MANAGERIAL ECONOMICS

1

Preface

This is an attempt to the integration of economic theory with business practices for the purpose

of facilitating Decision Making and Forward Planning by the management. As economics

provides as a set of concepts, these concepts furnish us the tools and techniques of analysis. It is

in this context economic analysis is an aid to understand business practices in a given

environment. As decision making is a basic function of manager, economics is a valuable guide

to the manager. In the following we shall be discussing the decision making process of the

management and how managerial economics and its various tools and techniques help a

manager in this process.

Index

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S.I. Nos. Chapter Title

Page no.

1 Managerial Decision Making

2 Business Forecasting

3 Demand Analysis

4 Cost Analysis

5 Production Analysis

6 Objectives of the Firm

7 Pricing Policy of the Firm

8 Market Structure

Chapter-I

Managerial Decision Making

Contents:

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1.1 Introduction1.2 Decision Making Process1.3 Management Decision Problems1.4 Corporate Decision Making: Ford Introduces the Taurus 1.5 Types of Decision 1.6 Conditions Affecting Decision Making1.7 The Steps of Decision Making1.8 Selecting the Best Alternative1.9 Implementing the Decision1.10 Evaluating the Decision1.11 Decision Making Model

1.11.1 The Classical Model 1.11.2 The Administrative Model

1.12 Decision Making Techniques1.12.1 Marginal Analysis1.12.2 Financial Analysis

1.13 Group Decision Techniques1.13.1 Brainstorming1.13.2 Nominal Group Technique1.13.3 Delphi Group Technique

1.14 Decision Making Tools1.14.1 Linear Programming1.14.2Inventory Control

1.1 Introduction

Managerial Economics is the integration of economic theory with business

practices for the purpose of facilitating Decision Making and Forward Planning by

the management. As economics provides as a set of concepts, these concepts

furnish us the tools and techniques of analysis. The use of Economic Analysis is to

make business decisions involving the best use (allocation) of scarce resources.

Economic Theory helps managers to collect the relevant information and process

it in order to arrive at the optimal decision given the goals of a firm. A decision is

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optimal if it brings the firm closest to its goals. It is in this context economic

analysis is an aid to understand business practices in a given environment. As

decision making is a basic function of manager, economics is a valuable guide to

the manager. In the following we shall be discussing the decision making process

of the management and how managerial economics and its various tools and

techniques help a manager in this process.

1.2 Decision Making Process

Decision making is commonly defined a choosing from among alternatives.

Decision is a choice made from alternative courses of action in order to deal with

a problem. A problem is the difference between a desired situation and the actual

situation. Therefore, decision making is the process of choosing among alternative

courses of action to solve a problem. The Decision making process is construed as

searching the environment for conditions calling for a decision; inventing,

developing and analyzing the available courses of action; and choosing one of the

particular courses of action.

A second and more detailed method is the following:

Identify the problem.

Diagnose the situation.

Collect and analyze data relevant to the issue.

Ascertain solution that may be used in solving the problem

Analyze these alternative solutions.

Select the approach that appears most likely to solve the problem

Implement it.

1.3 Management Decision Problems

• Product Price and Output

• Production Technique

• Stock Levels

• Advertising Media and intensity

• Labor hiring and firing

• Investment and Financing

A practical example can be found in the following:

1.4 Corporate Decision Making : Ford Introduces the 5

Taurus

In late 1985 Ford Introduced the Taurus -a newly designed, aerodynamically

styled, front-wheel drive automobile. The car was a huge success at the time and

helped Ford almost to double its profits by 1987. The design and efficient

production of this car involved not only some impressive engineering advances,

but a lot of economics as well. Ford, had to think carefully about how the public

would react to the Taurus design. Would consumers be swayed by the styling and

performance of the car? How strong would demand depend on the price Ford

changed? Understanding consumer preferences and trade-offs and predicting

demand and its responsiveness to price were essential parts of the Taurus

program.

Ford had to be concerned with cost of the Car. How high would production costs

be, how would this depend on the number of cars for produced each year? How

would union wage negotiations or the prices of steel and other raw materials

effect costs? How much and how fast would costs decline as managers and

workers gained experience with the production process? To maximize profits, how

many cars should Ford plan to produce each year?

Ford also had to design a pricing strategy for the car and consider how its

competitors would react to this strategy. For example, should Ford charge a low

price for the basic stripped-down version of the car but high prices for individual

options, such as air conditioning and power steering? Or would it be more

comfortable to make these options "Standard" items and charge a high price for

the whole package? Whatever prices ford choose, how were its competitors likely

to react? Would GM and Chrystler try to under cut Ford by lowering prices? Might

Ford be able to deter GM and Chrysler from lowering prices by threatening to

respond with its own price cuts? The Taurus program required a large investment

in new capital equipment and Ford had to consider the risks involved and the

possible outcomes. Some of this risk was due to uncertainty over the future price

of gasoline (Higher gasoline prices would shift demand to smaller cars). What

would happen if world oil prices doubled or tripled, or, if the government imposed

a new tax on gasoline? How should Ford take these uncertainties into account

when making its investment decisions? Ford also had to worry about

organizational problems, Ford is an integrated firm -separate divisions produce

engines and parts, then assemble finished cars. How should the managers of the

different divisions be rewarded? What price should the assembly division be

charged for engines it receives from another division? Should all the parts be

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obtained from the upstream divisions, or other firms? All these decision come

under managerial decision taking process.

1.5 Types of Decision

Managers make many decisions, in order to answer the following questions:

What goods shall firm produce?

How should firm raise the necessary capital and what shall be its legal

form.

What technique shall be adopted, and what shall be the scale of operations?

Where production is located?

How shall its product be distributed?

How shall resources be combined?

What shall be the size of output?

How shall it deal with its employees?

Managers make these decisions, and in order to obtain a clear understanding of

the decision making process, a classification system is useful. Three such systems

are available; each based on different types of decisions.

Organizational and personal decisions,

Basic and routine decisions

Programmed and non-programmed decisions.

Organizational decisions are those executives make in their official role as

managers. The adoption of strategies, the setting of objectives and the approval of

plans constitute only a few of these. Such decisions are often delegated to others,

requiring the support of many people throughout the organizational if they are to

be properly implemented.

Personal decisions are related to the managers as an individual, not as a member

of the organizations. Such decisions are not delegated to others because their

implementation does not require the support of organizational personnel.

Deciding to retire, taking a job offer from a competitive firm, or slipping out and

spending the afternoon on the golf course are all personal decisions.

A second approach is to classify decisions into basic and routine categories. Basic

decisions can be viewed a much more important than routine ones. They involve

long-range commitments, large expenditures of funds, and such a degree of

importance that a serious mistake might well jeopardize the well being of the

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company. Selection of a product line, the choice of a new plant site, or a decision

to integrate vertically by purchasing sources of raw materials to complement the

current production facilities are all basic decisions.

Routine decisions are often repetitive in nature, having only a minor impact on the

firm. For this reason, most organizations have formulated a host of procedures to

guide the manager in handing these matters. Since some individuals in the

organization spend most of their time making routine decisions, these guidelines

are very useful to them.

Taking a cue from computer technology, decision could be classified as computer

technology programmed and non-programmed. These two types can be viewed on

a continuum, programmed being at one end and non-programmed at the other.

Programmed decisions correspond roughly to the routine decisions, with

procedures playing a key role. Non programmed decisions are similar to the

category of basic decisions, being highly novel, important, and unstructured in

nature. The value of viewing decision making in this manner is that it permits a

clearer understanding of the methods that accompany each type.

1.6 Conditions Affecting Decision Making

In an ideal business situation, managers would have al of the information they

need to make decisions with certainty. Most business situations however are

characterized by incomplete or ambiguous information, which affects the level of

certainty with which a manager makes a decision. There are three conditions that

affect decision making:

Certainty

Risk

Uncertainty

Certainty is the condition that exists when decision makes are fully informed

about a problem its alternative solutions, and their respective outcomes. Under

this condition, individuals can anticipate, and even exercise some control over,

events and their outcomes.

In the context of decision making, risk is the condition .that exists when decision-

makers must rely on incomplete, yet reliable information. Under a state of risk,

the decision-maker does not know with certainty the future outcomes associated

with alternative courses of action; the results are subjects to chance. However,

the manager has enough information to determine the probabilities associated

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with each alternative. He or she can then choose. The alternative that has the

highest probability of success.

Uncertainty is the condition that exists when little or no factual information is

available about a problem, its alternative solution, and their respective outcomes.

In a state of uncertainty, the decision-maker does not have enough information to

determine the probabilities associated with each alternative. In actually, the

decision-maker may have so little information that he or she may be unable even

to define the problem, let alone identify alternative solutions and possible

outcomes.

1.7 The Steps of Decision Making

Identifying the problem

Generating the alternative course of action

Evaluating the alternative

Selecting the best alternative

Implementing the decision; and

Evaluating the decision

The first step in the decision-making process is identifying the problem. Problem

identification is probably the most critical art of the decision making process, for

it is what determines the direction that the decision making process takes, and,

ultimately, the decision that is made.

The second step in decision-making process is generating alternative solutions to

the problem. This step involves identifying items or activities that could reduce or

eliminate the difference between the actual situation and the desired situation.

For this step to be effective, the decision makers must allot enough time to

generate creative alternatives as well as ensure that all individuals involved in the

process exercise patience and tolerance of others and their ideas.

In the Pursuit of “quick fix” managers too often shortchange this step by failing to

consider more than one or two alternatives, which reduces the opportunity to

identify effective solutions. After generating a list of alternatives, the arduous task

of evaluating each of them begins. Numerous methods exist for evaluating the

alternatives, including determining the pros and cons of each; performing a cost-

benefit analysis for each alternative; and weighting factors important in the

decision, ranking each alternative relative to its ability to meet each factor, and

then multiplying cumulatively to provide a final value for each alternative.

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1.8 Selecting the Best Alternative

After the decision-makers have evaluated all the alternatives, it is time for the

fourth step in the decision-making process; choosing the best alternative.

Depending on the evaluation method used, the selection process can be fairly

straightforward. The best alternative could be the one with the most "pros" and

the fewest "cons"; the one with the greatest benefits and the lowest costs; or the

one with the highest cumulative value, if using weighting.

1.9 Implementing the Decision

This is the step in the decision making process that transforms the selected

alternative from an abstract situation into reality. Implementing the decision

involves planning and executing the actions that must take place so that the

selected alternative can actually solve the problem.

1.10 Evaluating the Decision

In evaluating the decision, the sixth and final step in the decision-making process,

managers gather information to determine the effectiveness of their decision. Has

original problem identified in the first step been resolved? If not, is the company

closer to the situation it desired than it was at the beginning of the decision-

making process?

1.11 Decision Making Model

There are basically two major models of decision-making -the classical model and

the administrative

model.

1.11.1 The Classical Model

The classical model of decision making is a prescriptive approach that outlines

how managers should make decisions. Also called the rational model, the classical

model is based on economic assumptions and asserts that managers are logical,

rational individuals who make decision that are in the best interest of the

organization. The classical model is characterized by the following assumptions:

The manager has completed information about the decision situation and

operations under a condition of certainty.

The problem is clearly defined, and the decision-maker has knowledge of all 10

possible alternatives and their outcomes.

Through the use of quantitative techniques, rationality, and logic, the

decision-maker evaluates the alternatives and selects the optimum

alternative -the one that will maximize the decision situation by offering the

best solution to the problem.

1.11.2 The Administrative Model

The Administrative model of decision making is a descriptive approach that

outlines how managers actually do make decisions. Also called the organizational,

neoclassical, or behavioral model, the administrative model is based on the work

of economist Herbert A. Simon recognized that people do not always make

decisions with logic and rationality, and he introduced two concepts that have

become hallmarks of the administrative model- bounded rationality and satisfying.

Bounded rationality means that people have limits, or boundaries, to their

rationality. These limits exist because people are bound by their own values and

skills, incomplete information, and their own inability-due to time, resource, and

rational decisions. Because managers often lack the time of ability to process

complete information about complex decisions, they usually wind up having to

make decisions with only partial knowledge about alternative solutions and their

outcomes. this leads managers often forgo the six steps of decision making in

favor of a quicker, yet satisfying, process- satisficing. The Administrative model of

decision making also have some basic assumptions:

The manager has incomplete information about the decision situation and

operates under a condition of risk or uncertainty.

The problem is not clearly defined, and the decision-maker has limited

knowledge of possible alternatives and their outcomes.

The decision-maker satisfies by choosing the first satisfactory alternative-

one that will resolve the problem situation by offering a good solution to the

problem.

1.12 Decision Making Techniques

It is useful to examine some of the specific technique that has proved valuable in

the decision making process, two of which are marginal analysis and financial

analysis.

1.12.1 Marginal Analysis11

The "marginal product" of a productive factor is the extra product or output added

by one extra unit of that factor, while other factors are being held constant.

Labor’s marginal product is the extra output you get when you add one unit of

Labor holding all other inputs constant. Similarly, land's marginal -product is the

change in total product resulting from one additional unit of land with all other

inputs held constant. The manager can use the concept to answer questions such

as how much more output will result if one more worker is hired? The answer

often called marginal physical product, provides a basis for determining whether

or not one new man will bring about profitable additional output.

