepticism notwithstanding,
S
that a surge of technological progress in America has indeed Notes
applied a significant positive supply shock to the economy. But it ___________________

is certain, as opposed to merely likely, that the recent oil-price
___________________
hike is a substantial negative supply shock. The future course of
the economy will depend on which of these forces proves more
E
___________________
powerful. If low inflation persists alongside very low
___________________
unemployment, the new-economy shock can be declared the
winner. But if, with oil pegged at more than, say, $ 20 a barrel, ___________________
low inflation can be maintained only at the cost of rising ___________________
UP
unemployment, the oil price will have had its revenge. It was
___________________
denied its full share of thanks for the current boom; it may be
harder to ignore in any forthcoming recession. ___________________
Questions ___________________
1. What is the impact of oil price on international business and ___________________

economy?
2. Do you agree with Mr. Oswald? Give reasons.
3. Analyze the cause-effect relationship between unemployment

E-
and oil price.
4. Contrast the "demand side" and the "supply side" views on the
case.
Source: The Economist, April 1, 2000)
CC
(c)
196
Case Study 2: Color Chips Plans Hollywood Animation Unit
S
Notes
Color Chips (India) Ltd., India's largest animation house, is
___________________ planning a pre-production facility in Hollywood. "It could be as a
joint venture or outright purchase of one of the animation studios
___________________
there. We are talking to one of Hollywood's top 10 companies,"
___________________ Color Chips chairman and managing director Uttam Kumar told
E
___________________ Business Standard on Monday. Kumar spent over a decade in
Hollywood's top animation studios before setting up his company
___________________
here.
___________________
The proposed tie up, Kumar said, was in line with the company's
UP
___________________ plan to corporatize animation and emerge as a leader in
animation and cartoons feature syndication.
___________________
Color Chips recently acquired UBC Feature World, India's largest
___________________
cartoon and graphics based syndication company. It has tied up
___________________ with the Chandamama group of publications to provide creative
and technical services for digital publishing and revised editions
of Chandamama, the most popular magazine for children in India
with 12 language editions.
Initially, the company will concentrate on producing 2D and 3D
E-
animation for the electronic media, special effects for feature films
and features, cartoons, puzzles and games for the print media.
The company has acquired state-of-the-art equipment in a 25,000
sq ft area in Jubilee Hills here and production will start on April
14. Uttam Kumar said for 3D animation, he was negotiating for
interactive games, CDs and game engines with some of India's top
companies, not only for production but also strategic partnership
CC
and joint ventures.

He strongly feels that it is time India also builds an Indian
character just as in the West, where stories revolve around known
characters like Mickey Mouse and Donald. "We don't have a
single such character," he said.
According to Uttam Kumar, Color Chips provides facilities in
advanced systems with SGI workstations and leading software for
digital content creation, SFX and processing, full-fledged set up
for animators, BG and layout artists and editors.
Other facilities include motion capture set up, sound editing and
post-production suite, library of print and digital references
(c)
besides research materials, leased lines for ISDN communication

and data transfer besides web hosting facility at Singapore. He
has invested ` 10 crores in the venture.
Though it is the presence of IT companies that drew Uttam

Kumar to Hyderabad, he maintains that animation is "neither IT
Contd.
nor movie". He adds: "It is an artistic driven technology. I hire 197
S
artists and not programmers. To create, say a cloud, the artiste Notes
can imagine better than a programmer."
___________________
He said that required manpower was not readily available in
___________________
India. "Parents want their children to go for professional courses
like engineering and medicine and now for IT, but not for creative
E
___________________
work as artists. This mindset has to change," he said.
___________________
In Korea and Taiwan, which have made great strides in
___________________
animation industry, a single studio employs several thousand
artists. Color Chips now has 400 employees which will treble in a ___________________
UP
year's time. ___________________
"But we are handicapped by the lack of women artists. Women ___________________
are not coming into this field," says Uttam Kumar.
___________________
Questions
___________________
1. State clearly the objectives and constraints of Color Chips
(India) Ltd.
2. Explain the nature of the "company" and its "product". Figure

out its "strategy".
E-
3. Identify the production function, supply function and demand
function for the company's product line.
Source: Business Standard, April 6, 2000)
CC
(c)
198
S
Notes
___________________
___________________
___________________
E
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
E-
CC
(c)
UNIT 21: Economic Profits
199
S
Notes
___________________
___________________
E
___________________
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
BLOCK-V
E-
CC
(c)
200
S
Notes
UNIT 21: ECONOMIC PROFITS
___________________ UNIT 24: LEADERSHIP IN ECONOMIC
DECISIONS
z Introduction
___________________ z Introduction
z Meaning of Economic Profits
___________________ z Leading in Japan
E
z Classification of Profits
___________________ z Leading in the United States
UNIT 22: BREAK-EVEN ANALYSIS z Leading in China
___________________
z Introduction z Management by Teamwork at Ford
___________________
Concept of Break-even Analysis
UP
z
___________________ UNIT 25: CASE STUDIES
UNIT 23: DECISION MAKING PROCESS
___________________
z Introduction
___________________
z Managerial Decision Making System
___________________
z Managerial Decision Making Environment
z Quantitative Models
E-
CC
(c)
Unit 21
201
S
Notes
Economic Profits
___________________
___________________
E
___________________
Objectives
___________________
topics: ___________________
\ Economic profit ___________________
UP
\ Meaning of Gross Profit and Net Profit ___________________
\ Difference between Accounting & Economic Profit
___________________
___________________
Introduction
___________________
Profit is the reward of the entrepreneur rather than the
entrepreneurial functions. Profit differs from the return on other
factors in three important respects (a) Profit is residual income and
not contractual or certain income as in the case of the other factors
E-
(b) There are much greater fluctuations in profits than in the
rewards of the other factors (c) Profits may be negative whereas
rent, wages and interest must always be positive. The term 'profit'
means all excess of income over costs and this includes the
earnings of self used factors; i.e., entrepreneur's own land, capital
and his own labour work called respectively implicit rent, implicit
CC
interest and implicit wage. But in economics, profit is regarded as

a reward for the entrepreneurial functions of final decision making
and ultimate uncertainty bearing.
Meaning of Economic Profits

Profit plays two roles in a market economy. Firstly, changes in
profit signal producers to change the rate of production. Secondly,
profit is a reward to entrepreneurs for taking risks, being
especially innovative in developing new products, and reducing
production costs.
Having restated that the goal of the firm is profit maximization, it

(c)
is necessary to define the term 'profit'. Profit is generally

considered as revenues minus costs. But the definition of cost is
quite different for the economist and the accountant. Suppose an
individual who has an MBA degree and is considering investing `
2,00,000 in a retail store that he would manage. The projected
202
income statement for the year as prepared by as accountant is
S
Notes shown below:
___________________ Particulars Amount (`)
___________________ Sales 90,000

Less: Cost of goods sold 40,000
___________________
E
Gross Profit 50,000
___________________ Less: Advertising 10,000
___________________ Depreciation 10,000
Utilities 3,000
___________________
Property tax
UP
2,000
___________________
Misc. Expenses 5,000 30,000
___________________ Net Accounting Profit 20,000
Less: Implicit costs:
___________________
Return on ` 200,000 of invested capital 10,000
___________________
Foregone wages 40,000 50,000
Net Economic Profit -30,000
In the example, ` 2,00,000 shown in the income statement are the

accounting costs of the retail store. The accounting or business
E-
profit is the revenue of the firm minus the explicit costs or
accounting costs of the firm. Explicit costs are the actual out-of-
pocket expenditures of the firm to purchase or hire inputs it
requires in production. These expenditures are wages to hire
labour, interest on borrowed capital, rent on land and buildings,
and the expenditures on raw material.
To the economist, however, economic profit equals revenue of the

CC
firm minus the explicit and implicit costs. Implicit costs refer to
the value of the inputs owned and used by the firm in its own
production processes. The inputs owned and used by the firm in its
production process are not free for the firm, even though the firm
can use them without any actual or explicit expenditure. Their
implicit costs are what these same inputs could earn in their best
alternative use outside the firm. Accordingly, economists include
both explicit and implicit costs in their definition of costs.
There are two implicit costs in the above example. First, the owner
has invested ` 2,00,000 in the business. Suppose the best
alternative use of the money is a bank account paying a 5 percent
(c)
interest rate. The ` 10,000 return on this investment is the implicit

cost or opportunity of having the ` 2,00,000 invested in the retail
store. Manager's time and talent is the second implicit cost.
Suppose the annual return from being employed elsewhere is `
40,000 per year then this is the implicit cost. Thus, the business is
projected to lose ` 30,000 in the first year. The accounting profit of
` 20,000 disappears when both the explicit and implicit costs are 203
S
considered. Rational decision making requires that all relevant Notes
Activity
costs should be considered. Classify profits into various
___________________
categories.
The concept of business profit is useful for tax and accounting ___________________
purposes and the concept of economic profit is helpful in reaching
E
___________________
correct investment decisions.
___________________
Classification of Profits ___________________
Profits can be expressed in the following different ways: ___________________
UP
Gross Profit and Net Profit ___________________
Gross profit = Total Revenue Explicit costs ___________________
___________________
A business analyses gross profit income available to him after
payment is made to contractual hired factors like taxes, ___________________
depreciation charges, insurance charges. In other words, it is
excess of revenue receipt over explicit payment and charges.
Net profit, also called as pure profit or economic profit, is the

E-
residual balance of income after making payments to all
contractual and non-contractual payments to factors of production.
Implicit costs have to be deducted from gross profit to arrive at net
profit, which could be positive or negative.
Normal Profit and Supernormal Profit