1.12.2 Financial Analysis

The firms are supposed to safeguard their interest and avert the possibilities of

risk or try to minimize it. For this a firm needs to analyze the assets as well as

liabilities, efficiency of capital investment, choice of project and various vital

ratios. The cost benefit analysis ensures the firms to take prudent financial

decision.

1.13 Group Decision Techniques

There are several group decision techniques:

1.13.1 Brainstorming

Brainstorming is a technique in which group members spontaneously suggest keys

to solve a problem. Its primary purpose is to generate a multitude of creative

alternatives, regardless of the likelihood of their being implemented.

1.13.2 Nominal Group Technique

The Nominal Group Technique involves, the use of highly structured meeting

agenda and restricts discussion or interpersonal communication during the

decision making process. While the group members are all physically present,

they are required to operate independently.

1.13.3 Delphi Group Technique

The Delphi group Technique employs a written survey to gather expert opinions

from a number of people without holding a group meeting. Unlike in

brainstorming and nominal groups, Delphi group participants never meet fact to

face; in fact, they may be located in different cities and never see each other.

1.14 Decision Making Tools

The major decision- making tools are as under:

1.14.1 Linear Programming:12

One of the most widely used techniques is that of linear programming. It has been

described as a technique for specifying how to use limited resources or capacities

of a business to obtain a particular objective, such as least cost, highest margin, or

least time, when those resources have alternative uses. It is a technique that

systematizes for certain conditions the process of selecting the most des able

course of action from a number of available courses of action, thereby giving

management information for making a more effective decision about the resources

under its control.

All linear programming problems must have two basic characteristics. First, two

or more activities must be competing for limited resources. Second, all

relationships in the problem must be linear.

Linear programming can be used in the solution of many kinds of allocation

decision problems, but its application is certainly limited. For example, to be

employed effectively the decision problem must be formulated in quantitative

terms. Nevertheless, the approach has many advantages and its application in the

area of business decision making is increasing.

1.14.2Inventory Control

A problem faced by managers is that of maintaining adequate inventories. On the

one hand, no one wants to have too many units available because there are costs

associated with carrying these customers’s future business.

There are two types of costs that merit the manager's consideration. One way for

the manager to solve the inventory problem is to make certain assumptions

regarding future demand and then attempt a solution. Three of the most common

assumptions made in determining optimal inventory size are: demand is known

with certainty; the lead time necessary for recording goods is also known with

certainty; and the inventory will be depleted at a constant rate. Now, the

manager has to decide if he or she wishes to use what can be labeled a trial-and -

error approach, or if he wants to employ an OR (Operations Research) tool known

as the economic order quantity formula which can be given by:

OQ = {2DA}½ ⁄ vr

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Where:

D = expected annual demand

A = Administrative costs per order

V = Value per item

r = Estimate for taxes, insurance and other expenses

The EOQ formula is used by many firms in solving inventory control problems.

However, it is only one of many mathematical techniques that lave been developed

to help the manager make decisions.

Another important tool in taking one of the most economical decisions is

"Decision Trees"

Many managers weight alternatives base don their immediate or short-run results,

but a decision- tree format permits a more dynamic approach because it makes

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some elements explicit that are generally implicit in other analyses. A decision

tree is a graphic method that the manager. can employ in identifying the

alternative courses of action available to him in solving a problem; assigning

payoff corresponding to each act-event combination.

For example, consider the case of a firm that has expansion funds and must decide

what to do with them. After careful analysis, three alternatives identified:

Use the money to buy a new company

expand the facilities of the current firm

put the money in a saving account

And wait for better opportunities. In deciding which alternative is best, the

company has gathered all the available information and constructed the decision

tree.

In the figure there are four important components. One is the decision point,

represented by a square, which indicates where the decision maker must choose a

course of action. second is a chance point, represented by a circle, which indicates

where a chance event is expected, such as solid economic growth, stagnation, or

high inflation. A third is the branch, represented by a line flowing from the chance

points, which indicates an event and its likelihood such as 0.5 per solid growth,

0.3 for stagnation or 0.2 for high inflation. Finally, at the far right is a payoff

associated with the each branch. It is called a conditional payoff since its

occurrence depends on certain conditions. For example, in figure the conditional

ROI (Return on Investment) associated with buying a new firm and having solid

economic growth is 15 per cent, but this return is conditional on the two

preceding factors (buying the firm and having solid growth).

In building a decision tree, the company will start by identifying the three

alternatives, the probabilities and events associated with each alternative, and the

amount of return that can be expected from each. Having then constructed the

tree, the firm will roll back it from right to left, analyzing as it goes.

This analysis is conducted, first by taking the conditional ROls at the far right of

the tree and multiplying them by the probability of their occurrence. For example,

if the company buys a new firm and there is solid growth in the economy, as seen

in figure, it will obtain a 15 per cent ROL However, the probability of such an

occurrence is 0.5 Likewise, the probabilities associated with stagnant growth,

where the return will be 9 percent, and high inflation, where the return will be 3

percent, are .3 and .2 respectively. In order to determine the expected return

associated with buying a new firm, each of the conditional ROl’s is multiplied by

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its respective probability and the products are then totaled. For alternative one,

buying the firm, the calculation is as follows:

Conditional ROI Probability Expected Return

15.0 0.5 7.5

9.0 0.3 2.7

3.0 .02 0.6

10.8

For alternative two, expanding current facilities, the calculation is:

Conditional ROI Probability Expected Return

10.0 0.5 5.0

12.0 0.3 3.6

4.0 0.2 0.8

9.4

For alternative three, expanding current facilities, the calculation is:

Conditional ROI Probability Expected Return

6.5 0.5 3.25

6.0 0.3 1.80

6.0 0.2 1.20

6.25

These expected returns are often placed over the chance points on the decision

tree. They can be determined only after the tree has been drawn and the analysis

of the branches has been conducted. The first alternative is the best, because it

offers the greatest expected return. In evaluating alternatives, decision these help

the manager identify both what can happen and the likelihood of its occurrence .In

building the tree we moved from left to right but in analyzing we moved from right

to left. In the final analysis the decision tree does not provide any definitive

answers. However, it does allow the manager to allow benefits against costs by

assigning probabilities to specific events and then ascertaining the respective

payoff.

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End Chapter quizzes :

Q.1. The Technique that employs a written survey to gather expert opinions from a

number of people without holding a group meeting is known as -

(a) Brainstorming

(b) The Delphi group Technique

(c) The Nominal Group Technique

(d) None of the above

Q.2. Approval of Plans is the best example of -

(a) Organizational decisions,

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(b) Basic decisions

(c) Programme decisions.

(d) Both (a) & (c)

Q.3. Which sort of decision does not require the organizational support-

(a) Basic decision

(b) Routine decision

(C) Personal decision

(d) Organizational decision

Q.4 In the context of formulation of an investment decision on a project, the

availability of land, plant, machinery, raw materials and technical know how etc.

means-

(a) Technical Feasibility

(b) Financial feasibility

(c) Commercial feasibility

(d) None of the above

Q.5. The method of inventory valuation & thereupon decision making in which, the

cost of production is calculated on the assumption that the material which was

last to enter the inventory of the company was used first is –

(a) LIFO

(b) FIFO

(c) F I LO

(d) None of the above

Q.6. Which out of following is significant threat in front of a manager in his

decision making related to technological up gradation?

(a) Conflict of Interest

(b) Time & Resource constraints

(c) Both A & B

(d) None of the above

Q.7. Knowing the problem, its possible alternative solutions and their respective

outcomes in the decision making process of a manager refers to the condition of –

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(a) Risky information,

(b) Certainty

(c) Uncertainty of probable action,

(d) Risk & Uncertainty

Q.8. Prescriptive approach that outlines how managers should make decisions is –

(a) Administrative Model of decision making

(b) Rational Model of decision making

(c) Alternative Model of decision making

(d) Both (b) & (c)

Q.9. The use of highly structured meeting agenda and restricted discussion or

interpersonal communication during the decision making process is known as –

(a) Nominal Group Technique,

(b) Brainstorming,

(c) Delphi Group Technique,

(d) Both (b) & (c)

Q.10. In identifying the alternative courses of action available to a manager while

solving a problem, a decision tree is –

(a) More dynamic in nature,

(b) Graphical method,

(c) Assigns payoff corresponding to each act-event combination,

(d) All of the above.

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Chapter-II

Business Forecasting

Contents:

1.1 Introduction

1.2 Purpose and need of forecasting 1.2.1 Specific purposes of demand forecasting

1.3 Steps Involved in Forecasting

1.4 Period of forecasting 1.5 Levels of Forecasting 1.6 Methods of Forecasting

1.6.1Qualitative Forecast 1.6.1.1 Survey techniques 1.6.1.2 Opinion pools

1.6.2 Statistical Forecast 1.6.2.1 Trend projection method1.6.2.2 Barometric methods

1.6.2.3 Regression method1.6.2.4. Simultaneous equation method

(Econometric Models)

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1.6.2.5. Input Output Forecasting 1.7 Reasons for fluctuations in time series data

1.7.1 Cyclical fluctuations

1.7.2 Seasonal variation1.7.3 Irregular and random variation

1.8 Smoothing Techniques

1.8.1 Moving average smoothing technique 1.8.2 Exponential smoothing technique

1.9 Risks in Demand Forecasting

1.1 Introduction

Estimation of demand for a product in a forecast year/ period is termed as

Demand forecast. Demand forecast is a must for a firm operating its business as

today's market is competitive, dynamic and volatile.

1.2 Purpose and need of forecasting

Forecasting is done both for long term as well as short term. The purpose of the

two however differs. In a short run forecast seasonal patters are of prime

importance. Such a forecast helps in preparing suitable sales policy and proper

scheduling of output in order to avoid over-stocking or costly delay in meeting the

orders. It helps in arriving at suitable price for the product and necessary

modifications in advertising and sales techniques. Long run forecasts are helpful

in proper capital planning. It helps in saving the wastages in material, m -hours,

machine time and capacity. Long run forecasting is used for new unit planning,

expansion of the existing units, planning long run financial requirements and

manpower requirements. Different set of variables is used in than in short term

forecasts.

1.2.1 Specific purposes of demand forecasting

Better planning and allocation of resources

Appropriate production scheduling

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Inventory control

Determining appropriate pricing policies

Setting s les targets and establishing controls and incentives.

Planning a new unit or expanding existing one

Planning long term financial requirements

Planning Human Resource Development strategies.

1.3 Steps Involved in Forecasting

Identification of objective

Determining the nature of goods under consideration.

Selecting a proper method of forecasting.

Interpretation of results.

1.4 Period of forecasting

Short run forecasting: In short run forecasting, we look for factors which

bring fluctuation in demand pattern in the market for example weather

conditions like monsoon affecting the demand.

Medium run forecasting: In medium run forecasting is done basically for

timing of an activity like advertising expenditure.

Long run forecasting: It is done to ascertain the validity of trend. It is done

for decision like diversification.

1.5 Levels of Forecasting

Macroeconomic forecasting is concerned with business conditions of the

whole economy. It is measured with the help of indices like wholesale price

index, consumer price index.

Industry demand forecasting gives indication to firm regarding direction in

which the whole industry will be moving. It is used to decide the way the

firm should plan for future in relation to the industry.

Firm demand forecasting is done for planning companies overall operations

like sales forecasting etc.

Product line forecasting helps the firm to decide which of the product or

products should have priority in the allocation of firm's limited resources.

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General purpose or specific purpose forecast helps the firm in taking

general factors into consideration while forecasting for demand.

Forecast of established product or a new product

Types of commodity for which forecast is to be done. Goods can be broadly

classified into capital goods, consumer durable and Non-durable consumer

goods. For each of these categories of goods there is a distinctive pattern of

demand.

1.6 Methods of Forecasting

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1.6.1Qualitative Forecast

1.6.1.1 Survey techniques

Survey of business executives, plant and equipment, expenditure

plans. Basically compilation of expenditure plans of related

industries.

Survey of plans for inventory changes and sales expectations.

Survey of consumer expenditure plans.

1.6.1.2 Opinion pools

Consumer survey: In this method the consumers are contacted

personally to disclose their future purchase plans. This could be of

two types-Complete enumeration and sample survey.

Sales force opinion method: In this method people who are

closest to the market are asked for their opinion on future

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demand. Then opinion of different people is compiled to get

overall demand forecast. This method has advantage that it is

based on first hand knowledge of sales people and also it is cheap

and easy. However the opinion of the concerned people could be

biased or twisted for their own benefit. Therefore a final

ratification has to be done by the head office.

Experts’ opinion method: In this method opinion of experts' in

the related field is solicited and the final forecast based on their

opinion. A special case in this method is the Delphi Technique. In

this different sets of experts are given the relevant problem

without each knowing about the other and their opinions or

conclusions are compared. If the opinion is matching then the

opinion is accepted other wise the experts are asked to sit

together and arrive at a narrow range. Thus the experts giving a

very high or a very low value are concerned and the group argues

until it comes up with a narrow range of value. This process is

continued till a sufficient range is reached. Then the mean of the

upper and lower values is computed to reach a point estimate.