Normal profit refers to that portion of profit which is absolutely
CC
necessary for the business to remain in operation. In other words,

it is the minimum necessary to induce the business to remain and
operate. Normal Profit forms a part of the average cost. The
organizer obtains normal profit when average revenue is equal to
average cost (AR = AC).
Supernormal profit or abnormal could be treated as any return

above the normal profit. It is the residual surplus after paying for
explicit costs, implicit costs and normal profit. When average
revenue or price is more than the average cost, the entrepreneur
gets supernormal profits. The existence of this profit is not
obligatory to the firm to remain in business like normal profits.
(c)
Accounting Profit and Economic Profit
ormal Accounting profit is the revenue obtained during the period

minus the cost and expenses incurred to produce the goods
responsible for getting the revenue.
204
Accounting profit = Total revenue the cost
S
Notes
Activity involved in reducing and selling.
Define normal & supernormal
___________________
profits. This theory is heavily discounted on the ground that it does not
___________________ take into consideration other expenses like the entrepreneurs
___________________ wages, rental incomes on self owned land and interest on self-
E
capital (also called as imputed cost).
___________________
The economic profit refers to those items that take into
___________________
consideration both explicit costs and implicit cost. Economists
___________________ point out that economic profits are important than accounting
UP
___________________ profits since they alone reflect the true profitability position of the
business enterprise.
___________________
___________________ Economic profit = Total Revenue

Explicit costs + imputed costs
___________________
Or
Economic Profit = Accounting Cost Imputed cost.
Check Your Progress

E-
Fill in the blanks:
1. ................... refers to those items that take into
consideration both explicit costs and implicit cost.
2. ................... refers to that portion of profit which is
absolutely necessary for the business to remain in
CC
operation.
3. ................... is the residual surplus after paying for
explicit costs, implicit costs and normal profit.
4. ................... is the revenue obtained during the period
minus the cost and expenses incurred to produce the
goods responsible for getting the revenue.
Summary
Profit is regarded as a reward for the entrepreneurial functions of
final decision making and ultimate uncertainty bearing. Profit is
(c)
generally considered as revenues minus costs. Break even analysis

examines the relationship between the total revenue, total cost and
total profits of the firm at various levels of output. It is used to
determine the sales volume required for the firm to break even and
the total profits and losses at other sales level.
Lesson End Activity 205
S
Notes
Take an example of sale of any product in relation to its cost prices.
___________________
Identify the profits incurred by the seller.
___________________
Keywords
E
___________________
___________________
Accounting profit: It is the revenue obtained during the period
minus the cost and expenses incurred to produce the goods ___________________
responsible for getting the revenue. ___________________
UP
Economic Profit: Economic profit equals revenue of the firm ___________________
minus the explicit and implicit costs.
___________________
Normal profit: It refers to that portion of profit which is
___________________
absolutely necessary for the business to remain in operation.
___________________
Supernormal profit: It is the residual surplus after paying for

E-
1. Illustrate the classification of profits.
2. What do you mean by Economic Profit?
3. What is the difference between Accounting Profit & Economic

Profit?
CC
4. The profit and loss data of a company X for a particular year

is as follows:
Net sales ` 1,00,000

Cost of goods sold:
Variable cost 40,000
Fixed cost 10,000
Gross profit 50,000
Selling cost:
Variable 10,000
Fixed 5,000
(c)
Net profit 35,000
(a) Compute the breakeven point.
(b) Forecast the profit for the sales volume of ` 1,60,000 and
` 70,000.
206
(c) What should be the sales volume to earn a net profit of `
S
Notes
55,000?
___________________
___________________ Further Readings

___________________
E
Books
___________________
___________________
Maurice - Special Indian, 8th Ed, McGraw Hill Education.
___________________
UP
___________________
Web Readings
___________________ www.wisegeek.com/what-is-profit-analysis.htm
___________________ en.wikipedia.org/wiki/Cost-Volume-Profit_Analysis
___________________ www.accountingformanagement.com/gross_profit_anal... - United
States
E-
CC
(c)
UNIT 22: Break-even Analysis
Unit 22
207
S
Notes
Break-even Analysis
___________________
___________________
E
___________________
Objectives
___________________
topics: ___________________
Break-even analysis ___________________
UP
Uses of break-even analysis ___________________
Limitations of break-even analysis
___________________
___________________
Introduction
___________________
Break-even analysis is a technique widely used by production
management and management accountants. It is based on
categorising production costs between those which are "variable"
(costs that change when the production output changes) and those
E-
that are "fixed" (costs not directly related to the volume of
production).
Total variable and fixed costs are compared with sales revenue in
order to determine the level of sales volume, sales value or
production at which the business makes neither a profit nor a loss
(the "break-even point").
CC
Concept of Break-even Analysis

Break-even analysis or profit contribution analysis is a technique
used to make managerial decisions with regard to relation between
total revenue (TR), total costs (TC) and total profits. It is often
used by managers to determine the sales volume required for the
firm to break even and to assess the total profits and losses at
various levels of sales.
Assumptions
(c)
The break even analysis is based on certain assumptions, namely.
ven All costs are either perfectly variable or absolutely fixed over the
entire period of production but this assumption does not hold well
in practice.
208
The volume of production and the volume of sales are equal; but in
S
Notes
Activity reality they differ.
Explain linear break-even
___________________
analysis. All revenue is perfectly variable with the physical volume of
___________________ production and this assumption is not valid.
___________________
The assumption of stable product mix is realistic.
E
___________________
Linear Break-even Analysis
___________________
Figure 22.1 (a) shows a linear break even relationship. The vertical
___________________
axis depicts total revenues and total costs whereas output is shown
UP
___________________ on the horizontal axis. The slope of the TR curve refers to the
___________________ constant price of ` 10 per unit at which the firm can sell its output.
The TC curve indicates the total fixed costs (TFC) of ` 200 (the
___________________
vertical intercept) and a constant AVC of ` 5 (the slope of the TC
___________________ curve).
TR (a) Linear TR (b) Non linear

TC TC TC
TR B TR
Profit Profit
E-
TC
400
B A
300 Loss
Loss TFC TFC
0 O
40 Q1 Q2 Q3
Quantity Quantity
Figure 22.1: Break-even Analysis

CC
Total cost curve is a straight line because AVC is taken as

constant. Since AVC is constant, the extra cost of extra unit must
be constant too and equal to AVC. This is often the case for many
firms for small changes in output or sales. The firm breaks even at
40 units of output (point B) where TR is equal to the TC. The firm
incurs operating losses at smaller outputs (since TC > TR) and
earns operating profits at higher output levels (since TR > TC).
The break even chart is a flexible tool to quickly analyze the effect
of changing conditions on the firm. For example, an increase in the
price of the commodity can be shown by increasing the slope of the
(c)
TR curve. An increase in TFC of the firm can be depicted by an

increase in vertical intercept of the TC curve and an increase in
the AVC by an increase in the slope of the TC curve. The chart will
then show the change in the breakeven point of the firm and the
profit or losses at other output or sales levels.
Cost-volume profit analysis can be calculated algebraically. TR is 209
S
the price per unit times the quantity of output or sales (Q) Notes
TR = P. Q ___________________
___________________
TC = TFC + TVC
E
___________________
Since TVC = (AVC) (Q)
___________________
TC = TFC + (AVC) (Q)
___________________
Setting TR = TC and substituting QB (breakeven output) for Q we ___________________
UP
have
___________________
(P) (QB) = TFC + ( AVC ) (QB)
___________________
Solving for break even output, we get ___________________
(P) (QB) - (AVC) (QB) = TFC ___________________
(QB) (P - AVC) = TFC
TFC
QB =
P AVC
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The equation can be modified to calculate the contribution margin
towards the fixed costs and desired amount of profit ().
TFC +
SB =
P AVC
The profit volume (PV) ratio can also be used to find the BEP for
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sales for multi-product firms. It can be calculated with the help of

a formula
SV
(100)
PV ratio =
S
Where S is the selling price and V the variable cost. The PV ratio is
helpful in making choice of a product. If there is no time
constraint, then a product with a higher PV ratio should be
selected. On the other hand, PV ratio per time unit is taken as the
basis of choice in case of time constraint.
The linear approach to profit contribution has been criticized as it

considers both price and AVC constant. The price assumption is
(c)
not realistic for many firms, because they may not sell all they
produce at the going price.
Especially firms, where sales are large relative to the size of

market, may have to reduce price to sell more output. For some
firms, the assumption of constant AVC may be unrealistic. Also,
210
empirical studies suggest that the TC function is often close to
S
Notes linear, as long as the firm is not operating at or close to capacity.
___________________ However, if the price and AVC are roughly constant, at least over
___________________ the limited range of output relevant to the problem, breakeven
analysis is a useful tool for managerial decisions. But care and
___________________
judgment are required in its application.
E
___________________
Non-linear Break-even Analysis
___________________
If assumptions of constant price and AVC are relaxed we get non-
___________________ linear break even analysis (Figure 22.1b). There are two break
UP
___________________ even points Q1 and Q3. Profit, the vertical distance between the
total revenue and total cost, is maximized at output rate Q2. The
___________________
output rate Q2 is relevant when the firm begins to earn profits. The
___________________ firm should not produce beyond Q2 because this would lead to
___________________ reduction in profit. No rational manager will expand production to
second breakeven rate Q3 and, therefore, it is irrelevant.
Contribution Margin
In short run, managers are concerned with the contribution
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margin or contribution profit since fixed costs are sunk costs.
Break even charts can be used to measure the contribution of
business activity towards covering fixed costs. Average
contribution margin (ACM) is the difference between unit price
and AVC (P AVC). Total contribution analysis can also be used to
determine the total contribution profit. Contribution is the
difference between the total revenue and variable costs. That is, it
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is the revenue on the sale of unit of output after variable costs

have been covered.
Total contribution margin (TCM) = TR TVC

or TCM = Total net profit (TNP) TFC
Thus at the breakeven point
TCM = TFC and TNP = 0.
The equation also shows that
TR = TCM + TVC
= (TNP + TFC) +TVC
(c)
Uses of Break-even Analysis

Significant managerial decisions can be made from the break even
analysis.
1. Optimum level of output can be estimated from which the firm

will start earning profits.
2. It is used to determine the target capacity for the firm to get 211
S
the benefit of minimum unit cost of production. Plant Notes
Activity
expansion and contraction decisions are often based on break Give any one use of break-
___________________
even analysis. even analysis.
___________________
3. Profit or losses can be forecast from estimates of revenue and
E
___________________
cost.
___________________
4. Effect of change in volume of sales, price, and cost of
production can be analyzed. ___________________
___________________
5. Product mix can be determined - to produce or to purchase a
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product and whether to drop a product line or not. ___________________
6. Effect of high fixed costs and low variable costs on the total ___________________
costs can be appraised. ___________________
7. Planning of cash requirements can be done from cash break ___________________

even.
The break even analysis is not free from limitations. In case of

multi-product or joint product firms the breakeven analysis can be
E-
applied only if product wise estimates of cost and revenue are
available which is extremely difficult. It ignores the selling costs
and takes into account only the production costs. Despite these
limitations, the concept is used in production planning as it is
simple, inexpensive, and explains fundamental relationships
between revenue, costs, and profits.
Limitations
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Break even analysis is generally used to find out the output level
at which the total fixed cost of a company are covered up by the
contributions. But due to non-availability of separate data for fixed
and variable cost for each product manufactured by the company
the analysis had to be carried out with respect to time.
The analysis itself has got some inherent limitations which have
been mentioned earlier.
The company considered manufacturing a wide range of products

and is operating at various locations. Hence, to carry out the
(c)
analysis at company scale is very complex procedure which

involves sorting of relevant data from a heap of data and then
compiling it in the form required by the analysis. Generally
companies don't differentiate very clearly and hence don't record
cost on the basis of fixed and variable cost.
212
Data needed for the analysis is generally kept secret by the
S
Notes
companies otherwise it can indicate their profit margins per unit.
___________________
E
___________________ 1. ................... is generally used to find out the output
level at which the total fixed cost of a company are
___________________
covered up by the contributions.
___________________
2. ................... is a straight line because AVC is taken as
UP
___________________
constant.
___________________
___________________ Summary
___________________
In economics & business, specifically cost accounting, the break-
even point (BEP) is the point at which cost or expenses and
revenue are equal: there is no net loss or gain, and one has "broken
even". A profit or a loss has not been made, although opportunity
costs have been "paid", and capital has received the risk-adjusted,
E-
expected return.
Lesson End Activity

With the help of internet, find out how non-linear break-even
analysis can be represented graphically.
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Keywords
Break even charts: It can be used to measure the contribution of
business activity towards covering fixed costs.
Average contribution margin (ACM): It is the difference
between unit price and AVC (P AVC).
Total contribution analysis: It can also be used to determine the
total contribution profit.
Contribution: It is the difference between the total revenue and
variable costs.
(c)

1. Explain the concept of break even analysis. How can
management use it as a tool for profit planning?
213
2. Explain the limitations of break-even analysis.
S
Notes
3. Describe the uses of break-even analysis.
___________________
4. Explain the linear and non-linear break-even analysis.
___________________
E
___________________
Further Readings
___________________
Book ___________________
Managerial Economic by Christopher R Thomas, S Charles ___________________
UP
Maurice - Special Indian, 8th Ed, McGraw Hill Education. ___________________
Web Readings ___________________
___________________
www.wisegeek.com/what-is-profit-analysis.htm
___________________
en.wikipedia.org/wiki/Cost-Volume-Profit_Analysis
www.accountingformanagement.com/gross_profit_anal... - United
States
E-
CC
(c)
214
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Notes
___________________
___________________
___________________
E
___________________
___________________
___________________
UP
___________________
___________________
___________________
___________________
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CC
(c)
UNIT 23: Decision Making Process
Unit 23
215
S
Notes
Decision Making Process

___________________
___________________
E
___________________
Objectives
___________________
topics: ___________________
Quantitative decisions ___________________
UP
Importance of variables ___________________
Importance of eight decision making tools
___________________
___________________
Introduction
___________________
A decision always involves choice among several alternatives. In
the most basic sense a decision always involves the answer to the
question "to do or not to do?" Not to do (inaction) determines that
decision. To do (action) usually involves different options. The
E-
mathematical model identifies the optimal way, but for a variety of
reasons, other satisfying options may be selected and acted upon.
There are industry-wide and market-wide decisions that have to be
made. Often these decisions must transcend domestic
considerations to incorporate international aspects.
CC
Managerial Decision Making System

Every decision making task results in an output which is the
evidence of the decision taken. In industry, it is ultimately some
kind of product, that is, a good service or on idea. The reasoning
takes place in the decision making rectangle which is sometimes
referred to as, quite appropriately, the black box. Here a
transformation of the inputs takes place that results in the output.
The transformation process has both physical and mental
properties. On the input side a large number of variables may be
listed. These variables can be classified in terms of the traditional
factors of production, i.e., land, labour and capital as well as the
(c)
more recently emerged complex variables related to systems,

technology and entrepreneurship. Underlying this input-output
system is a feedback loop identified as managerial control system.
Its function is to optimize the transformation of inputs into the
desired output. In a nutshell, in industry optimization means the
216 minimization of costs and the maximization of profits subject to
S
Notes
Activity legal, social and ideological constraints.
Define stochastic variables.
___________________
The computer has forced the decision maker to very carefully
___________________ delineate and quantify the variables that makeup the building
___________________ blocks of the decision task. What is needed and how much is
E
needed for decision optimization have become the important
___________________
questions. In addition, the proper time sequencing of the decision
___________________ variables within the decision process had to be understood. And all
___________________ answers had to be unequivocally quantified. It soon became
apparent to every decision maker that quantified variables had
UP
___________________
different properties and specific quantitative control mechanisms
___________________ had to be designed. Not only was the decision maker confronted
___________________ with variable-inherent properties, the decision tasks themselves
have such peculiar quantitative properties.
___________________
A variable, the building block of the decision task, may be seen as a
small piece of a complex behaviour. Buying a house,
manufacturing a product, spending money on a show are examples
of variables. Each variable represents a distinct dimension of the
E-
decision making task. So the decision space is always
multidimensional, and it is a major task for the decision maker to
find out which variables make up that space. If an important
variable is overlooked, obviously the decision will be less than
optimal. Furthermore, the quantitative impact of the variable
must be ascertained. And here the special variable-inherent
properties come into play. The following illustrations may show the
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differences among the three types of variables.
Deterministic variables can be measured with certainty. Thus,

equal measures have equal cumulative impact, or, to use a simple
illustration, a + a = 2a.
Stochastic variables are characterized by uncertainty. Thus, a + a

= 2a + X, where X is a value that comes about because of the
uncertainty that is associated with the variable.
Heuristic variables are those that exist in highly complex,

unstructured, perhaps unknown decision making situations. The
impact of each variable may be explained contingent upon the
existence of a certain environment. For example,
(c)
a + a = 3a but only if certain conditions hold. Actual industrial

decision making situations in each case may involve the number of
gallons of aviation fuel obtained by cracking a barrel of crude oil
(deterministic), projected product sales given amount spent on
advertising the product (stochastic) and the construction of a
platform in outer space (heuristic).
217
Check Your Progress
S
Notes
Activity
Fill in the blanks:
Define managerial hierarchy.
___________________
1. Reasoning is .. by nature, which can be
___________________
rational or irrational.
E
___________________
2. All types of human decision-making are essentially
___________________
processes.
___________________
Managerial Decision Making Environment ___________________
UP
The reason for the existence of a managerial hierarchy, that is, ___________________
lower, middle and top management, finds itself in different
___________________
parameters in which an organization operates. There are industry-
wide and market-wide decisions that have to be made. Often these ___________________
decisions must transcend domestic considerations to incorporate ___________________
international aspects. Such decisionsusually made by top
managementoccur in a broad-based, complex, ill-defined and
non-repetitive problem situation. Middle management usually
addresses itself to company-wide problems. It sees to it that the
E-
objectives and policies of the organization are properly
implemented and that operations are conducted in such a way that
optimization may occur.
You may note that while most of the quantitative decision making
toolsindeed virtually all of the deterministic toolswere
developed to optimize the decision making process, actual
managerial practice has sometimes moved away from that
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objective. The previously mentioned legal or social constraints

often at times do not permit optimization and satisfying has been
substituted for it. Satisfying refers to the attainment of certain
minimum objectives. For example, a company may have the
economic and technological power to smother the competition
within its industry but refrains from doing so because of MRTP
considerations. Big size per se may be considered in violation of the
law or in the international arena, may result in the imposition of
quotas.
Lower management is responsible for the conduct of operations

the firing line so to speak is thisin production, marketing,
(c)
finance or any of the staff functions like personnel or research.