1.6.2 Statistical Forecast

1.6.2.1 Trend projection method

Under the trend method the time series data on the variable under forecast

are used to fit a trend line or curve either graphically or by means of a

statistical technique known as the Least Squares method. Trend projection

method can be used when there is some sort of correlation between the two

variables. It could be linear, logarithmic or power correlation. The linear

regression model will take the form of

Y = a + bX

Fitting a trend line by observation: This method involves the

plotting of the data on the graph and estimating where the trend line

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lies. The line can be extrapolated and the forecast read from the

graph.

Trend through least squares method: This method uses statistical

formulae to find the trend line which best fits the available data. The

trend line is the estimating equation, which can be used for

forecasting demand by extrapolating the line for future and reading

the corresponding values of variables on the graph.

Time series analysis: This is an extension of linear regression which

attempts to build seasonal and cyclical variations into the estimating

equation. This method assumes that past data can be used to predict

future sales. This is one of the most frequently used forecasting

methods. It refers to he values of variable arrange chronologically by

days, weeks, months, quarters or years. The first step in time series

analysis is usually to plot past values of the variable that we seek to

forecast on vertical axis and the time on the horizontal axis in order

to visually inspect the movement of the time series over time. It

assumption is that the time series will continue to move as in the

past. For this reason time series analysis is often referred as "native

forecasting”.

1.6.2.2 Barometric methods

Barometric methods are used to forecast or anticipate short term changes

in economic activity by using leading economic indicators. These indicators

are time series that tend to precede changes in the level of economic

activity. There are only three types of indicators:

Leading economic indicator: These indicators tend normally to

anticipate turning points in a business cycle. There are certain

problems associated with this method. The major problem is not

choosing the technique but choosing the relevant indicator for the

product in question. Secondly even if the relevant indicator is found

out the changes in factors may render the indicator redundant over

time. Thirdly the time lag between the indicator and forecast could

26

be so small that it could become useless.

Coincident indicators: These are indicators which move in step or

coincide with movements in general economic activity or business

cycle.

Lagging indicator: These are indicators which lag the movements in

economic activity or business cycle.

1.6.2.3 Regression method

It is one of the statistical tools to fore cast demand. In this estimating

equations are established and tests can be carried out to observe any

statistically significant. It involves following steps

Identification of variables which influence the demand for the good

whose function is under estimation.

Collection of historical data on all relevant variables.

Choosing an appropriate form of the function.

Estimation of the function

Regression method is popular because it is prescriptive as well as

descriptive. Also it is not as subjective or objective as other methods.

However if the variables chosen are wrong then the forecast will also

be wrong. A typical demand equation could be :

Log d = -12.4 + 1.78 log y -1.22 log 0 + 2.20 log v + 0.8 log g + 1.62

log e

Y = National income

O = groundnut oil price

V = Vanaspati price

G = ghee price

E = egg, fish and meat price

The above equation is a demand forecast equation for groundnut oil

1.6.2.4.Simultaneous equation method (Econometric

Models)

27

Econometric forecasting incorporates or utilizes the best features of other

forecasting techniques such as trend and seasonal variation, smoothing

techniques and leading indicators. Econometric forecasting models range

from single equation models of the demand that the firm faces for tits

product to large multiple equation models describing hundreds of sectors

and industries of the economy.

Single equation models: The simplest form of econometric forecasting is

with the single equation model. The first step here is to identify the

determinants of the variable to be forecasted.

Q = a0 + a1P + a2Y +a3N + a4P5 + a5Pc + a6a + e

Q = demand

P = Price

Y = disposable income

N = size of population

Ps = price of a substitute

Pc = price of complement

A = level of advertising by the firm

Multiple equation model: Sometimes economic relationships may be so

complex that a multiple equation model may be required. This is

particularly used in forecasting micro variables or the demand and sales of

major sectors or industries. Multiple equation model for GNP

Ct = a1+b1GNPt+u1t

It =a2+b2IIt-1+U2t

GNPt= Ct+ It+Gt

C = consumption expenditures

GNP = Gross national product in year t

I = investment

II = Profit

G = Government expenditures

U = stochastic disturbance (random error term)

T = current year

t-1 = previous year

28

Variables to the left of the equal sign are called endogenous variable.

These are the variables that the model seeks to explain or predict

from the solution of the model. Exogenous variables are those

determinants outside the model or right of the equal sign of the

equation.

1.6.2.5.Input Output Forecasting

Input output analysis was introduced by Prof. Leontief. With this technique

the firm can also forecast using Input output tables. It shows the use of the

output of each industry as input by other industries and for final

consumption. Input and output analysis allow us to trace through all these

inter industry input and outputs flow though out the economy and to

determine the total increase of all the inputs required to meet the increased

demand. In this technique we have two input output matrixes.

Direct Requirement Matrix

Total Requirement Matrix

1.6.2.5.1 Uses and shortcomings of input output

forecasting

Input output analysis and forecasting has many uses and applications. It is

used by the firm to forecast the raw material, labor and capital requirement

needed to meet the forecasted change in the demand for their product. The

shortcomings are that the direct and total coefficients are assumed to be

fixed and thus do not allow input substitution. Input output tables are

usually available with a time lag of many years and while the input output

coefficients do not change very rapidly they can become very biased.

1.7 Reasons for fluctuations in time series data

Changes occur in secular trend i.e. long run increase or decrease in data

series.

1.7.1 Cyclical fluctuations

There are the major expansions and contractions in most economic time

series data that seem to re-occur every several years.. A typical cycle could

29

last 15-20 years.

1.7.2 Seasonal variation

This refers to regularly recurring fluctuations in economic activity during

each year e.g. a typical factor could be weather and social customs.

1.7.3 Irregular and random variation

This is the variations in the data series resulting from unique events like

wars, natural disasters or strikes. The total variation in the time series is

the result of all the above four factors operating together. They are usually

examined separately by qualitative techniques.

1.8 Smoothing Techniques

This technique predicts feature value of time series on the basis of some

average of its past value only. This technique is useful when the time series

exhibits little trend or seasonal variation but a great deal of random

variation. There are two smoothing techniques.

1.8.1 Moving average smoothing technique

The simplest smoothing technique is the moving average. Here the

forecasted value of a time series in a given period is equal to the average

value of the time series in a number of previous periods. This method is

more useful the more erratic or random is the time-series data.

1.8.2 Exponential smoothing technique

This technique is used more frequently than simple averages in forecasting.

This method is a refined version of moving average method. The

disadvantage of moving average method is that it gives equal weightage to

the data related to different periods (i.e. months) in the past. According to

exponential smoothing method more recent the data the more relevant it is

for forecasting and therefore it would be more appropriate to give more

weightage to recent observations. The value given to weightage is normally

chosen to form a geometric progression.

With exponential smoothing, the forecast for period t +1 (i.e. Ft + 1) is a

30

weighted average of the actual and forecasted values of the time series in

period. The value of the time series at period t (i.e. At) is assigned the

weight of 1-w6. The greater the value of w, the greater is the weight given

to the value of the time series in period as opposed to previous periods.

Thus, the value of the forecast of the time series in period t +1l is Ft + 1 =

WA1 + (1-w) Ft.

In general, different values of W are tried, and the one that leads to the

forecast with smallest root-mean-square error (RMSE) is actually used in

forecasting.

1.9 Risks in Demand Forecasting

Demand forecasting faces two major risks

Overestimation of demand

Underestimation of demand

One risk arises from entirely unforeseen events such as war, political

upheavals and natural disasters. The second risk arises from inadequate

analysis of the market.

All these forecasting errors could possibly have been avoided

through:

Carefully defining the market for the product to include all potential

users of the market and considering the possibility of product

substitution.

Dividing total industry demand into its components and analyzing

each component separately.

Forecasting the main driver or user of the product in each segment

of the market and projecting how they are likely to change in the

future.

31

End Chapter quizzes :

1. Out of the given plannings, short run forecasting is required for

(a) Expansion of the existing units

(b) New unit planning

(c) Sales forecasting

(d) capital planning

32

2 This forecasting technique helps the firm to decide which of the

product or products should have priority in the allocation of firm's

limited resources.

(a) Product line forecasting

(b) Industry demand forecasting

(c) Firm’s demand forecasting

(d) Sales Forecasting

3. In Sales force opinion method, opinion of sales people is collected

to forecast the future demand, because

(a) They cannot deny from providing the information.

(b) They are paid by the company.

(c) They are the only experts of consumer behaviour.

(d) Sales People are closely associated with the market.

4. Reasons for fluctuations in time series data may occur due

to

(a) Seasonal variation

(b) Cyclical fluctuations

(c) Irregular and random variation

(d) All of the above

5. Which one is not a type of Barometric Indicator?

(a) Leading economic indicator

(b) Coincident indicators

(c) Lagging indicator

(d) Climate indicator

6. The disadvantage of this technique is that it gives equal

weightage to the data related to different periods (i.e. months) in the

past.

33

(a) Moving average smoothing technique

(b) Exponential smoothing technique

(c) Input Output Forecasting

(d) None of the above

7. Which of the following step may help in avoiding or

minimizing the errors in business forecasting?

(a) Carefully defining the market for the product to include all

potential users of the market and considering the possibility of

product substitution.

(b) Dividing total industry demand into its components and analyzing

each component separately.

(c) Forecasting the main driver or user of the product in each

segment of the market and projecting how they are likely to

change in the future.

(d) All of the above

8. This forecasting technique incorporates or utilizes the best

features of other forecasting techniques such as trend and seasonal

variation, smoothing techniques and leading indicators.

(a) Regression Technique

(b) Econometric forecasting

( c) Barometric methods

(d) None of the above

9. Variation in Data occurring due to regularly recurring

fluctuations in economic activity during each year is

(a) Cyclical fluctuations

(b) Seasonal Variations

(c) Random Variation

(d) Irregular Variation

34

10. In this technique two types of matrices i.e. Direct Requirement

Matrix and Total Requirement Matrix are used to forecast the

demand.

(a) Regression Technique

(b) Exponential smoothing technique

(c) Input Output Forecasting

(d) Econometric forecasting

Chapter-III

Demand Analysis

Contents:

1.1 Meaning of Demand

1.2 Types of Demand

1.2.1 Individual and Market Demand

1.2.2 Autonomous and derived demand

1.2.3 Demand for durable and nondurable goods

1.2.4 Demand for firm’s product and industry

product

1.2.5 Demand for consumers and producers goods

35

1.3 Determinants of Demand

1.4 Demand Function

1.5 Law of Demand

1.6 Demand Schedule

1.7 Demand Curve

1.8 Shift of Demand Curve v/s Movement along the demand curve

1.9 Effect of a Price Change

1.10 Elasticities of Demand

1.10.1 The Price Elasticity of Demand

1.10.1.1 The relationship between marginal revenue

and price elasticity

1.10.1.2 Determinants of Price Elasticity of Demand

1.10.1.3 Price elasticity and Decision Making

1.11 Classification of Goods

1.12 Exceptions to the Law of Demand – Upward Sloping

Demand Curve

1.13 Theory of Consumer Behaviour

1.13.1The Cardinal Utility Theory

1.13.1.1 Equilibrium of Consumer

1.13.2The Ordinal Utility Theory

1.13.2.1Equilibrium of Consumer

1.13.2.2 Properties of Indifference Curve

1.14 The consumer surplus

36

1.1 Meaning of Demand

Conceptually, demand can be defined as the desire for a good backed

by the ability and willingness to pay for it. The desire without

adequate purchasing power and willingness to pay do not become

effective demand and only an effective demand matters in economic

analysis and business decisions.

1.2 Types of Demand

The demand for various commodities is generally classified on the

basis of the consumers of the product, suppliers of the product,

nature of goods, duration of the consumption of the commodity,

interdependence of demand, period of demand and nature of use of

the commodity(intermediate or final).

Individual and Market Demand

Autonomous and derived demand

Demand for durable and nondurable goods

37

Demand for firm’s product and industry product

Demand for consumers and producers goods

1.2.1 Individual and Market Demand

The quantity of a commodity which an individual is willing to buy at a

particular price during a specific time period given his money

income, his taste and prices of other commodities is called

individual’s demand for a commodity. On the other hand market

demand of a commodity is the summation of individual demand by all

the consumers. Market demand is a multivariate relationship and

determined by many factors simultaneously. Some of the most

important determinants of the market demand for a particular

commodity are its own price, consumer’s income, prices of other

commodities, consumer’s taste, income distribution, total population,

consumer’s wealth, credit availability, Government policy, past level

of income and past level of demand.

1.2.2 Autonomous and derived demand

The demand for a commodity that arises on its own out of a natural

desire to consume or possesses a commodity independent of the

demand of other commodities, which may be substitute or

complementary or on the raw material side or on the product side,

the demand for the product is termed as independent. Commodities

like tea and vegetables do come on absolute terms. On the other

hand if the demand for a product is tied to the demand for some

parent product, the demand is termed as derived demand.