This decision environment is usually well-defined and repetitive.
Obviously, with reference to a given decision making situation, the
distinction between top, middle and lower management may
become blurred. In other words, in any ongoing business there is
218
always a certain overlapping of the managerial decision making
S
Notes parameters.
___________________
The study and analysis of the existence and interaction of these
___________________ parameters is of great importance to the management systems
___________________ designer or communication expert. From the quantitative
E
managerial decision making point of view, their importance lies in
___________________
recognizing their peculiar constraints and then to build the
___________________ appropriate decision models and to select the best suited
___________________
quantitative decision tools. A brief discussion of each environment
in this light may enhance the understanding of the tools that are
UP
___________________
discussed later on. The companys approach to the domestic or
___________________ international market is filtered through industry-wide
considerations. What does the market want, what does the
___________________
competition already supply? Where is our field of attack? Do we
___________________ have the knowledge how do we have the resources? What is the
impact of our actions upon the market, our own industry and other
industries? These are some of the questions that have to be asked,
defined and answered. The problems are unstructured and
complex. Thus, often a heuristic decision making process can be
E-
utilized to good advantage. Forecasting is of major importance and
hence stochastic decision making is widely employed in this
uncertain decision environment. But even a deterministic tool
usually intended for decision making situations that assume
certaintyinput-output analysis, can be effectively used in this
environment.
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Middle management decisions are primarily company-wide in

nature. As mentioned before, these decisions steer the organization
through its life cycle.
Major features of a firms life are objectives, planning, operation

and the ultimate dissolution. The objectives are general and
specific in nature. Obviously, the top management establishes the
objectives, but middle management functions as their guardian.
Indeed, every decision at this level must provide feedback control
for each of the other components.
Planning refers to both policy execution as well as policy
development. Scale of production, pricing of the product, product
(c)
mix, in short the orderly and efficient arrangement of the input

factors is to be decided at this point. Making these factors into a
product is the job of operations. Some operations have been
traditionally called line (financing, production, and marketing) and
others staff (personnel, research, etc.); yet, in the quantitative
decision systems of the modern firm, such differences are difficult
to trace in the decision patterns, because the same decision, 219
S
making tools are employed. Since the decision environment at this Notes
level is somewhat more structured than at the top level but still ___________________
highly uncertain, stochastic decision tools are frequently employed.
___________________
In those finance, production and marketing situations that can be
well-defined, may be repetitive, deterministic decision tools are
E
___________________
found. ___________________
It may appear somewhat odd that the decision environment
___________________
includes attention being paid to the dissolution of the firm. The life
cycle concept has been mentioned, and it will be encountered again ___________________
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as one of the major underlying conceptual aids in forecasting. It is ___________________
well known that business organizations are born, live and die like
natural organisms. ___________________
Therefore, decision making should always be cognizant of the ___________________
possibility of dissolution. That moment comes when, to use the ___________________

vernacular, good money is thrown after bad. While market forces
and the application of quantitative analysis normally show the
approaching occurrence of that momenteven if the management
involved shuts its eyes to the facts or is ignorant about themat
E-
this point the decision is made or superimposed to opt for a
turnaround or dissolution. Public agencies unfortunately are rarely
subject to such stress producing alternatives.
The lower management decision making environment represents a
specialized, narrowly defined area within a companys total
decision or operational field. Supervisory personnel of all types are
operating in this environment. The decision tasks are normally
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well defined and repetitive. While the element of uncertainty never

leaves the decision environment, here uncertainty can often be
programmed into general or sub-routine and stochastic decisions
taken as if they were deterministic in nature. A good example is
the pricing system of clothing discounters. Merchandise is put on
the floor at price A on day one. On, say, day ten the price is
automatically reduced to price B and so on until the article is
either sold or given to charity after thirty days. This is known as
programmed decision making. It should be noted that while the
nature of the decision environment remains intact, the decision
makers tasks have been greatly reduced. The complex variables
and unstructured decision environment of the merchandising task
(c)
have been placed first into a model and then into decision making
sequence (algorithm). This is the general idea behind model
building and the development of algorithms.
It is highly important that every decision maker has a firm
understanding of the philosophy upon which quantitative decision
making is based. Under no circumstances is it sufficient to just
220
know how to perform a certain quantitative analysis and to obtain
S
Notes a solution to be able to make a decision.
___________________ To turn to the specific aspects of the quantitative decision making
___________________ process, it is possible to recognize three distinct phases in every
decision situation. Given a carefully defined problem, a conceptual
___________________
E
model is generated first. This is followed by the selection of the
___________________ appropriate quantitative model that may lead to a solution. Lastly,
a specific algorithm is selected. Algorithms are the orderly
___________________
delineated sequences of mathematical operations that lead to a
___________________ solution given the quantitative model that is to be used. The
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algorithms generate the decision which is subsequently
___________________
implemented by managerial action programs.
___________________
Problem Definition
___________________
___________________ Problem definition is a cultural artifact which is especially visible

in a societys economic and industrial decision making process.
Obviously, if such cultural determinants are operative in the first

phase of managerial decision making, their effect can be noticed at
various stages in the process irrespective of the quantitative, thus
E-
hopefully objective, methods that are used in the design of the
models and algorithms as well as the decision itself.
A brief digression into problem identification may be in order at

this point. For purposes of this book and for quantitative
management decision methodology in general, it is presupposed
that a problem has been identified.
CC
In the private sectors of free enterprise economies, however, a

managers ability to recognize problems and even to anticipate
problems that may emerge at some future time is vital to the
survival of the firm. Those managers that make effective decision
concerning a known problem are good administrators; those that in
addition can recognize and anticipate problems are creative. It is
known that creativity is partially inborn and partially acquired.
Thus, the quantitative decision maker will not only try to master
the methodology but also attempt to sharpen his or her problem
identification skillshis or her creativity.
The Design of Conceptual Models

(c)
The conceptual model represents the logic that underlies a

decision. Based on this logic the quantitative model and specific
algorithms are constructed. The logic may be a priori or empirical
in nature, e.g., when shooting craps in a casino, a gambler has pre-
established a conceptual model concerning the odds of the game.
On a priori groundusing only his or her intellectin determining 221
S
the odds of every roll of the dice, the concept dictates that the win Notes
Activity
of a seven or eleven on the first roll has likelihoods of 6/36 and 2/36 , What does the conceptual
___________________
respectively. (There are 6 possible combinations of spots showing model represent?
___________________
on 2 dice that yield a seven and 2 combinations that yield an
eleven with 36 combinations for all spots from two through twelve.)
E
___________________
Given this conceptual model, quantitative models and algorithms ___________________
can be designed that facilitate the betting decision.
___________________
Now suppose that our gambler stumbles across a floating craps
___________________
game in some dark alley. After observing the action on the
UP
pavement for a while, he notices that sevens and elevens do not ___________________
occur on the first roll with the likelihood dictated by his conceptual ___________________
model. Rather there seems to be a preponderance of twos, threes
___________________
or twelveswhich he knows are losses. Crooked dice, he may very
quietly think to himself. For crooked dice, an a priori logic which is ___________________
based on the ideal situation in which every spot on a dice has an
equal probability of occurring (1/6) and any spot on two dice as well
(1/6 1/6 = 1/36) according to the multiplication theorem) is
unsuitable. Rather, he will now ascertain by observation (by
E-
experiment) the empirical probabilities which are determined by
the weights that have been cleverly or crudely (it is a dark alley)
concealed in or on the dice. Once this empirical conceptual model
has been generated, our gambler may continue the betting decision
process in terms of the amount of the bets at each roll, etc. He may
also redefine the problem and leave.
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Conceptual models may take many forms. In every case the

general design intent is to understand and to depict the reality
that relates to the problem. Most conceptual models show a
functional relationship in graphic or matrix format. All models
that are used in this book are of this type. But it is also possible,
indeed necessary in some decision cases, to build a physical model.
In the natural and engineering sciences, it is the usual form. If the
decision involves mass production of some item, the physical model
is known as a prototype.
In the design of the conceptual model, it is important to observe

that the decision maker clearly delineates the interrelationships
(c)
that make up the realityor the systemsin which the problem

occurs. But in the model building process it is virtually impossible
to include all variables that have a bearing on the decision. The
model includes only the major variables (endogenous variables) as
seen from the decision makers vantage point. There will be always
decision-related variables that exist outside of the decision space
222
(exogenous variables) because of their unrecognized status or
S
Notes
conscious exclusion due to time, cost or limited impact
___________________ considerations. Such variables should be kept mentally ready
___________________ because over a set decision horizon they may indeed become
sufficiently important to be included into the system.
___________________
E
___________________
Once the conceptual model has been designed and its logic
expressed in terms of some systems configuration such as the
___________________
graph or matrix or perhaps network or flow diagram, the
___________________ quantitative models are simply superimposed by quantifying the
UP
___________________ logic. Once that has been accomplished a relatively minor task
remains in the selection of the algorithms and the computerization
___________________
of the process. Many decision processes have been needlessly and
___________________ most of time injuriously to some extent, commenced because of
___________________ faulty problem definition or poor conceptual model building. Then
there is no optimal or even satisfying outcome. To put it simply,
number crunching and possible error correction is relatively easy,
even though the reader may not immediately share this view as he
or she does just that in the chapters that follow. Only the difficult
E-
tasks, that is, sound insight into the problem and its careful
definition as well as proper logic employed in the conceptual model
building process, will yield sound decisions and outcomes. Here
errors are very difficult to correct.
Quantitative Models
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Once the conceptual model has been properly designed, the

quantitative model and its algorithms should almost flow out of
it. The transition is natural, smooth, and almost automatic. The
quantitative model is selected from the many such models that
have been designed by mathematicians. So while the decision
maker will always build a conceptual model, the quantitative
model is typically selected from an available pool of such decision
making tools. The selection is made on the basis of the
predominantly stochastic, deterministic or heuristic nature of the
variables. There are available quantitative models for each kind as
discussed in the following chapters, and the decision makers task
(c)
is to select the appropriate one for a given decision situation.