1.2.3 Demand for durable and nondurable goods

Durable goods are those whose total utility is not exhausted in a

38

single or short run use. Such goods can be used repeatedly over a

period of time. Durable goods may be consumer goods as well as

producer goods. The demand for durable goods changes over a

relatively longer period. Perishable (non-durable) goods are defined

as those which can be used only once. Their demand is of two types.

Replacement of old products and expansion of existing stock. The

demand for nondurable goods depends largely on their prices,

consumer income and is subject to frequent change.

1.2.4 Demand for firm’s product and industry product

Firm’s demand denotes the demand for the products by a particular

company or firm whereas industry demand is the aggregation of

demand for the product of all the firms of an industry as a whole. A

Clear understanding of the relation between company and industry

demand necessitates the understanding of different market

structures. These structures can be differentiated the basis of

product differentiation and number of sellers.

1.2.5 Demand for consumers and producers goods

Consumer goods are those, which are, meant for the final

consumption by the consumers or the end users. Producer's goods on

the other hand are used for the production of consumer goods or they

are intermediate goods, which are further processed upon to convert

them into a form to be used by the end user. Another distinction is

that the demand for producer’s goods is derived demand and it

indirectly depends on the demand for the consumer goods which the

producer goods is used to produce. It may also be possible that this

demand may be accelerated or accentuated in the same proportion as

the change in the demand for the final consumer goods. A small

39

change in the demand for consumer goods may either completely

wipes out the demand for the producer goods or may accelerate it.

1.3 Determinants of Demand

Commodity’s Own Price

Prices of related goods → Substitutes and Complements

Income level of consumer

Tastes & Preferences

Expectations

Population

Other exogenous factors

1.4 Demand Function

The determinants of quantity demanded when summarized in the

form of functional notations are called a demand function. A typical

demand function can be specified as follows:

Dn = f( pn, p1, p2,…….pn-1, Y,T, Ep, Ey, Ad. Exp.,

N, D, u)

Where pn = price of n product

P1………Pn-1 = Prices of other products

Y = income level of consumers

T = Taste and preferences of consumers

Ep = expected prices

Ey = expected income

Ad. Exp. = advertising expenditure

N = number of consumers

D = distribution of consumers

40

u = other factors

1.5 Law of Demand

There is negative relationship between price of a product and

quantity demanded of that product, ceteris paribus i.e., other factors

remaining constant.

1.6 Demand Schedule

A demand schedule is one way of showing the relationship between

quantity demanded and price, all other things being held constant.

Price($ per

dozen)

Quantity

demanded (dozen

per month)

0.50 7.0

1.00 5.0

1.50 3.5

2.00 2.5

2.50 1.5

3.00 1.0

1.7 Demand Curve

Demand curve is the graphical representation of the relationship

between price and quantity demanded of a good, all other things

being held constant. A demand curve is said to be linear when its

slope is constant all along the curve, whereas for a nonlinear or

curvilinear curve the slope never remains constant. The linear

demand curve may be written in the form of;

41

1.8 Shift of Demand Curve v/s Movement along the

demand curve

A movement along the demand curve is in response to a change in

price and leads to expansion or Contraction of Demand. This is called

Change in Quantity Demanded. On the other hand Shift in the

demand curve either upward or downward is in response to a change

in one of the other determinants of demand.

Q

P

Linear Demand Curve

Q

P

Non – Linear Demand Curve

42

1.9 Effect of a Price Change

Price Effect

Income Effect – A price change causes Real Income to change

and therefore consumption of both goods changes

Substitution Effect – Price change of one good causes the

relative price of the two goods to change and consumers

substitute the relatively cheaper good for the more expensive

one.

1.10 Elasticities of Demand

There are as many elasticities of demand as its determinants. The

most important of these elasticities are:

Price elasticity of demand

Income elasticity of demand

Cross elasticity of demand

1.10.1 The Price Elasticity of Demand

The price elasticity is a measure of the responsiveness of demand to

changes in the commodity’s own price. For very small changes in

43

price point elasticity of demand is used as a measure of

responsiveness of demand and arc elasticity of demand is the suitable

measure for comparatively large changes in price.

The point elasticity of demand is defined as the proportionate change

in the quantity demanded resulting from a very small proportionate

change in price. Symbolically it is written as;

Or

If the demand curve is linear

Its slope is substituting in the elasticity formula we

obtain

Which implies that the elasticity changes at the various points of the

linear demand curve?

44

The range of values of the elasticity is

If the demand is perfectly inelastic.

If the demand is perfectly elastic

If the demand is unitary elastic, total expenditure remain

constant with a change in price.

If the demand is inelastic total expenditure total expenditure

and price change move in the same direction.

If the demand is elastic, total expenditure and price change

move in the opposite direction.

45

1.10.1.1 The relationship between marginal revenue

and price elasticity

The marginal revenue is related to the price elasticity with the

formula

46

This is a crucial relationship for the theory of pricing

Proof

The total revenue is

The MR is

The price elasticity of demand is defined as

Rearranging we obtain

Substituting in the expression of the MR we have

We may summarize this relationship as follows:

If the demand is inelastic (e < 1) an increase in price leads

to an increase in total revenue and vice versa.

If the demand is elastic (e>1) an increase in price will lead

to a decrease in total revenue and vice versa.

If the demand has unitary elasticity (e =1), total revenue is

not affected by changes in price.

1.10.1.2 Determinants of Price Elasticity of Demand

47

Number and availability of Substitutes

The proportion of income spent on the particular commodity

Nature of the need that the product satisfies

Length of time period under consideration

The number of uses to which a commodity can be put

1.10.1.3 Price elasticity and Decision Making

Information about price elasticities can be extremely useful to

managers as they contemplate pricing decisions.

If demand is inelastic at the current price, a price decrease will

result in a decrease in total revenue.

Alternatively, reducing the price of a product with elastic

demand would cause revenue to increase.

Remember TR = P*Q

1.10.2 The income elasticity of demand

The income elasticity of demand is defined as the proportionate

change in the quantity demanded resulting from a proportionate

change in income. The income elasticity is positive for normal goods.

Symbolically it may be written as:

1.10.3 The cross elasticity of demand

The cross elasticity of demand is defined as the proportionate change

in the quantity demanded of x commodity resulting from a

48

proportionate change in the price of y commodity. The sign of cross

elasticity is negative if x and y are complementary goods and positive

if x and y are substitutes. The higher the value of the cross elasticity

the stronger will be the degree of substitutability or complementarity

of x and y. symbolically we may write it as:

1.11 Classification of Goods

Normal Goods – Demand Increases as Income increases

Inferior Goods – Demand decreases as consumer Income

increases

Basic Necessities – Commodities like salt, food grains etc for

which demand is relatively inelastic and does not vary with

income after a point

1.12 Exceptions to the Law of Demand – Upward

Sloping Demand Curve

Giffen Goods – a subclass of Inferior goods for which the

income effect outweighs the substitution effect

Veblen Products / Snob effect – Goods that have a snob value

attached to them for which demand actually increases as price

goes up

Speculative Effect – In periods of rising prices, anticipation of

future increases may cause consumers to demand more

49

Bandwagon Effect – Occurs when people demand a

commodity only because others are demanding it and in order

to be fashionable

Emergencies like war, famine etc.

1.13 Theory of Consumer Behaviour

The consumer is assumed to be rational. Given his income and the

market prices of the various commodities, he plans the spending of

his income so as to attain the highest possible satisfaction or utility.

This is the axiom of utility maximization. In order to attain this

objective the consumer must be able to compare the utility of the

various ‘baskets of goods’ which he can buy with his income. There

are two basic approaches to compare the utilities, the cardinalist

approach and the ordinalist approach.

1.13.1The Cardinal Utility Theory

The cardinal school stated that utility can be measured. Under

certainty i.e., complete knowledge of market conditions and income

levels over the planning period utility can be measured in monetary

units, called utils. There are certain assumptions of cardinal utility

theory.

Rationality of consumer

Constant marginal utility of money

Diminishing marginal utility

Total utility is additive

1.13.1.1 Equilibrium of Consumer

50

Assuming the simple model of a single commodity x, the consumer

can either buy x or retain his money income y. Under these

conditions the consumer is in equilibrium when the marginal utility of

x is equated to its market price.

If there are more commodities, the condition for the equilibrium is

the equality of the ratios of the marginal utilities of the individual

commodities to their prices.

1.13.2The Ordinal Utility Theory

The ordinalist school postulated the utility is not measurable, but is

an ordinal magnitude. It suffices for the consumer to be able to rank

the various baskets of goods according to the satisfaction derived.

The main ordinal theory is known as the indifference-curve theory is

based on certain assumptions.

Rationality of consumer

Utility is ordinal

Diminishing Marginal rate of substitution

Consistency and transitivity of choice

Total utility depends on the quantities of the commodities

consumed

1.13.2.1Equilibrium of Consumer

The consumer is in equilibrium when he maximizes his utility, given

his income and the market prices. Two conditions must be fulfilled for

the consumer to be in equilibrium.

51

The first condition is that the marginal rate of substitution be equal to

the ratio of commodity prices. This is necessary but not sufficient

condition.

The second condition is that the indifference curve be convex to the

origin. This condition is fulfilled by the axiom of diminishing marginal

rate of substitution of x for y and vice versa.

At the

point of

tangency

(point e)

the

slopes of

the budget line ( ) and of the indifference curve (

) are equal:

1.13.2.2 Properties of Indifference Curve

An indifference curve has a negative slope

The further away from the origin an indifference curve lies, the

higher the utility it denotes

52

Indifference curve do not intersect

The indifference curves are convex to the origin

1.14 The consumer surplus

Consumer surplus is equal to the difference between the amount of

money that a consumer actually pays to buy a certain quantity of a

commodity and the amount that he would be willing to pay for this

quantity rather than do without it. Graphically the consumers’

surplus may be found by his demand curve for commodity and the

current market price, which he cannot affect by his purchase of that

commodity.

Consumer surplus = PCA

53

End Chapter quizzes :

Q.1. The demand curve of a normal commodity is

(a) Upward Sloping

(b) Downward sloping

(c) Horizontal

(d) Vertical

Q.2 What happens to demand when price of the commodity falls

(a) Demand expands

(b) Demand contracts

(c) No change

(d) Can expand or contract

Q.3 In case of substitute goods if the price of commodity x increases the

demand of commodity y

(a) Remain constant

(b) Increases

(c) Decreases

(d) Fluctuates

Q.4 At a downward sloping demand curve the price elasticity of demand is

(a) Equal to unity

(b) Varies at different points

(c) Equal to zero

(d) Equal to infinity

Q.5 According to the cardinal approach the marginal utility of money

54

(a) Increases

(b) Decreases

(c) Remain constant

(d) Fluctuates

Q.6 The shape of indifference curve is

(a) Upward Sloping and concave to the origin

(b) Downward sloping and concave to the origin

(c) Upward Sloping and convex to the origin

(d) Downward sloping and convex to the origin

Q.7 The shape of indifference curve implies

(a) Diminishing MRSxy

(b) Increasing MRSxy

(c) Constant MRSxy

(d) Infinite MRSxy

Q.8 The marginal utility from successive consumption of normal good

(a) Increases

(b) Decreases

(c) Remain constant

(d) Undefined

Q.9 According to the ordinal approach consumer’s equilibrium is where

(a)

(b)

(c)

(d)

55

Q.10 Given the demand function Q = 90-3p and P = 6, Q=?

(a) Q = 67

(b) Q = 72

(c) Q = 108

(d) Q = 81

Chapter-IV

Cost Analysis:

Contents:

1.1 Introduction

56

1.2 Accounting Cost Concepts

1.2.1 Opportunity vs. Actual Cost

1.2.2 Explicit cost vs. implicit cost

1.3 Analytical Cost Concepts

1.3.1 Sunk vs. Incremental cost

1.3.2 Fixed and Variable Costs

1.3.3 Total, Average and Marginal Costs

1.3.3.1 Total Cost

1.3.3.2 Average cost

1.3.3.3 Marginal Cost

1.4 Properties of Short Run Cost Curves

1.5 Short-Run Output Decision

1.6 Long-Run Cost Function

1.6.1 Long Run Average Cost Curve

1.7 Economies and Diseconomies of Scale

1.7.1 Economies of Scale

1.7.1.1 Internal economies of scale

1.7.1.2 External economies of scale

1.7.2 Diseconomies of Scale

1.7.2.1 Internal diseconomies of scale

1.7.2.2 External diseconomies of scale

1.1 Introduction

Cost functions are derived functions from the production function which

describes the available efficient methods of production at any one time. The

cost of production is an important factor in almost all the business analysis

and decisions, especially those related to locating the weak points in

production management, minimizing the cost, finding the optimum level of

output, determination of price and dealers margin, estimation of the cost of

57

business operation. The cost concepts can be grouped under two categories

on the basis of their nature and purpose.

1.2 Accounting Cost Concepts

1.2.1 Opportunity vs. Actual Cost

The opportunity cost may be defined as the expected returns from the

second best use of the resources which are foregone due to the scarcity of

resources. It is also called alternative cost. The concept of economic rent or

economic profit is associated with it. On the other hand actual Cost

considers only explicit cost, the out of pocket cost for items such as wages,

salaries, materials, and property rentals.

1.2.2 Explicit cost vs. Implicit cost

Explicit costs are cash expenses for the payment of wages, salaries,

material, license fee, insurance premium, depreciation charges and are

recorded in normal accounting practices. In contrast implicit costs are non

cash expenses. Opportunity cost is an important example of implicit cost.

The explicit and implicit costs together make the economic cost.

1.3 Analytical Cost Concepts

1.3.1 Sunk vs. Incremental cost

The sunk costs are those which cannot be altered, increased or decreased,

by varying the rate of output. A sunk cost is an expenditure that has been

made and cannot be recovered since it accord to the prior commitment.

Incremental cost is the change in cost tied to a managerial decision

associated with expansion of output or addition of new variety of product.

1.3.2 Fixed and Variable Costs

Fixed costs are those which are fixed in volume for a certain given output. It

does not vary with variation in the output for a certain scale. The fixed costs

include the cost of managerial and administrative staff, depreciation of fixed

assets, maintenance of land etc. Fixed costs are associated with the short

58

run. Variable costs are those which vary with the variation in the total

output. It include cost of raw material, cost of direct labor, running cost of

fixed capital such as fuel, repairs, routine maintenance etc.

1.3.3 Total, Average and Marginal Costs

1.3.3.1 Total Cost

Total cost is the total expenditure incurred on the production. It connotes

both explicit and implicit money expenditure and include fixed and variable

costs.

Where total cost

output

technology

prices of factors

fixed factors

Total Cost Curves

59

1.3.3.2 Average cost

Average cost is obtained by dividing the total cost by the total output.

Average cost further can be categorized as average fixed cost (AFC) and

average variable cost (AVC).

Average cost curves

1.3.3.3 Marginal Cost

Marginal cost is the change in the total cost for producing an extra unit of

output.

60

Marginal Cost Curve

1.4 Properties of Short Run Cost Curves

Short run cost curves get their shape from the marginal productivity

of the variable factor

If capital is held constant (short run) then the marginal product of

labor gives the short run cost curves their shape.

The levels of cost curves are determined by market price of factor

along with technology.

AFC falls continuously

MC equals AVC and ATC at their minimum

Minimum AVC occurs at a lower output than minimum ATC due to

FC

61

1.5 Short-Run Output Decision

Firm sets output at Q1, where MC=MR subject to checking the average

condition:

If P > ATC, the firm produces Q1 at a profit

If ATC > P > AVC, the firm produces Q1 at a loss

P < AVC, the firm produces zero output

62

1.6 Long-Run Cost Function

The long-run total cost curve describes the minimum cost of producing each

output level when the firm is free to vary all input levels. One of the first

decisions to be made by the owner/manager of a firm is to decide the scale

of operation (size of the firm).

1.6.1 Long Run Average Cost Curve

In the Long Run, plant size is variable, and the firm is able to adjust

its scale of operations according to demand

Therefore, corresponding to each different scale of operation is a

relevant Short Run Cost Curve.

The Long Run Average Cost Curve is then an envelope of the

different SRACs.

63

1.7 Economies and Diseconomies of Scale

Economies and diseconomies are associated with long run cost functions.

Economies of scale are advantages and diseconomies of scale are

disadvantages that arise due to the expansion of production scale and lead

to a fall and rise in the cost of production respectively.

1.7.1 Economies of Scale

The economies of scale are classified as

Internal economies of scale

External economies of scale

1.7.1.1Internal economies of scale

Internal economies of scale are advantages that a firm gains from

increasing the scale of its own operations. Whereas external economies of

scale are advantages that a firm gains from the expansion and size of the

industry as whole industrial clusters. It is important to note that internal

economies of scale determine the shape of the LRAC curve while the

position of this curve depends on external economies such as change in

technology and changes of factor prices in the industry as a whole.

64

Technological advantage

Advantages of division of labor and specialization

Economies in marketing

Managerial economies

Economies in transport and storage

1.7.1.2 External economies of scale

Large scale purchase of raw material

Large scale acquisition of external finance

Massive advertisement campaign

Growth of ancillary industries

Change of factor prices in the industry

1.7.2 Diseconomies of Scale

Like economies, diseconomies may be internal or external.

1.7.2.1 Internal diseconomies of scale

Managerial inefficiency

Labor inefficiency

1.7.2.2 External diseconomies of scale

Natural constraints especially in agriculture and extractive industries

Pressure on inputs market due to increasing demand

Pressure on inputs prices due to bulk purchase

End Chapter Quizzes

1. Change in the total cost for producing an extra unit of output is know as –

A: Incremental CostB: Marginal CostC: Variable costD: Both A & B

65

2. Over a range of output, Marginal Cost equates with – A: First AVC and then ATCB: First ATC and then AVCC: Never equates with ATCD: Never Equates with AVC

3. The shape of SATC necessarily reflects the operation of –A: Law of Variable Proportion,B: Economies of Scale,C: Diseconomies of scaleD: None of the above

4. When MC is rising and is more than AVC – A: The ATC may be rising B: The ATC may be fallingC: Either of the two cases mentioned above is possible,D: Difficult to say as information is inadequate.

5. The nature and shape of AFC is – A: A rectangular HyperbolaB: A horizontal Line C: It is “U” shaped D: A vertical Line

6. Which one of the statement is correct – A: All costs are variable costs in the long run except LMC B: TFC is inverse “S“Shaped reflecting Laws of Returns. C: Over a very long range of Operation, AFC is Zero. D: None of the above is correct.

7. Explicit cost is also known as – A: Imputed CostB: Implied CostC: Accounting CostD: Opportunity Cost

8. TCn - TCn-1 = ∆ TC/ ∆Output = Marginal Cost { Where ∆ denotes small change}

A: The above statement is correct.B: The above statement is incorrect.C: The statement is Vague & irrelevant D: The above statement is partially true.

9. Gain from the increasing scale of production can be viewed as – A: External economies of scaleB: Internal economies of scaleC: Externalities D: Internalities

66

10.An Envelop Curve is drawn from – A: Short run Average Cost CurvesB: Long run Average Cost CurvesC: Planning CurvesD: None of the above

Chapter-V

Production Analysis

Contents:

1.1Production Function

1.2 Short Run Analysis

1.2.1 Marginal Product of Labor

1.2.2 Average Product of labor

1.3 Laws of Production

1.3.1 Law of variable proportions

1.3.2 Laws of Returns to Scale

1.3.2.1 Constant returns to scale

67

1.3.2.2 Increasing returns to scale

1.3.2.3 Diminishing Returns to Scale

1.4 Isoquant

1.5 Equilibrium of the Firm

1.6 Isocost

1.7 Isocost Curve and Optimal Combination of L and K

1.8 Production with Two (or more) Outputs-Economies of Scope

1.1Production Function

The creation of any good or service that has value to either producers or

consumers is termed as production. Production function is a technical

relation between factor inputs and outputs. It describes the laws of

proportion that is the transformation of factor inputs into outputs at any

particular time period. The production function includes all the technically

efficient methods of production.

68

In the process of production, the manager is concerned with efficiency in

the use of inputs (Labor, Capital, Land and Entrepreneurship)

Technical Efficiency – Occurs when it is not possible to increase output

without increasing inputs

Economic Efficiency – Occurs when a given output is being produced at

the lowest possible cost. Improvement of Technology is reflected in an

upward shift in the Production Function. The same amount of input leads to

a higher output

L

X f L` a

f L` a

f1 L` a

L

Q

69

1.2 Short Run Analysis

Short Run is the period of time in which one (or more) of the factors of

production employed in a production process is fixed or incapable of being

varied. We usually assume Capital (K) to be fixed and analyze how output

varies with changes in Labor (L)

1.2.1 Marginal Product of Labor

The change in output resulting from a very small change in Labor keeping

all other factors constant.

MPL = ∂X ∕ ∂L

If MP > 0, total production is rising

If MP < 0, total production is falling

Total production is maximum when MP = 0

1.2.2 Average Product of labor

APL = X / L

If MP > AP, then AP is rising

70

If MP < AP, then AP is falling

MP = AP when AP is maximum

1.3 Laws of Production

The laws of production analyze the technically possible ways of increasing

the level of production. Output may increase in various ways. In the short

run output may be increased by using more of the variable factors while

keeping other constant. This is referred to as Law of variable proportions.

While in long run output expansion may be achieved by varying all factors

and it is known as laws of returns to scale.

1.3.1 Law of variable proportions

In general if one of the factors of productions (usually capital K) is fixed

after a certain range of production additional output (i.e., marginal product)

starts to diminish. It is also known as the Law of diminishing returns. The

range of output over which the marginal products of the factors are positive

but diminishing is considered as equilibrium range of output. The range of

increasing returns to a factor and the range of negative productivity are not

suitable for equilibrium.

Three stages of production

APL

MPLL

71

1.3.2 Laws of Returns to Scale

In the long run expansion of output may be achieved by varying all factors

by the same proportion or by different proportions. The laws of returns to

scale refer to the effects of scale relationship. Three types of returns to

scale are observed.

Constant returns to scale

Increasing returns to scale

Decreasing returns to scale

1.3.2.1 Constant returns to scale

If the quantity of all inputs used in the production is increased by a given

proportion and we have output increased in the same proportion; it is

termed as constant returns to scale.

Stage I – Capital isUnderutilized and Successive units of L add greater Amounts to TP

MPL

APL

L

Stage II – Addition to TP due to increase in L continues to be positive but is fallingwith each unit

Stage III – Fixed Input capacity is reached and additional Lcauses output to decline

72

1.3.2.2 Increasing returns to scale

If output increases by a greater proportion in comparison to a change in the

scale of inputs it is termed as increasing Returns to Scale. The causes of

increasing returns to scale are:

Specialization of labor

Inventory Economies

Managerial indivisibilities

Technical indivisibilities

73

1.3.2.3 Diminishing Returns to Scale

If output increases by a smaller proportion in comparison to the change in

the scale of inputs, it is described as diminishing returns to scale. The

reasons of diminishing returns to scale are:

Managerial inefficiency

Exhaustible natural resources

Increased bureaucratic

Labor inefficiency

Pressure on inputs market due to increasing demand

Pressure on inputs prices due to bulk purchase

74

1.4 Isoquant

An isoquant is the locus of all the technically efficient methods or all the

combinations of factors of production for producing a given level of output

given the state of technology.

A higher isoquant refers to a larger output, while a lower isoquant

refers to a smaller output.

The slope of Isoquant shows diminishing marginal rate of input

substitution.

C – shaped isoquants are common and imply imperfect

substitutability

Isoquants may take various shapes depending on the degree of

substitutability of inputs. However continuous isoquants (an approximation

to the realistic form of kinked isoquant) has mostly been adopted because

they are mathematically simpler to be handled. In case the two inputs are

imperfectly substitutable, the optimal combination of inputs depends on the

degree of substitutability and on the relative prices of the inputs.

The degree of imperfection in substitutability is measured with marginal

rate of technical substitution (MRTS):

75

1.5 Equilibrium of the Firm

A profit maximizing firm will be using optimal amount of an input at the

point at which the monetary value of the input’s marginal product is equal

to the additional cost of using that input. Monetary value of the input is;

Profit Maximization requires

Price of final output

76

Wage rate (Cost of input)

1.6 Isocost

The isocost line is the locus of all combinations of factors the firm can

purchase with a given monetary cost outlay. If a firm uses only L & K, the

total cost or expenditure of the firm can be represented by:

One can solve Optimization problem for the combination of inputs that

either minimizes total cost subject to a given constraint on output

OR

maximizes output subject to a given total cost constraint.

1.7 Isocost Curve and Optimal Combination of L and

K

Optimal input Combination Depends on the relative prices of inputs and the

degree to which they can be substituted for each other represented by the

point of tangency between Isocost and Isoquant.

77

1.8 Production with Two(or more) Outputs-Economies

of Scope

Economies of scope exist when the unit cost of producing two

or more products/services jointly is lower than producing them

separately, producing related products, and the products that

are complementary.