Know thy tools should be inscribed on every decision makers
desk. As it is possible to build a wall with a spade when the trowel
would be the more appropriate tool, decision makers may
sometimes misuse quantitative tools.
The Decision 223
S
Notes
A decision always involves choice among several alternatives. In
the most basic sense a decision always involves the answer to the ___________________
question to do or not to do? Not to do (inaction) determines that ___________________
decision. To do (action) usually involves different options. The
E
mathematical model identifies the optimal way, but for a variety of ___________________
reasons, other satisfying options may be selected and acted upon. ___________________
These other options are firmly rooted in an organizations
objectives and planning activities. As shown in greater detail later, ___________________
a decision maker always has control over setting the objective and ___________________
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planning which interfaces with policies, strategies and tactics. But
___________________
one has no control over the reaction to the decision within the
market environment. Here various states, collectively known as ___________________
the states of nature, emanating from customers, suppliers,
___________________
competitors, public agencies, etc., render the final judgment about
the soundness of the decision. The decision is the end product of a ___________________
sequence of mental activities as illustrated in the preceding pages.
To make a decision does not necessarily mean that it gets carried
out. In order to accomplish that, numerous managerial action
programs are necessary. They represent the physical extension to
E-
the decision making process. This book stops at the point when the
decision is rendered. The action programs, the physical component,
cannot be discussed because they must be specifically designed for
each situation. A good decision maker, however, will try to place
the seeds for proper implementation into the decision.
Check Your Progress

CC
Fill in the blanks:

1. Inertia is often due to a fear of .
2. Problem definition is a cultural artifact which is
especially visible in a society's economic and
industrial .
Summary
Every decision making task results in an output which is the
evidence of the decision taken. A variable, the building block of the
decision task, may be seen as a small piece of a complex behaviour.
(c)
Buying a house, manufacturing a product, spending money on a

show are examples of variables.
The reason for the existence of a managerial hierarchy, that is,

lower, middle and top management, finds itself in different
parameters in which an organization operates. There are industry-
wide and market-wide decisions that have to be made.
224
The conceptual model represents the logic that underlies a
S
Notes decision. Based on this logic the quantitative model and specific
___________________ algorithms are constructed. Once the conceptual model has been
properly designed, the quantitative model and its algorithms
___________________
should almost "flow" out of it. The transition is natural, smooth,
___________________ and almost automatic.
E
___________________
The mathematical model identifies the optimal way, but for a
___________________ variety of reasons, other satisfying options may be selected and
___________________
acted upon. These other options are firmly rooted in an
organization's objectives and planning activities.
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___________________
___________________ Lesson End Activity

___________________ Find out more about the quantitative models of decision making
processes.
___________________
Keywords
Deterministic variables: Deterministic variables can be
measured with certainty.
E-
Stochastic variables: Stochastic variables are characterized by
uncertainty.
Heuristic variables: Heuristic variables are those that exist in
highly complex, unstructured, perhaps unknown decision making
situations.
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1. Every decision making task results in an output which is the
evidence of the decision taken.
2. Define variable. What are the different types of variables?
3. What are the key decisions taken at different managerial
levels?
4. Write a note on problem definition.
5. Discuss the process of designing conceptual and quantitative
models.
(c)
Further Readings
Books
R S Bhardwaj, Mathematics for Economics and Business, Excel
Books, New Delhi, 2005
D C Sanchethi and V K Kapoor, Business Mathematics 225
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Notes
Sivayya and Sathya Rao, An Introduction to Business Mathematics
___________________
Web Readings ___________________
www.managementstudyguide.com
E
___________________
www.textbooksonline.tn.nic.in ___________________
www.mathbusiness.com ___________________
___________________
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___________________
___________________
___________________
___________________
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(c)
226
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Notes
___________________
___________________
___________________
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___________________
___________________
___________________
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(c)
UNIT 24: Leadership in Economic Decisions
Unit 24
227
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Notes
Leadership in Economic Decisions

___________________
___________________
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___________________
Objectives
___________________
topics: ___________________
Leading practices of multinationals in developed countries ___________________
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Leading in different cultures of multinationals ___________________
Decision making ways in developed countries
___________________
Need to formulate strategy for implementing decisions
___________________
How people management policies influence leadership and decision
making in various countries? ___________________
Introduction
Leadership and decision making are the studies of organisational
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behaviour. Leadership is the focus and conduct of most of the
others areas of organisational behaviour. There are a number of
factors that potentially contribute to differences in effective leader
processes across cultures. Based on the culture, business and
people decision making is dovetailed to sent the strategy of the
multinational. This will have an impact on the policies on people
management. We have taken efforts to describe briefly the people
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management methods in various countries in the globe, which will

throw light on how organisational behaviours aspects like decision
making and leadership will have a bearing of such policies.
Leading in Japan
Japanese managers are seen as social integrators who are a part of
the work group. Using a paternalistic leadership approach,
managers show great concern for the welfare of their subordinates.
Common values and team spirit facilitate cooperation. The role of
managers is to create an environment of esprit de corps, and they
(c)
are willing to help out in doing the same work their subordinates
do. IN an attempt to maintain harmony at almost any cost,
mangers avoid face-to-face confrontation. This means that things
may be purposely left ambiguous. Leadership requires
followership, and managers are aided by the fact that individuals
228 are expected to subordinate their self-interest to that of the group
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Notes
Activity and the organisation. While managers may not be very directive,
Explain leading in United
___________________ influence is exerted through peer pressure. In fact, close personal
States.
relationships are nurtured not only because employees work
___________________
together on common tasks but also because they meet and
___________________
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associate outside the work environment. The result is a confluence
___________________ of organizational and private life.
___________________ Communication patterns parallel those for decision making.
___________________ Critical communication is top-down and bottom-up, while non-
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critical communication is often bottom-up. This communication
___________________
pattern is promoted by Japanese managers who take a great deal
___________________
of time communicating with their subordinates, emphasizing face-
___________________ to-face contact rather than memos.
___________________
Leading in the United States
The managerial function of leading is carried out quite differently
in U.S. companies. Leaders are seen as decision makers heading
the group; they are expected to be directive, strong, firm, and
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determined. Their task is to integrate diverse values, but the
emphasis on individualism in the society in general and in
organisations in particular may hinder cooperation. It is expected
that managers will take decisive actions and clarify the direction of
the group or the enterprise, even if this requires face-to-face
confrontation with those who may disagree. Although managers
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work hard, they value their private life and separate it from
working life. Within the organization, the communication pattern
is to a great extent from the top down through the hierarchy, with
considerable emphasis given to written communication.
Leading in China
The managerial function of leading in China has characteristics of
Japanese and U.S. practices. The leader is the head of the group
(in committees, for example), and the leadership style is generally
quite directive. One interviewee described the relationship
(c)
between the leaders and followers as Parent-Child, in

transactional analysis terms. In other words, it is expected that the
leaders commands will be obeyed. Leaders, in turn, are
responsible to higher authorities for performance and goals but not
for meeting customer needs and demands (this, however, is slowly
changing). Similar to leading in Japan, leading in China is aided
by common values and an emphasis on harmony rather than 229
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confrontation. On the other hand, communications primarily top- Notes
down, as in many U. S. corporations. ___________________
Can Ford and General Motors regain their Leadership? ___________________
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Ford and General Motors face tough global competition, for ___________________
Japanese carmakers have been gaining market share in the United ___________________
States. Ford Motor Company responded with the rather successful
___________________
Taurus model, using extensively teamwork concepts. General
___________________
Motors, on the other hand, built a completely new manufacturing
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and assembly plant in Tennessee. The departures from traditional ___________________
managing were spearheaded by Fords Donalnd Petersen and GMs ___________________
Roger Smith.
___________________
Fill in the blanks:

1. Leaders are seen as ................... heading the group;
they are expected to be directive, strong, firm, and
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determined.
2. ................... is the focus and conduct of most of the
others areas of organisational behaviour.
Management by Teamwork at Ford

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In the early 1980s Ford Motor Company was in trouble. It was

even said that FORD stood for fix or repair daily. Indeed, the
Ford story shows how a company can be turned around. The Ford
Taurus and Mercury Sale were the turning points for the company;
they illustrate that models produced by U.S. car makers can
compete with the very successful Japanese imports.
Problems can become opportunities, and during the 1980 recession
there were many difficulties to overcome. It became clear that Ford
had to compete not only against other U.S. car makers but also
against auto manufactures throughout the world. Drastic steps
were necessary: Ford invested $3 billion in its new models, made
(c)
quality its number-one concern, and learned from other carmakers,

especially the Japanese.
One of the first undertakings was to replace the old bureaucratic
structure with the team approach, or program management. The
old sequential approach was as follows: The product planners
230 developed the general concept of the new model, which was then
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Notes given to the designers. After the design stage, engineers got
___________________ involved, developing specifications for manufacturing and for the
various suppliers. This process was sequential, with little
___________________
communication among the various groups. When manufacturing,
___________________
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for example, got the specifications, little flexibility was possible,
___________________ even if changing the design would facilities assembly. If a problem
___________________ was discovered at the manufacturing stage, designers and
engineers had to be involved again, this time to correct the
___________________
problem. However, if parts were already purchased or dies already
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___________________ made, changes were costly; some were simply not made because of
___________________ the delay that would be involved. In this approach, the overall
___________________
responsibility was not clearly defined.
___________________ Ford recognized the need for dramatic changes, which were
incorporated in the project Team Taurus. Rather than having
each unit do the various tasks sequentially, the company
established a team consisting of planners, designers, engineers,
manufacturing people, and even suppliers (see the accompanying
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figure). Thus, representatives from all units were involved before
they became major problems. Ford also involved assembly line
workers in the development of the model. They were asked to
comment on difficulties they had with assembling the parts and to
make recommendations for improvements. Rather than adopting
the attitudes of we know best, Ford people carefully studied
cars made by other manufacturers and learned about their best
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features.
(c)
Figure 24.1
For example, Ford noted the accuracy of the Toyota fuel gauge and
the good tire storage of the BMW, as well as the design of Audits
accelerator pedal. Ford also tested different goes to top 231
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management for formal approval. The document, which is usually Notes
Activity
initialed by those involved in or affected by the decision, elicits the Explain how decision making
___________________
in China is done.
cooperation and participation of many people. This, in turn,
___________________
assures that the problem or the decision is examined from different
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perspectives. That his decision-making process is time-consuming ___________________
is obvious. But after a consensus is reached, the implementation of ___________________

the plans rather swift because of the understanding of the plan,
___________________
the clarification of the problem, the evaluation of the different
___________________
alternatives, and the involvement of those people who will
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implement the decision. But the sharing of decision power and ___________________
responsibilities can also in a problem in that no one feels ___________________
individually responsible for the decision.
___________________
Decision Making in the United States ___________________
In U. S. organizations, decisions are made primarily by individual,

and usually only a few people are involved. Consequently, after a
decision has been made, it has to be sold to others, often to people
with different values and different perceptions of what the problem
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really is and how it should be solved. In this way, the making of a
decision is rather fast, but its implementation is very time-
consuming and requires compromises with those managers holding
different viewpoints. The result is that the decision which is
eventually implemented may be sub-optimal because of the
compromises necessary to appease those with divergent opinions.
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It is true that decision responsibility can be traced to individuals

as long as they are in the same position, but at the same time this
may result in a practice of finding scapegoats for wrong decisions.
All in all, in U.S. companies, decision power and responsibility are
vested in designated individuals, while in Japan, many people
share both decision power and responsibility.
Decision Making in China