The average total cost of production decreases as a result of

increasing the number of different goods produced

End Chapter quizzes :

78

Q.1. Production function states

(a) Qualitative relationship between input and output

(b) Quantitative relationship between input and output

(c) Technical relationship between input and output

(d) No relationship between input and output

Q.2 Total output is maximum where

(a) Marginal production is maximum

(b) Marginal production is zero

(c) Average production is maximum

(d) Average production is zero

Q.3 The law of variable proportions states that given at least one input

constant the marginal product of variable factor

(a) Increases

(b) Decreases

(c) Remain constant

(d) Fluctuates

Q.4 Returns to scale means

(a) Change in output due to change in one variable factor of

production

(b) Change in output due to change in one constant factor of

production

(c) Change in output due to change in all variable factors of

production

(d) Change in output due to change in all constant factor of

production

Q.5 The slope of isoquant is called

(a) Marginal rate of technical substitution

(b) Marginal rate of factor substitution

79

(c) Marginal rate of production substitution

(d) Marginal rate of input substitution

Q.6 The shape of isoquant curve is

(a) Upward Sloping and concave to the origin

(b) Downward sloping and concave to the origin

(c) Upward Sloping and convex to the origin

(d) Downward sloping and convex to the origin

Q.7 Economies of scale are related with

(a) Size of plant

(b) Size of fixed factor

(c) Size of variable factor

(d) Choice of technique

Q.8 which of the statements is false

(a) At the point of producer’s equilibrium, the isoquant is tangent to

the

Isocost line

(b) Constant returns to scale means proportionate change in output

due to

Proportionate change in inputs

(c) When average product falls, marginal product also falls and lies

below

Average product

(d) The elasticity of technical substitution is measured by the slope

of

Isoquant

Q.9 Producer’s equilibrium is where

(a)

80

(b)

(c)

(d)

Q.10 Which of the statements about the Isocost line is false

(a) The budget constraint of the producer

(b) The budget constraint of the seller

(c) Shows all the combinations of inputs which may be purchased

(d) It touches both the axis compulsorily

Chapter-VI

Pricing Policy of the Firm

Contents:

1.1 Introduction

81

1.2 Objectives of Pricing Policies

1.3 Factors affecting Pricing Policies

1.4 Price Forecasting

1.5 Prospective supply and demand

1.5.1 Prospective Supply

1.5.2 Prospective Demand

1.6 Pricing Methods

1.6.1 Introduction

1.6.1.1 Skimming Pricing

1.6.1.2 Penetration Pricing

1.6.2 Growth

1.6.3 Maturity

1.6.4 Saturation

1.6.5 Decline

1.7 The various Pricing methods are:

1.7.1 Cost-plus or full-cost pricing:

1.7.2 Rate of Return pricing

1.7.3 Marginal cost pricing

1.7.4 Limit Pricing

1.7.5 Going Rate Pricing

1.7.6 Team pricing

1.7.7 Mark-up and Mark - down pricing

1.7.8 Peak Load Pricing

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1.1 Introduction

Managerial decision making consists of a number of procedures at each

individual stage of the product manufacturing. They are related to the

product development depending on the market requirement, product

manufacturing, product distribution and marketing of the same to realize

the company's sales targets.

One of the important factors which assist the company in realizing its

profits through targeted sales is the Pricing Policy, it formulates. As a result

the method of the company's Pricing Policy plays an important role in the

Managerial decision making. Price, in fact, is the source of revenue which

the firm seeks to maximize. Also it is the most important device a firm can

use to expand its clientele base. The company should fix the price

reasonably because if the price is set too high, it may lead it to loose its

83

market share. On the other hand, if the price is set too low the company

may not recover its cost. so the right choice of the Price fixation would

depend on number of factors and wide variety of conditions prevailing in

the market. Moreover the pricing decisions have to be reviewed and

formulated from time to time.

Some of the factors which affect the choice of the pricing policies are:

Business Objectives: This relates to rate of growth, establishing and

increasing its market share and maintenance of control and finally

profit realization. All these concepts play an important role in pricing

policy formulation.

Competition level: It is important for a company to offer the product

which satisfies the wants and desires of the consumer than the one

which sells at the lowest price.

4P's: Pricing happens to be one of the core concepts of marketing but

a firm must consider it together with Product, Place & Promotion.

Price sensitivity: Factors like variability in the consumer behavior

consumer income level, marketing effect, nature of product and after

sales service among others affect the price sensitivity.

Available information: The demand supply gap goes a long way in

affecting the choice of the pricing policy determination for as

company.

Pricing hence is more a matter of judgment since every pricing

situation is different from each other and as such there is no formula

existing for the price fixation.

1.2 Objectives of Pricing Policies

Pricing policies form an integral part of the company's overall

business strategy. Some of the important objectives, which the

company should take into consideration, are:

Profit maximization for the company's products

Relation of long term goals of the company.

Successfully thwart the competitors.

Flexibility in pricing to meet the changes in the market.

84

Achieving a satisfactory rate of return

1.3 Factors affecting Pricing Policies

The company should determine its pricing policies in such a way that

depending on the market trends, the company is able to adapt itself to the

changes occurring in the market.

Few of the factors are enlisted below:

Cost involved

Demand elasticity

Consumer psychology

Price changes

Type of product

Competitors in the market

Product segmentation and positioning.

Market structure and promotional policies

Degree of integration

Business Expansion

Complementary and substitution products and

Other considerations

a. Individual

b. Firm's

c. Economic

1.4 Price Forecasting

A Business unit is constantly faced with the risk of a substantial change in

the prices of raw materials as 'well as its products, these changes may be a

part of general economic fluctuations but, at times the prices may change

during the period of economic stability also The first step towards

successful price forecasting is the understanding of nature of the

commodity and its market. We should have the knowledge of the demand -

supply conditions, i.e.

Demand elasticity: Where the demand is elastic; a given change in

85

supply will bring a less sever change in price than where the demand

is inelastic.

Change in supply of commodity: When the change in demand for

commodity takes place price change will depend on the supply

conditions, which in turn will depend on the conditions of production

e.g. supply manufactured product can be altered according to the

demand condition. The price tends to vary for that product where the

supply of a product cannot be in accordance with that of demand.

Influence of supply and demand on the price: There are many

products particularly agricultural, whose demands remains constant

but where the supply may change continuously. So that analysis

should be made from the supply side and for the manufactured

product the rapid demand change can be matched with the supply

adjustments.

Related Commodities: The prices of many manufactured goods

depend on prices of raw material particularly on the current prices.

The manufacturer while pricing the product will take only this pricing

into consideration.

Type of product: The price of commodity will depend on the other one

specially if it is a by product. In that case supply of that by product

will depend on the main product and not on its (By-product's) demand

conditions.

Supply - Controllable and predictable: It may be possible for the

supply of a commodity to change substantially but this change may

be unpredictable and beyond control e.g. an increase in the supply of

crude oil will depend on the oil striking capacity.

Competitive situations: In case where a dominant producer leads the

market, his probable price policy becomes a significant factor in

making the price forecast. In case of a severe price competition,

resorting to the price cutting would be frequent and uncertain,

specially in the buyer's market.

1.5 Prospective supply and demand

86

In price forecasting a knowledge about the prospective supply and demand

conditions is also essential. In fact, besides estimating the supply and

demand conditions prevailing at the time of the forecast it is imperative to

find the probable demand and supply conditions during the next six months.

1.5.1 Prospective Supply

The current value of production of commodity should be compared with the

total productive capacity in order to ascertain the extent of excessive

productive capacity in the market. An excess of capacity creates a

persistent tendency towards over production and acts as a restraint upon a

rise in the price. The existing cost -Price relationship may also determine

the prospective supply. There will be a tendency among the firms producing

a commodity to curtail the production if price decreases over the cost of

production. On the other hand, when the price exceeds the variable cost

they would enter the industry once again.

1.5.2 Prospective Demand

The prospective demand is determined by the nature of need for that

commodity and the willingness of the buyer to buy the commodity and their

purchasing power. An analysis of a price movement of a commodity over a

period of time will reveal certain fluctuation. These fluctuations and their

relationships are helpful in price forecasting. Some of the fluctuations

observed are:

Seasonal price variation: These are common in case of number of

commodities notably agricultural and food products such variations

would take place in markets having seasonal cycles. These variations

may take place due to seasonal fluctuation in the price of raw

materials also.

Cyclical price variation: During the business cycle, price of all

commodities would generally record fluctuations. So it becomes

essential to realize this effect on the commodities in different ways.

The general business conditions influence the commodity prices

through changes in the demand supply relationships in the market for

each individual commodity.

87

Cob -Web Cycle: These cycles occur on account of the cumulative

effect of the price expectations of the millions of independent

producers. When farmers expect higher prices in future, they plan

independently to producer more. Also new ones enter the field.

As a result, the aggregate output, when the future date arrives, is so

large that the price falls. When the prices fall, all the producers plan

to produce less, once they have suffered losses on the account of non-

materialization of their expected prices. This time the cumulative

effect of smaller output plan leads to the shortage of products which

in turn increases the prices.

1.6 Pricing Methods

Before we proceed with the various pricing methods, it is essential for us to

understand the Life cycle concept. Many products generally have a

characteristic known as 'Perishable distinctiveness.’ The product cycle

begins with the invention of a new product followed by patent protection

and further development to make it saleable. This is usually followed by a

rapid expansion in its sales as the product gains its market acceptance.

Then the competitor enters the field with the imitation and the rival

products and the distinctiveness of the new product starts diminishing. The

speed of degeneration differs from product to product. The innovation of

new product and its degeneration into a common product is termed as Life

Cycle of the Product."

There are five distinct stages in the Life Cycle of the product'. They are as

follows:

1.6.1 Introduction

Research or engineering skills lead to the product development. There are

high promotional costs involved, volume of sales is low and there may be

heavy losses.

Pricing Policies in Introductory phase largely depend on the close

substitutes available in the market. Generally two kinds of pricing policies

88

are suggested,

1.6.1.1 Skimming Pricing: This pricing strategy is adopted when close

substitutes of a new product are not available in the market. To extract the

consumer surplus, setting up a very high price initially and then a

subsequent lowering of prices in a series of reduction.

1.6.1.2 Penetration Pricing: This pricing policy is generally adopted in

case of the availability of close substitutes of the new product in the market.

To penetrate in the market, initially a lower price is designed, as soon the

product captures the market, price is gradually raised up.

1.6.2 Growth

Due to the cumulative effects of introduction stage the product begins to

make rapid sales gain. High and sharply rising profits may be witnessed.

Consumer satisfaction has to be ensured.

1.6.3 Maturity

Sales growth continue, but at a diminishing rate, because of the declining

number of the potential customers who remain unaware of the product or

have taken no action. Profit margin slips despite rise in the sale.

During Maturity stage, firm should move in the direction of Product

improvement and market segmentation.

1.6.4 Saturation

Sales reach and remain on a plate marked by the level of the replacement

demand. There is a little additional demand to be stimulated.

1.6.5 Decline

Sales begin to diminish absolutely as the customers begin to tire of the

product and the product is gradually edged out by better products or the

substitutes.

The life cycle broadly gives the different stages through which a product

89

passes through. There are changes taking place in the price and

promotional elasticity of demand as also in the production and distribution

cost of the product. Pricing Policy, therefore, must be properly adjusted

over the various phases of the life cycle of the product.

1.7 The various Pricing methods are:

Marginal cost pricing,

Full Cost method pricing,

Limit pricing

Mark-up and Mark-down pricing,

Rate of Return pricing,

Going rate pricing,

Team pricing,

Value pricing,

Position based pricing,

Exports pricing,

Dual pricing

Administered pricing,

Skimming pricing,

Penetration pricing,

Peak load priding,

Charm pricing,

Discrimination pricing.,

Product mix pricing.

1.7.1 Cost-plus or full-cost pricing:

This is the most common method used for pricing. Under this method, the

price is set to cover the costs (materials, labour and overhead) and a

predetermined percentage for profit. The percentage differs from industry

to industry. This may reflect differences in competitive intensity, differences

in cost base, differences in rate of turnover and risk.

Ordinarily the profits are kept at a margin sensitive to the market

conditions. Mark-ups may be determined by trade associations either by the

90

means of advisory price-list or by actual list of mark ups distributed to

members. Usually profit margins under price control are so set as to make

it possible for even the least efficient firms to survive.

This method ignores the demands -there is no necessary relationship

between the costs and what the people pay for the product. Also it fails to

reflect the forces of the competition adequately.

Example: All the stationery products are priced in this way.

1.7.2 Rate of Return pricing

It is a refined variant of full cost pricing. Under this method a firm starts

with a rate of return they consider satisfactory and then set a price that

allows them to earn that return when there plant utilization is at some

standard rat. In other words the company determines the standard cost at

standard volume and adds the margins necessary to return a target rate of

profit over the long run.

This can be broadly grouped under the following:

1. Fixing prices to maintain constant percentage mark up over the

cost,

2. Fixing prices to maintain the profit as constant percentage of sale,

and

3. Fixing prices to maintain a constant return on the investment

capital.

Example: Most products are priced I this way for instance Philips audio

systems are currently priced based on what the manufacturers estimate the

returns to be.

1.7.3 Marginal cost pricing

Both under the full cost pricing and rate of return pricing, the prices are

based on total cost comprising fixed and variable cost. Under marginal cost

pricing, the fixed costs are ignored and prices determined on the basis of

marginal cost. The firm uses only those costs that are directly attributable

to the output of a specific product. With marginal cost pricing, the firm

seeks to fix its prices so as to maximise its total contribution to fixed cost

and profit. Unless the manufacturer's products are in direct competition

91

with each other, this objective is achieved by considering each product in

isolation and fixing its price at a level which is calculated to maximize its

total contribution.

With marginal cost pricing, the prices are never rendered up-competitively

because of a higher fixed cost are higher than those of the competitor. The

firm's prices will be rendered un- competitive by high variable cost, and

these are controllable in short run marginal cost more accurately reflects

future as distinct from present cost level and relationship. This method also

helps the manufacturer to develop a far more aggressive pricing policy than

the full cost pricing.

In a period of business recession, firm's using marginal cost pricing may

lower prices in order retain its market share. This may lead other firms to

reduce their prices leading to cut- throat competition. The price cut may be

up to such an extent that the fixed cost is not covered and thus a fair return

on the investment is not obtained.

Example: Nestle Tea is priced based on this method.

1.7.4 Limit Pricing

Bain explained why firms over a long period of time were keeping their

price at a level of demand where the elasticity was below unity, that is, they

did not charge the price which would maximize their revenue. Traditional

theory was concerned only with actual entry of the firms and not the

potential entry. Bain argued that in the long run because of the existence of

barrier to entry the price do not fall to the level of LAC. This behaviour can

be explained by assuming that there are barriers to entry and the existing

firms do not set the monopoly price but the limit price, i.e., the highest

price that the established firms believe they can charge without inducing

entry.

The level at which limit will be set depends on the estimation of the costs of

the potential entrant, market elasticity of demand, shape and level of LAC,

size of the market and number of firms in the industry.

92

1.7.5 Going Rate Pricing

Here instead of cost, the emphasis is on the market. The firm adjusts its

own price policy to general pricing structure in the industry. This may seem

to be a rational pricing policy when the costs are difficult to measure. Many

cases of this type are situations of price leadership. Where price leadership

is well established, charging according to what competitors are charging, is

the only safe policy.

It must be noted that this pricing is not quiet the same as accepting the

price impersonally set by a near perfect market. Whether it would seem

that the firm has some power to set its own price and could be a price

maker if it chooses to face all the consequences.

Example: Since Nescafe is the market leader in the instant coffee segment,

hence every manufacturer wanting to enter this segment has to be

Nescafe's line.

1.7.6 Team pricing

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According to this method, the companies sometimes assign special roles to

the various products they sell. Some items may be used as promotional

items which are priced and advertised with prime purpose of attracting the

customers and other may be intended to make up for the low margin

obtained on the promotional items.

Example: Several retailers give free items with certain items. Pantaloon,

Allen Solly & Van Heusen are examples, for instance with a Van Heusen

Blazer you can choose Van Heusen tie for free.

1.7.7 Mark-up and Mark - down pricing

When a retailer follows the practice of fixing the price over the one at which

he has obtained the product, such that it covers the cost and leaves a

reasonable profit margin he is said to follow the mark-up policy. In case

certain goods are not sold within a reasonable time, the retailer pulls the

price down i.e. "marks down" the product price.

Example: During Diwali as the day approaches the firecracker prices

increase and on the diwali afternoon the prices are significantly marked

down.

1.7.8 Peak Load Pricing

There are certain perishable products which are being demanded in

varying quantities at different point of time. E.g. During evening

hours, restaurants face peak demand and during day time, the

demand falls. For these kinds of products, a double pricing system is

adopted. A higher price, called peak-load price is charged during the

peak-load period and a lower price is charged during the off-peak

period.

End Chapter quizzes :

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1. Under marginal cost pricing, which cost is ignored

(a) Variable Cost

(b) Fixed Cost

(c) Marginal cost

(d) Opportunity Cost

2 Cost- Plus pricing methods ignores

(a) Labor cost

(b) Percentage for profit

(c) Demand for the product

(d) Supply price of Raw materials

3. Setting up higher prices initially to extract the consumer surplus

is known as

(a) Penetration Pricing

(b) Limit Pricing

(c) Skimming Pricing

(d) Team Pricing

4. In which Pricing method, the firm adjusts its own price policy to

general pricing structure in the industry:

(a) Team Pricing

(b) Going Rate Pricing

(c) Penetration Pricing

(d) Mark-up Pricing

5. Increase in Sales along with gain in profits is witnessed during

(a) Introductory Stage

(b) Growth Stage

(c) Maturity stage

(d) Decline Stage

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6. Peak Load pricing strategy involves fixing higher price when

(a) The product is launched in the market.

(b) the demand is reaching at its highest point.

(c) The product is in decline stage.

(d) the product has no close substitutes.

7. In this Pricing strategy, the company determines the standard

cost at standard volume and adds the margins necessary to return a

target rate of profit over the long run:

(a) Rate of Return pricing

(b) Cost plus Pricing

(c) Marginal cost Pricing

(d) Mark up Pricing

8. Which factor affects the determination of Price for a product

(a) Demand elasticity

(b) Consumer psychology

( c) Price changes

(d) all of the above

9. In case certain goods are not sold within a reasonable time, the

retailer pulls the price down, it is known as

(a) Adjustment pricing

(b) Administered pricing

(c) Mark-down pricing

(d) Mark-up pricing

10. This pricing strategy acts as a barrier to entry to new firms

(a) Limit Pricing

(b) Administered Pricing

(c) Peak –Load Pricing

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(d) Skimming Pricing

Chapter-VII

Objectives of the Firm

Contents:

1.1 Introduction

1.2 Baumol’s Sales Revenue Maximization Theory1.3 Marris’s model of the managerial enterprise1.4 Williamson Model of Managerial Discretion1.5 Satisficing Behavior Theory of the Firm

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1.1 Introduction

Traditional theories of the firm advocated that profit maximization is the

goal of the firms. This objective was based on the single entity of ownership

and management. With the course of development simple business activities

turned into complex organizations dealing with specialized and classified

activities. This development has led to the separation of ownership and

management. Further with this division the utility functions of both parties

faced confrontation in certain areas and profit maximization did not remain

the single objective of the firm. In this wake several objectives were

identified and proved to be true in real business practices. Coordination and

compromise between organizational parameters of concern and their

managerial counterparts is necessary. Organization could aim at profits, net

worth, growth and diversification and managers may aim at Salary, Perks,

Promotion, Job Security and Career.

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1.2 Baumol’s Sales Revenue Maximisation Theory

Manager’s rewards are more closely linked to Sales rather than

Profits.

Firms aim to maximize Sales Revenue, but subject to a Profit

Constraint.

Profit constraint is exogenously determined by the demand and

expectations of the shareholders, banks and other financial

institutions.

A Sales Revenue Maximizing firm, in general, produces a greater

output than a Profit Maximizing Firm and sells at a price lower than

the profit maximizer.

The maximum sales revenue will be where e = 1 (and hence MR = 0)

and will be earned only if the profit constraint is not operative.

If the profit constraint is operative the sales revenue maximizer will

operate in the area where price elasticity is greater than unity.

QΠ = Profit Maximizing Output

QS = Sales Maximizing Output

QRS = Constrained Sales Maximizing Output

Π = Profit Curve

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1.3 Marris’s model of the managerial enterprise

The growth of an organization depends on the separate but

interdependent Utility functions of both owners and managers

Utility of Owners → Profits, market Share, Public Esteem etc.

Utility of Managers → Salaries, Status, Job Security etc.

Long Term goal of an organization is assumed to be “Balanced

Rate of Growth”

Job Security is important for Managers which imposes a

constraint on the diversification and growth of the firm

On the other hand, there is a trade off between retained profits

(reinvested for growth) and profits declared as dividends.

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1.4 Williamson Model of Managerial Discretion

Managers have discretion in pursuing policies which maximize their own

utility rather than attempting the maximization of profits which maximizes

the utility of owners. This is attained by the expense preference such as

staff expenditure on emoluments, funds available for discretionary

investment. It gives managers a positive satisfaction because these

expenditures are a source of security and reflect the power, status, prestige

and professional achievement of managers. It emphasizes the ability of

managers to maximize their own Utility function (Owner’s Utility acts as a

constraint).

Where

→ staff expenditure

→ managerial emoluments

→ discretionary investment

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An important aspect is the non – pecuniary components of the

Managers’ Utility – reflected in Emoluments and Managerial Slack in

the form of expense accounts, luxurious offices etc.

Also important are the funds available to managers for “Discretionary

Investment”

1.5 Satisficing Behaviour Theory of the Firm

Behavioral economists argue that any corporation is composed

of various groups

a. Employees

b. Managers

c. Shareholders

d. Customers

Each group has different goals such as production goal,

inventory goal, sales goal, profit goal etc.

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People possess limited cognitive ability and so can exercise only

“Bounded Rationality” when making decisions in complex

uncertain situations.

Decisions are taken in conditions of uncertainty and ignorance.

Rather than an exhaustive search for the best or ideal solution,

decision makers seek an acceptable or satisfactory outcome.

Maximizing behavior may be replaced by “Satisficing”, i.e.,

setting minimum acceptable levels of achievement.

End Chapter quizzes :

Q.1. Traditionally the objective of the firm was

a) Sales maximization

b) Profit maximization

c) Barriers to new entrants

d) Maximization of managers utility function

Q.2 The equilibrium of the traditional firm is where

(a) MR > MC

(b) MR = MC

(c) MR < MC

(d) MR ≠ MC

Q.3 Sales revenue maximizer is successful when

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a) Profit constraint is too high

b) Profit constraint is non operative

c) Profit constraint is zero

d) Profit constraint is too low

Q.4 Which of the statements is false about sales revenue

maximisation

a) Output is more than profit maximiser

b) Prices are lower than profit maximizer

c) Sales revenue is maximum where elasticity = 1

d) Prices are higher than profit maximizer

Q.5 According to Marris the utility functions of manager and owner

are

a) Always same

b) Always separate

c) Interdependent

d) Separate but interdependent

Q.6 Maximisation of balanced rate of growth means

a) (a)

b) (b)

c) (c)

d) (d)

Q.7 The relationship between discretionary investment and managers

utility maximization is

a) Positively high

b) Positively low

c) Negatively high

d) Negatively low

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Q.8 Owners utility maximization is determined by

a) Revenue maximization

b) Profit maximization

c) Investment maximization

d) Prices maximization

Q.9 Satisficing behavior theory states that

a) Firm is a coalition of harmonized interest groups

b) Firm is a coalition of conflicting interest groups

c) Firm is not a coalition of interest groups

d) Firm is a single goal entity

Q.10 Satisficing behavior theory focuses on

a) Decision making process of small single product firms under

imperfect market conditions

b) Decision making process of large multiproduct firms under

imperfect market conditions

c) Decision making process of large multiproduct firms under

perfect market conditions

d) Decision making process of small single product firms under

perfect market conditions

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Chapter-VIII

Market Structure

Contents:

1.1 Introduction1.2 Meaning of market1.3 Classification of Market Structure

1.3.1 Perfect Competition

1.3.1.1 Price Output Determination Under Perfect

Competition

1.3.1.2 Equilibrium in Short Run

1.3.1.3 Perfect Competition in the Long Run1.3.1.4 Perfect Competition and Plant Size1.3.1.5 Perfect Competition and the LR

Supply Curve1.3.1.6 Long Run Equilibrium

1.3.2 Monopoly Market

1.3.2.1 Why do Monopolies exist?1.3.2.2 Equilibrium of the Firm1.3.2.3 Price Discrimination

1.3.3 Monopolistic Competition 1.3.3.1 Structure

1.3.3.2 Short Run Equilibrium1.3.3.3 Long Run Equilibrium

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1.3.3.4 Efficiency under Monopolistic Competition1.3.4 Oligopoly Market

1.3.4.1 Structure1.3.4.2 Mutual Interdependence1.3.4.3 Collusion is difficult if1.3.4.4 Explicit Collusion – Cartels1.3.4.5 Sweezey’s Model of Kinked Demand

Curve1.3.4.6 Price Stability with a Kinked Demand

Curve1.3.4.7 Tacit Collusion: Price Leadership

1.3.4.7.1 Dominant Firm Price Leadership

1.3.4.7.2 Barometric Price Leadership

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1.1 IntroductionMaximization of output or optimization of cost or optimization of resource

allocation is only one aspect of the profit maximizing behavior of the firm.

Another and equally important aspect of Profit Maximization is to find the

price from the set of prices revealed by the demand schedule that is in

agreement with the profit maximization objective of the firm.

The profit maximizing price does not necessarily coincide with minimum

cost of production. Besides, the level of profit-maximizing price also

depends on the nature of competition prevailing in the market. Therefore,

while determining the price for its product, a firm has to take into account

the degree of competition.

1.2 Meaning of market

A market is a group of people and firms which are in contact with one

another for the purpose of buying and selling some product. It is not

necessary that every member of the market be in contact with each other.

Market structure refers to the number and size distribution of buyers and

sellers in the market for a good or service. The market structure for a

product not includes firms and individuals currently engaged in Buying and

selling but also the potential entrants.

1.3 Classification of Market Structure

On the basis of the degree of competition, Markets are traditionally

classified as:

Perfect Competition

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Imperfect Competition

1.3.1 Perfect Competition

Characteristics of Perfect Competition:

Large number of small sellers and buyers: The number of buyer

as well as seller is so large that the share of each buyer in total

market demand and the share of each seller in total market supply is

insignificant and hence no individual buyer or seller can influence the

market price.

Homogeneous products: Products supplied by the firms are

identical and are regarded as perfect substitute to each other.

Perfect mobility of factors of production: For a market to be

perfectly competitive, the factors of production must be in the

position of moving freely into or out of the industry and from one firm

to another.

Free entry and free exit of the firms: No legal or otherwise

restrictions on the entry and exit of the firms.

Perfect dissemination of the information: to the buyers and

sellers.

No government intervention and Absence of collusion.

Examples: Agricultural commodities and Stock market

1.3.1.1 Price Output Determination Under Perfect

Competition

In a perfectly competitive market, where large number of sellers selling

homogeneous product, no single seller can influence the market price.