In China, major decisions are made by individuals at the top, but
many people are involved in operational decisions. Lower
managers have very little authority to make decisions. Decision
(c)
making through the central planning bureau is under the direct

control of the state. This, unfortunately, results in a lack of
flexibility in the implementation of the decisions. Although there is
a realization of the need to change, managers in the upper
232 echelons of the hierarchy resist reforms because reform would
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Notes mean giving up some of the privileges they have as officials.
___________________
Controlling in Japan
___________________
As noted in the discussion of decision making, the groupits
___________________
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dynamics and its pressureshas a profound impact on the
___________________ managerial process. In an office without dividing walls, peers are
___________________ well aware of the performance of their colleagues. Moreover,
managers are a part of the work group rather than being separated
___________________
from employees by an office door. The measurement of individual
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___________________ performance is not against specific verifiable objectives; instead,
___________________ emphasis is placed on group performance. Also, the Japanese
___________________
approach of letting subordinates save face would be incongruent
with fixing the blame for deviations from plans on individuals.
___________________
Control emphasizes process, not numbers. The Japanese are well
known for their concern for quality. Yet this has not always been
the case. In the 1950s and 1960s, Japanese products has an image
of shoddy quality. This image has changed; good quality is one of
the characteristics now associated with Japanese products. This is
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due, in part, to the success of quality control, which requires grass
roots involvement with very active participation in quality control
circles.
Table 24.1: Comparisons of Japanese, US, and Chinese Controlling

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Controlling in the United States

Control in the United States often means measuring performance
against pre-established precise standards. Management by
objectives, widely practiced in this country, requires the setting of
verifiable objectives against which individual performance is
(c)
measured. Thus the superior can trace deviations to specific

individuals, and this often results in fixing blame. In an attempt to
maximize individual results, group performance may suffer. We all
can think of example to maximize in which self-interest of
individuals was placed before group or organizational interest.
The use of quality control programs is not new. Hughes Aircraft 233
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Company, for example, had such programs for a long time under Notes
the names Zero Defects and Value Engineering. Many of these ___________________
programs were developed in this country and later used by the
___________________
Japanese for improvement of product quality and productivity.
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___________________
Controlling in China ___________________
In China, control is exercised primarily by group leaders. The
___________________
control focus is primarily on the group but also on the individual.
___________________
Factory managers, for example, are expected to meet their yearly
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quota. Chinese control practices are a mixture of U.S. and ___________________
Japanese managerial practices. In identifying deviations from ___________________
standards, there is a tendency to let the persons responsible for
___________________
sub-performance save face (this is similar to the Japanese
practice). There is some use of quality circles, but it is not a ___________________
common practice.
Conclusions about Managerial Practices in Different Countries

The comparisons of planning, organizing, staffing, leading, and
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controlling practices in Japan, the United States, and China make
it clear that the application of the principles and managerial
concepts differs in these countries. It is also clear that managers
with a global orientation will learn about management as it is
practiced not only in their own country but also in other places in
the world. Chinese managers look at both Japanese and U.S.
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managerial practices and compare them with their past

experiences, as shown in the discussions of the managerial
functions. Some practices from the United States and Japan may
be transferable, but others are not. The environment, especially
socio-cultural factors, does influence practice. But its impact may
have been overstated.
Check Your Progress

Fill in the blanks:
1. In the early 1980s Ford Motor Company was in trouble.
It was even said that FORD stood for ....................
(c)
2. In China, major decisions are made by individuals at

the .............. level, but many people are involved in
operational decisions.
234
Summary
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Notes
Leadership qualities or leading is practiced differently in various
___________________
countries - the comparison here are among Japan, the United
___________________ States, and the Peoples Republic of China. Next, the international
___________________ focus is on selected global aspects of leading-specifically, the
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___________________
influence of different cultures - finally a global car industry case
involving into U.S. Car makers in presented to illustrate
___________________
managerial leading in the international context. Managers
___________________ sometimes see decision making as their central job because they
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___________________ must constantly choose what is to be done who is to do it, and
when, where and acoustically even how it will be done. People
___________________
acting or deciding rationally are attempting to reach some goal
___________________
that cannot be attained without actions. Particularly in
___________________ management. Although many managerial decisions are made with
a desire to get by as safely as possible, most managers do attempt
to make the best decisions they can within the limits of rationality
and in light of the size and nature of the risks involved-keeping
these aspects in view a review of people management in different
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countries has been attempted.
Lesson End Activity

Find out the leadership control in two countries other than the
ones explained in this unit.
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Keywords
Communication: The transfer of information from one person to
another, with the information being understood by the receiver.
Effectiveness: The achievement of objective; the achievement of
desired effects.
Leadership: Influence, or the art or process of influencing people
so that they strive willingly and enthusiastically toward the
accomplishment of group goals.
Leading: The function of managers involving influencing people so
(c)
that they will contribute to organization and group goals; it has to

do predominantly with the interpersonal aspect of managing.
Situational Approach to Leadership: The approach that
studies leadership on the premise leadership that it is stroughly
influenced by the situation from which the leader emerges and in 235
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which he operators. Notes
Culture Organisation: The general patterns of behaviour, ___________________

shared beliefs and values that members of an organisation have in ___________________
common.
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___________________
___________________
___________________
1. Discuss the various factors that contribute to differences in
___________________
effective leadership processes across cultures.
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___________________
2. Briefly describe how business leaders communicate across
cultures of different countries. ___________________
___________________
3. What is the global project? What cultural dimensions have
been identified by the Globe researchers? What preliminary ___________________
findings have they found by this Globe research effort?
Further Readings
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Books
Gary A. Yukl, 1981. Leadership in Organisations, Engleword cliffs,
NJ Prentice Hall.
Ralph M. Stogarill, 1974. Handbook of leadership : A Survey of
Theory and Research, The free press, New York.
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Fred E. Fiedler, 1967. A Theory of Leadership Effectiveness

McGraw Hll Book Co., New York.
Kennath Labich, 1988. The Seven Keys to Business Leadership
Fortune, October 24 (pp. 58-66).
R. Gill and A. Wong, 1998. The Cross-Cultural Transfer of
Management Practices : The Case of Japanese Human Resource
Management in Singapore, International Journal of Human
Resource Management, Vol. 9, No. 1
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Notes
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___________________
___________________
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___________________
___________________
___________________
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___________________
___________________
___________________
___________________
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(c)
Unit 25
237
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Notes
Case Studies
___________________
___________________
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___________________
Objectives
___________________
___________________
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___________________
Case Study 1: Gopal Banerjee & Co.
___________________
Trading and Profit and Loss Account for the
Year Ending December 1994 ___________________
Dr. Cr. ___________________
` `
To opening stock 50,000 By sale 6,35,000
To purchase 5,50,000 By closing stock 60,000

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To inward parcel postage 5,000
To gross profit 90,000

__________ __________
6,95,000 6,95,000
__________ __________
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To salaries & wage 25,000 By gross profit 90,000

To advertisement 5,000
To boxes & wrappings 3,000
To office supplies & postage 1,000
To light & power 2,500
To insurance, taxes & repairs
of building 7,000
To telephone 2,000
To depreciation 5,000
To interest on borrowings 10,000
(c)
To misc. expenses 7,500

To net profit 22,000
__________ __________
` 90,000 ` 90,000
Contd.
238
The above statement was given to a business economist for his
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Notes
comments. On enquiry, Sri Gopal Banerjee supplied the following
___________________ additional information:
___________________ (a) His drawings during the year amounted to ` 18,000.
___________________
(b) Up to the year 1988, he worked as a manager of another
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jewellery shop where he was getting a salary of ` 600 per
___________________ month. Since then he left the service and started his own
___________________ retail shop.
___________________ (c) The building in which the retail shop is housed, is a two-
storey air-conditioned building owned by Sri Gopal Banerjee
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___________________ himself. The building is located in such a marketplace that it
___________________ can readily be let out any time for ` 800 per month.
___________________ (d) Sri Banerjee has invested his own capital of the order of
` 2,00,000. If borrowed, it would have been obtained at a 9 per
___________________
cent interest per annum.
The business economist made certain adjustments and thereby a
fresh calculation, which showed that Sri Gopal Banerjee was
actually running the business at a net loss of ` 5,800 per annum.
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On being told so, Sri Banerjee was surprised and argued:
(a) "Impossible; I am working for profits and not for salary. I
don't actually draw any salary from the business".
(b) "I have got my own building. I do not pay any rent".
(c) "I have invested my own money. I do not pay any interest. In
fact, I have worked hard to put this business in a position
where there is no need for borrowing money I think, it is
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creditable that a businessman here is free from any debt to

banks and moneylenders".
(d) "If I am saving some money by way of employing my own
labour, own building and own money, how can I incur loss?
Net loss; Unbelievable !"
Questions
1. What is the problem? Do you agree with Sri Gopal Banerjee?
2. In particular, Sri Banerjee fails to understand the way, the
net loss (of ` 5,800) figures is derived. Prepare a small table
which would help him to understand this derivation. And, if
necessary, explain.
(c)
3. Is Sri Banerjee, an efficient businessman? Should he continue

with or close down his business?
Hints: Review your understanding of the concepts of "economic profit" and "accounting profit".
Source: Author's book on Managerial Economics

Case Study 2: Lintas in a Hornet's Nest 239
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Karmakar, a cricket player playing in International Tests, was Notes
employed with Lintas Shoes Corporation. Karmakar faced a ___________________
personal problem when playing and practicing in the humid
___________________
climate in India and some of the countries abroad - the sports
shoes which he wore became sticky shortly after he took to the
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___________________
field, and by lunch time they started smelling badly. He enquired
___________________
of his fellow players whether this was common or his unique
problem. He came to know that this was a common problem ___________________
though, of course, varying in intensity and the timing of sweating. ___________________
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He also came to know that, like him, the other fellow players had
___________________
also experimented with all kinds of shoes available in the market,
but with hardly any success. ___________________
Karmakar brought this problem to the notice of his company and ___________________
was persuasive enough to make the company interested in his
___________________
problem. The company wanted to understand
1. Was there a real consumer need for a highly improved kind of

shoe for the purpose?
2. Had the company necessary technological facilities and

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scientific ability to develop the product?
3. Was the size of the market for this product large enough to
make the new product commercially viable?
To confirm for itself, the company undertook market research in

various forms like personal interviews, questionnaires, etc. The
market research confirmed the opinion expressed by Karmakar.
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The company ascertained that since it was already in shoe

business it had necessary scientific and technological
infrastructure to take up the project. The basic problems were,
however, the justification of crores of rupees which would go in for
research, development and mass production of shoes, will the
likely demand be adequate enough to justify this investment, and,
above all, the profitability of the venture. The company found,
through the surveys, that besides the consumer need for the
product and the technical capacity of the firm to undertake the
production of such a product, there was a large enough potential
market for the product it produced at a mass scale.
(c)
After the product development was accomplished, a pilot test was

conducted by supplying a small quantity of these unnamed shoes
and given free to some players. However, the results were not
encouraging because the shoes were too thin to protect the feet
from damage during play. So, the product was back to the product
development department. After a year's efforts, the company
Contd.
240 came out with a revolutionary design of shoes, which were thick
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Notes enough to protect the feet but thin and light enough to prevent
sweating of the feet in humid climates.
___________________
The accountants kept the record of costs at each stage of the
___________________
product development. The accountants, with the help of the
___________________ advertising group, developed a price based on estimates of how
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___________________ many of these new shoes could sell in terms of total potential
market (50 lakh shoes every year) and how many players would
___________________
take to the new shoes.
___________________
The company test marketed the product in the states of
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___________________ Maharashtra, Karnataka, Delhi and West Bengal. The product
was named Keep Fresh and priced at ` 350 in the test market.
___________________
The response was quite discouraging. The consumers liked the
___________________ new shoes but not its price.
___________________ The company again got stuck with a problem. Is the company
charging more than what it should charge? Are the consumers
poor enough not to pay the price? Such kinds of questions were
raised in the company meetings. There was, however, an opinion
expressed during the discussions that the price of ` 350 was fixed
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on the basis of production for test marketing, but when shoes
would be mass produced, the production costs would come down.
Questions
1. What kind of pricing technique was used while pricing?
2. Was there any indication of using penetration or skimming

pricing in the pricing decision of Lintas?
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3. What should the company do next regarding the price?

(c)
Case Study 3: International Application 241
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Business Leaders Communicate across Cultures: One of the Notes
biggest challenges facing leaders doing business internationally is ___________________
that the nationals of each country typically use their language
___________________
and speech in a different way. In one culture people will lower
their voice to indicate the seriousness of a situation, whereas in
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___________________
another culture they will speak very loudly to convey the same
___________________
message. In one culture people will talk rapidly and be regarded
as highly credible, whereas in another they will speak slowly and ___________________
achieve the same result. The challenge in dealing with business ___________________
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leaders across cultures is to know how they use their language to
___________________
communicate and what they are looking for from the other person.
Here are some specific examples. ___________________
British: The British tend to use a reserved tone in speaking and ___________________
like to understate things. They also have a fondness for conceding
___________________
points early to their opponents in order to take the steam out of
the others arguments. British business leaders are very good at
being vague in order to maintain politeness and to avoid
confrontation. When trying to influence them, use of humor and
anecdotes and the offers of reasonable prices and good quality
E-
works best.
Spaniards and Italians: Spaniards and Italians like to use a
broad vocabulary and employ their hands, arms, and facial
expressions when conveying their message. In particular business
leaders let others clearly understand how they feel about things.
When trying to persuade others to a particular point of view,
these business leaders appeal directly and strongly to good sense,
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a warm heart, and generosity. Additionally, these business

leaders often insist that others make a decision right away.`
Germans: German business leaders rely on logic, but they also
place strong importance on gathering a great deal of information
to back up their positions. They like to present their points
effective negotiators find it very effective to work with German
business leaders to find common ground and thus ward off a win-
lose situation. German business leaders are influenced by
technical information, good prices, high quality, and specific
delivery dates.
Scandinavians: Scandinavian business leaders like to list the
(c)
pros and cons of a position before providing the other person with
their decision on the matter. They are also very slow to give up on
their position because they feel that they have more than ample
support for it. They also like to forego the niceties and get down to
the business at hand. Quite often their presentations are factual,
succinct, and well thought through. In persuading Scandinavian
Contd.
242 business leaders, it is important to emphasize quality, design,
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Notes technical information, and delivery dates.
___________________ Japanese: Japanese business leaders are extremely polite and
almost never say no. On the other hand, the fact that they smile a
___________________
great deal does not mean that they agree with the other person.
___________________ Those who deal with Japanese business leaders on a regular basis
E
___________________ find that they are greatly influenced by presentations that help
them understand how something works or why it is a good idea or
___________________
how it will be profitable for them. Two of the main things that
___________________ outsiders need to focus on when dealing with Japanese business
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leaders are good price and politeness.
___________________
Finally, it is important to remember that business leaders from
___________________
each culture have their own attention span, and if someone goes
___________________ beyond this time period, they may find themselves losing out. For
___________________ example, the British have a moderate time span, about 40
minutes. Scandinavians have a somewhat longer span, about 50
minutes. The Japanese typically give others about an hour before
they begin losing interest. The Germans are the longest of all in
this regard, tending to have attention spans of about 75 minutes.
So when interacting with business leaders across cultures,
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attention must be given to both content and length and
communications must be adapted accordingly.
Question
From the five examples given above, how did the use their
longuage to communicate and what are they looking for from the
other person?
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(c)
Glossary
Glossary
243
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Notes
___________________
Accounting profit: It is the revenue obtained during the period ___________________
minus the cost and expenses incurred to produce the goods
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___________________
responsible for getting the revenue.
___________________
Actual costs mean the actual expenditure incurred for producing ___________________
a good or service.
___________________
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Advertisement: Advertisement or promotional elasticity of
___________________
demand is the ratio of percentage change in quantity demanded to
a percentage change in advertisement outlay. ___________________
___________________
Autonomous demand: It is not linked to demand of any other
product. It is independent of demand of any other good. ___________________
Average contribution margin (ACM): It is the difference

between unit price and AVC (P AVC).
Average fixed cost is the ratio of total fixed cost to the output
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produced by the firm.
Average product is the total output produced per unit of input
used.
Average variable cost is the variable cost per unit produced.
Break even charts: It can be used to measure the contribution of
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business activity towards covering fixed costs.

Cardinal utility: The concept of cardinal utility implies that
utility can be assigned a cardinal number like 1, 2, 3, etc.
Communication: The transfer of information from one person to
another, with the information being understood by the receiver.
Complementary goods: COMPLEMENTS are products that tend
to be used jointly, e.g., cars and gasoline, hamburgers and French
fires, tapes and tape players.
Consumer equilibrium: A consumer is said to have reached his
equilibrium position when he has maximized the level of his
(c)
satisfaction, given his resources and other conditions.

Contribution: It is the difference between the total revenue and
variable costs.
244
Cost plus pricing: Some mark up is added to the average cost in
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Notes
arriving at the price.
___________________
Costs: It refers to the cost of factors used in production.
___________________
Cross Elasticity of Demand: Measures the responsiveness of
___________________
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demand for good X to a change in price of good Y.
___________________
Culture Organisation: The general patterns of behaviour,
___________________
shared beliefs and values that members of an organisation have in
___________________ common.
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___________________ Delphi Technique: Way of getting repeated opinion of experts
___________________ without their face to face interaction.
___________________ Demand curve: It is a graphical depiction of price-quantity

relationships.
___________________
Demand Function: A demand function is a comprehensive
formulation in an equation form, which specifies the major factors
that influence the demand for a product.
E-
Deterministic variables: Deterministic variables can be
measured with certainty.
Diminishing Marginal Utility: The quantity consumed of a
CC

commodities.
Economic Profit: Economic profit equals revenue of the firm
minus the explicit and implicit costs.
proportionately faster than the use of inputs.
Effectiveness: The achievement of objective; the achievement of
desired effects.
Elasticity of Demand: It is the responsiveness of the quantity
demanded of a good or service to a change in any one variable
(c)
influencing demand.
Equilibrium Price: The price at which the market demand
equals market supply is called the equilibrium price.
Glossary
245
Expansion path of the firm represents the least cost combination
S
Notes
of inputs for different levels of output.
___________________
Firm: It is an organization that combines and organizes resources
for the purpose of producing goods and/or services for sale. ___________________
E
___________________
Fixed costs are the total costs per period of time incurred by the
firm for the fixed inputs. ___________________
Forecasting: Forecasting is the prediction of demand for a good or ___________________

service, for the forecast period, on the basis of present and past ___________________
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behavior patterns of some related events.
___________________
Giffen goods or inferior goods: These are an inferior commodity,
___________________
much cheaper than its superior substitutes, consumed by poor
___________________
___________________
Graphical Method: The time series data on the variable (e.g.
Group Discussion: Decisions may be taken with the help of
brainstorming sessions or by structured discussions.
E-
Heuristic variables: Heuristic variables are those that exist in
highly complex, unstructured, perhaps unknown decision making
situations.
Implicit costs refer to the value of inputs owned and used by the
firm in its production process.
CC
Income Elasticity: It is the ratio of a percentage change in the

remaining constant.
Individual Demand: The quantity of the commodity which an
individual household is willing to purchase per unit of time at a
particular price.
Isocost line is the locus of alternative combinations of labour and
capital that a firm can purchase with a given monetary cost outlay.
Isoquant depict physical relationship of all combinations of two
inputs, say labour and capital input rates that will produce the
(c)
same level of output.

Law of diminishing returns states that as additional units of
variable input are combined with a fixed input, the additional
output (i.e., marginal product) initially increases at an increasing
246 rate, then diminishing rate, eventually leading to a decline in the
S
Notes total product.
___________________
Leadership: Influence, or the art or process of influencing people
___________________ so that they strive willingly and enthusiastically toward the
___________________ accomplishment of group goals.
E
___________________ Leading: The function of managers involving influencing people so
that they will contribute to organization and group goals; it has to
___________________
do predominantly with the interpersonal aspect of managing.
___________________
Least Square Method: The trend line can be projected for
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___________________
___________________ exponential trend.
___________________ Long Run: It refers to a time period sufficient enough to vary all
___________________ inputs used in production of a good or service.
Macroeconomics: It is the study of economy as a whole. It deals
with questions relating to national income, unemployment,
inflation, fiscal policies and monetary policies.
E-
addition to the last unit of output.
Marginal product is the change in the total product resulting
from a unit change in a variable input.
Marginal rate of technical substitution is the rate at which
one input can be substituted for the other to maintain the same
CC
level of output.
Marginal Utility: The addition to the total utility resulting from
the consumption of one additional unit.
Market Demand: It is the summation of demand for a good by all
individual buyers in the market.
Market Structure: An industry which operates plays a decisive
role in price and output decisions of a firm.
Microeconomics: It is concerned with the study of individuals like
a consumer, a commodity, a market and a producer.
(c)
Movement along a demand curve: It is the change in quantity

demanded due to a change in price.
Multiple-Equation Models: Although single-equation models are
often used by firms to forecast demand or sales, economic
Glossary
relationships may be so complex that a multiple-equation model 247
S
may be required. Notes
Normal profit: It refers to that portion of profit which is ___________________

absolutely necessary for the business to remain in operation. ___________________
Opportunity Cost: This is the amount of subjective value foregone
E
___________________
in choosing one alternative over the next best alternative. It is the
___________________
cost of sacrificed alternatives.
___________________
Peak load Pricing: Peak-load pricing can be used to reduce costs
___________________
and increase profits if the same facilities are used to provide a
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product or service at different periods of time, the product or ___________________
service is not storable or the demand characteristics vary from ___________________

period to period.
___________________
Perfect competition: Where firms cannot engage in rivalrous ___________________
behaviour because they are price takers in the market.
Perishable Good: Perishable goods are those which can be
consumed only once while in the case of durable goods, their
services only are consumed.
E-
Prestige Pricing: A perception on the part of the firm or producer
that charging a higher price will increase the quantity of the
product sold because of the prestige achieved by the customer, is
known as prestige pricing.
CC
difference in costs.
Price Discrimination: Price discrimination occurs when
variation in prices for a product in different markets does not
reflect variation in costs. It is designed to increase the total profit.
Price Elasticity of Demand: It is the ratio of a percentage
change in quantity demanded and the percentage in price, other
factors remaining constant.
Producer Goods: Refer to the goods used for production of other
goods, like plant and machines, factory buildings, services of
(c)
employees, raw materials, etc.

Product Bundling: Bundling is the practice of selling two or more
Product market is a meeting place between buyers and sellers
where individuals demand goods and services to satisfy
248 consumption desires by bidding and firms anxious to earn profits
S
Notes supply them.
___________________
Product Price: The quantity supplied varies directly to price of
___________________ the good, other factors held constant.
___________________ Production function is a purely technical or physical relation
E
___________________ between inputs and maximum output that can be produced, within
a given period of time, with a given level of technology.
___________________
Rationality: Rational being in the sense that consumer satisfies
___________________
his wants in the order of their preference.
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___________________
Scarcity: It can be defined as a condition in which resources are
___________________
not available in adequate amount to satisfy all the needs and
___________________ wants of a specified group of people.
___________________ Shift in the demand: It is the changes in non-price determinants
(price remaining constant) result in changes in demand.
Short Run Costs: These are the costs incurred on the variable
inputs in the short run.
E-
Single-Equation Models: The simplest form of econometric
forecasting is with a single-equation model.
Situational Approach to Leadership: The approach that
studies leadership on the premise leadership that it is stroughly
influenced by the situation from which the leader emerges and in
which he operators.
CC
Socio-cultural factors: These are factors like customs and

religious practices determine the preferences and tastes of the
consumer.
Stochastic variables: Stochastic variables are characterized by
uncertainty.
Substitute Goods: Goods that can be used in place of another
good are called substitutes, e.g., a bus ride substitutes for a train
ride, ball pens for fountain pens.
Supernormal profit: It is the residual surplus after paying for
(c)
Supply: Quantity of a good a firm or an industry is willing to

supply at a given price during a given period of time.
Glossary
249
Technology: It refers to technological innovations or
S
Notes
improvements introduced to reduce the unit cost of production or
increase factor productivity. ___________________
Total contribution analysis: It can also be used to determine the ___________________
total contribution profit.
E
___________________
Total Utility: The sum of the utilities derived by a consumer from ___________________
the various units of goods and services he consumes. ___________________
Transfer Pricing: It refers to the determination of the price of the ___________________
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intermediate products sold by one semiautonomous division of the
___________________
same firm.
___________________
Utility: Utility is the want-satisfying property of a commodity.
___________________
Value Pricing: The selling of quality goods at much lower prices
___________________
than previously.
Veblen or conspicuous goods: These goods are purchased for
snob appeal, ostentation and prestige value.
E-
CC
(c)

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UNIT 20: Case Study

Dr S R Das Dr Sanjay Mittal Prof V K Nangia

SLM Development Team

Mr Kapil Mehra Mr A N Sinha

Manager Material Sr Manager Printing

Course Code: MBCE-701D

Course Name: Economics & Management Decisions

Version: July 2013

MPower Applied Learning Enterprise

Unit 1 Introduction to Managerial Economics ......................................................................... 3

Unit 6 Law of Demand ............................................................................................................. 47

Unit 11 Supply Analysis ............................................................................................................ 91

Unit 16 Market Equilibrium.................................................................................................... 149

Unit 17 Market Structures & their Pricing - I ....................................................................... 159

Unit 22 Break-Even Analysis .................................................................................................. 207

Unit 23 Decision Making Process............................................................................................ 215

Unit 25 Case Studies................................................................................................................ 237

Glossary ............................................................................................................................................ 243

z Economics and Managerial Decision Making UNIT 4: DEMAND ANALYSIS

z Quantifying Utility UNIT 5: CASE STUDIES

\ Concepts of economic analysis ___________________

provides adequate solution to the economic problems. To quote

Nature of Managerial Economics

Contribution of Economic Theory to Managerial Economics

Baumol believes that economic theory is helpful to managers for

Managerial Economics is micro-economic in nature because it deals

encompasses variables, concepts and models that constitute micro-

Contribution of Quantitative Techniques to Managerial

regression is applied for forecasting and probability theory is used

Thus, Managerial Economics deals with the economic principles

Managerial Economics plays an equally important role in the

agencies, hospitals and educational institutions. Regardless of

Check Your Progress

unemployment, inflation, fiscal policies and monetary

___________________ A firm applies principles of economics to answer these questions.

started TCS, while in 1993, the company ceded TOMCO to HLL.

Allocation of available capital in long-term investment projects can

domestic market or the foreign market. Production of a premium 7

Appropriate business decision making with the help of economic ___________________

Check Your Progress

1. ................... theory guides the manager in the selection of

2. Allocation of available capital in long-term investment

Role of Managerial Economist

suggest suitable policies for solution of problems like:

1. What product and services should be produced?

2. What inputs and production techniques should be used?

___________________ 5. When should the equipment be replaced?

Check Your Progress

1. A ........................... makes an assessment of change.

Economics and Managerial Decision Making

companies have applied established principles of Managerial

Example 1: Reliance Industries has maintained top position in

which make RPL Indias largest manufacturer, exporter.

RPL is planning to expand its capacity from 27 to 30 million tonnes

expansion will further consolidate the position of RPL in the sector 9

To ward off rivals and to make it a better competitor the company

Example 5: Apple, the company that began the PC revolution, had

ease of use of the Apple Macintosh. This change in the competitive

Check Your Progress

Managerial Economics to improve their .. .

constitute micro-economic theory. Mathematical Economics and

has to evaluate changes in the macroeconomic indicators like 11

constraints arising basically due to scarcity of resources. ___________________

Visit an organisation and try to collect the last information ___________________