Similarly, each buyer has too small share in total market demand to

influence the price. Market Price is therefore determined by the market

demand and market supply for the industry and is given for each individual

firm and for each buyer. Thus, a seller in a perfectly competitive market is a

‘price-taker’ not a ‘price maker’. This means the individual firm will face a

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horizontal demand curve. It will be horizontal at the market price,

established by supply and demand on the market as a whole.

1.3.1.2 Equilibrium in Short Run

A Short run is a period in which firms can neither change their size nor quit,

nor can new firms enter the industry. Firms can increase (or decrease) the

supply of the product by increasing (or decreasing) the variable inputs.

Therefore, supply curve is elastic in short run.

The determination of market price in the short run is illustrated in the Fig.

4.1(a) and adjustment of output by the firms to the market price and firm’s

equilibrium are shown in Fig. 4.2(b). Fig. 4.1(a) shows the price

determination for the industry by the demand curve D and supply curve S at

the price OP. This price is fixed for all the firms in the industry. Given the

Price OP, an individual firm can produce and sell any quantity at this price.

To determine the profit maximizing output, firm’s cost curves are required

to be studied.

The process of firm’s output determination and its equilibrium are shown in

the Fig 4.2(b). Profit maximizing condition for a firm is MR=MC. Since price

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is fixed at OP, firm’s average revenue AR= OP and also if AR is given,

MR=AR. Firm’s upward sloping MC curve intersects MR

1.3.1.3 Perfect Competition in the Long Run

In the long run, entry and exit become possible. Why? Because potential

firms can buy fixed inputs and become actual firms. And existing firms can

sell off or stop renting their fixed inputs and go out of business.

Firms will choose to enter the industry if the existing firms in the industry

are making economic profits. The profits are an incentive to enter. As a

result the total market supply will increase and, therefore, the market

supply curve must shift to the right. It drives down the price on the market,

thereby reducing the profits of each firm.

Now the firms are making profits, but smaller profits than before. But if

there are still economic profits being made, more firms will enter. This must

continue until there are no economic profits. What has to be true when

profits equal zero?

TR = TC

p*×q = q×ATC

p* = ATC

So entry finally stops when firms are producing at their lowest average total

cost. Here is a diagram of the final, long-run equilibrium under perfect

competition:

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What if typical firm is making losses? Then the reverse process will take

place. Firms will exit the market, causing a left shift of market supply,

causing a rise in market price, causing a reduction of losses. This continues

until losses are zero. Thus, Long Run competitive equilibrium consists of

two conditions:

• p* = MC

• p* = minimum ATC

The first condition is caused purely by profit maximization, and it’s true in

both the SR and the LR. The second condition, however, is caused by entry

and exit in the LR. It won’t necessarily be true in the SR.

These two conditions have important efficiency implications. Marginal-cost

pricing (p*= MC) means that consumers who buy the product face the true

opportunity cost of their choices. They will only buy the good if the value to

them is greater than the price, which represents the value of the resources

that went into making the product. Minimum average cost pricing (p* =

minimum ATC) means that the product is being made at the lowest average

cost possible, so that no resources are being wasted in its production.

The conclusion that firms make zero profit in the LR may seem odd, given

the profits that many firms earn in reality. What could explain the difference

between theory and reality? (1) Reality may differ from the perfectly

competitive model, and to that extent economic profits can be made. But

also, (2) the profits we generally hear about are accounting profits, not

economic profits. To find out whether these “profitable” firms are really

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making economic profits, we’d need more information about their implicit

costs.

Finally, (3) we may be observing short-run profits, not long-run profits.

1.3.1.4 Perfect Competition and Plant Size

It turns out that the perfectly competitive firm produces not just at the

minimum of its SRATC, but also its LRATC. Why? Because any PC firm not

at its minimum LRATC will, in the LR, change its input combination to take

advantage of lower average costs. If firms are able to make positive profits

by moving outward on the LRATC curve, those profits will attract entrants

into the industry in the usual fashion. So by the same arguments as before,

profits will eventually dissipate to zero. The price must be at the bottom of

the LRATC, not just the SRATC.

1.3.1.5 Perfect Competition and the LR Supply Curve

As we have seen, changes in demand in a PC market create profits and

losses for firms. In the SR, this has no effect on the supply curve; but in the

LR, firms enter for profits and leave to escape losses, leading to supply

curve shifts. We want to use this information to derive a LR supply curve. A

LR supply curve, just like a SR supply curve, shows the total quantity that

will be supplied in a market at different prices; but unlike the SR supply

curve, it shows the quantity supplied after all long-term changes, including

entry and exit of firms, have been taken into account.

In the basic supply-and-demand framework, notice that we can use demand

curves and equilibrium points to “trace out” the supply curve. If you look at

three

different demand curves, and then mark the equilibrium point on each one,

you can

connect the equilibrium points to find where the supply curve must be.

Now we’re going to use the same basic technique to trace out the LR supply

curve. We can do this by changing demand, and then finding the

equilibrium points after allowing LR adjustments, including entry and exit.

Start with an initial (short-run) supply and demand. If we are in long-run

equilibrium, profits are zero. Now, let demand shift to the right. In the

short-run, price rises a lot. But the higher price creates profits, and profits

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attract entry in the long run. So eventually supply shifts to the right as well,

pushing price back down (though possibly not as low as it was before). Once

profits are back to zero again, you’re in a new long-run equilibrium. Do this

all again to find a third long run equilibrium, and then connect the dots to

get the long-run supply curve.

The interpretation of the LR supply curve is pretty much the same as the SR

supply

curve: it shows the willingness of producers to sell at each price. But the LR

supply

curve measures this willingness in the broadest sense, including all firms

that might

potentially supply this product.

Notice that the LR supply curve is flatter than the SR supply curve. This

must be so,

since the LR supply curve takes into account the quantity responses of all

firms, not just the ones currently in the market, but potential firms as well.

It is even possible that the LR supply curve can be downward-sloping. Why?

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Consider what must happen if entry and exit do not affect the cost curves of

individual firms. Then after all adjustment to a change in demand has taken

place, the market price must have returned to the lowest point on the

LRATC, which is exactly where it was before. So in this case, the LR supply

curve must be horizontal. We call this a constant--cost industry. This is most

likely to be the case when the industry in question constitutes only a small

portion of the demand for its inputs.

If the industry in question has a large impact on the markets for its inputs,

then the LR supply curve may slope upward or downward. If the effect of

entry into the industry is to bid up the price of inputs, so that a firm’s cost

curves rise as a result of the entry of new firms, then the market price after

adjustment will be higher than it was before. In this case, the LR supply

curve must be upward-sloping as in the picture above; this is called an

increasing-cost industry, which results from external diseconomies. On the

other hand, if entry into the industry creates a greater demand for inputs

that allows those inputs to be produced through mass production

techniques (i.e., at lower average cost), then the industry can benefit from

lower costs of production. In this case, the LR supply curve is downward-

sloping. This is called a decreasing-cost industry, which results from

external economies. They face a perfectly elastic demand curve Market

prices change only if demand and supply change

1.3.1.6 Long Run Equilibrium

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Normal profit is necessary to attract and maintain capital investment

Marginal Analysis

MR = MC => Normal Profits

Output will settle at the point where;

P = MC = AC = MR

1.3.1.7 Supply Curve under Perfect Competition

Short Run Firm Supply – MC curve is the SR supply curve so long as

P > AVC

Long Run firm Supply – LMC curve is the LR supply curve so long as

P > ATC

In the LR, the firm must cover all necessary costs of production and

earn a normal profit

1.3.2 Monopoly Market

A monopoly market is one in which there is only one seller of a product

having no close substitutes. The firm has substantial control over the price.

Further, if product is differentiated and if there are no threats of new firms

entering the same business, a monopoly firm can manage to earn excessive

profits over a long period.

Only one firm produces the product

Low cross elasticity of demand between the monopolist’s product and

any other product; that is no close substitute products.

Substantial barriers to entry that prevents competition from entering

the industry.

1.3.2.1 Why do Monopolies exist?

Barriers to Entry

a) Control of scarce resources or input

b) Economies of scale natural monopolies

c) Technological superiority

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d) Govt. created barriers

e) Patents

1.3.2.2 Equilibrium of the Firm

Monopoly firms’ ability to set price is limited by the demand elasticity

Supernormal profits may be earned in the Long Run since there is no

entry

P > competitive price

Q < competitive quantity

The monopolist will always try to operate on the elastic portion of the

demand curve

1.3.2.3Price Discrimination

Price discrimination means selling the same or slightly differentiated

product to different sections of consumers at different prices. The

necessary conditions for price discrimination are:

Different markets must be separable

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The elasticity of demand must be different in different markets

There must be imperfect competition in the market

Profit maximizing output is much larger than the quantity

demanded in a single market

Price discrimination can be categorized into three types:

First degree of price discrimination – Charging two different

prices in different markets having demand curves with different

elasticities.

Second degree of price discrimination – Charging more than

two different prices from each customer’s block

Third degree of price discrimination – Charging different prices

from each consumer. The demand curve becomes the marginal

revenue curve of the seller.

1.3.3 Monopolistic Competition

It implies a market structure with a large number of firms selling

differentiated products. The differentiation may be real like brand name,

trade mark, colour , shape, design, packaging, credit terms etc, or is

perceived so by the customers like product image. Two brands of shampoos

may just be identical but perceived by customers as different on some fancy

dimension like freshness. Firms in such a market structure have some

control over price.

1.3.3.1 Structure

Several firms in the market.

Producing differentiated products.

“Free” entry and exit.

Full and symmetric information.

Consumers have “brand preference” but can be induced to change

brands

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Advertising often plays a big role in monopolistically competitive

markets

1.3.3.2 Short Run Equilibrium

The firm under Monopolistic Competition acts just as a monopolist in the

Short Run

1.3.3.3 Long Run Equilibrium

Free Entry and Exit drive Long Run Profits to the level of Normal

profits

Firm demand will be tangent to its LR Average Cost Curve

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1.3.3.4 Efficiency under Monopolistic Competition

Excess Capacity under Monopolistic Competition

Compared to perfect competition:

less will be sold at a higher price

firms will not be producing at the least-cost point (i.e. min AC) =>

firms have excess capacity

On the other hand it is often argued that these wastes are

insignificant and perhaps well compensated to the consumer by the

greater variety of products to choose.

1.3.4 Oligopoly Market

It is a market structure in which a small number of firms account for the

whole industry's output. The product may or may not be differentiated. For

example only 5 or 6 firms in India constitute 100% of the integrated steel

industry's output. All of them market almost identical products. On the

other hand, passenger car industry with only three firms is characterized by

marked differentiation in products The nature of products is such that very

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often one finds entry of new firms difficult. Oligopoly is characterized by

vigorous competition where firms manipulate both prices and volumes in an

attempt to outsmart their rivals. No generalization can be made about

profitability scenarios.

1.3.4.1 Structure

In an oligopoly there are very few sellers of the good.

The product may be differentiated among the sellers (e.g.

automobiles) or homogeneous (e.g. petrol).

Homogenous product → Pure Oligopoly

Entry is often limited

by legal restrictions (e.g. banking in most of the world)

by a very large minimum efficient scale

by strategic behavior.

1.3.4.2 Mutual Interdependence

The essence of an oligopolistic industry is the need for each firm to

consider how its own actions affect the decisions of its relatively few

competitors

To predict the outcome in such a market, economists need to model

the interaction between firms.

Oligopoly may be characterized by Collusion Cartels Or Non -

Cooperation

1.3.4.3 Collusion is difficult if

There are many firms in the industry

The product is not standardized

Demand and cost conditions are changing rapidly

There are no barriers to entry

Firms have surplus capacity

1.3.4.4 Explicit Collusion – Cartels

A Cartel is a formal organization of sellers that seeks to restrict

competition

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Maximum possible profits that can accrue as a result of a cartel is the

amount that would prevail under Monopoly

If the firms compete vigorously on the basis of price, lowest possible

equilibrium price that could prevail is the competitive price and

output

1.3.4.5 Sweezey’s Model of Kinked Demand Curve

Explains Price Rigidity under Oligopoly

Starts with a predetermined Price – Output

Demand Curve is kinked at current price:

The firm may expect rivals to respond if it reduces its price – so,

demand in response to a price reduction is likely to be relatively

inelastic

For a price rise, rivals are less likely to react, so demand may be

relatively elastic

1.3.4.6 Price Stability with a Kinked Demand

CurveFor any MC between a and b, the profit maximizing price and output remain

unchanged.

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1.3.4.7 Tacit Collusion : Price Leadership

One firm sets the price and others follow three types of leaders:

Dominant firm price leadership

Barometric Price Leadership

Price Leadership by a low – cost firm

1.3.4.7.1 Dominant Firm Price Leadership

Dominant Firm sets the price for the industry but lets followers sell

all they want at that price

The Dominant firm will provide the rest of the market demand

Followers, like in Perfect Competition, accept the price as given

1.3.4.7.2 Barometric Price Leadership

There is no one dominant firm

Price changes are in response to changes in some underlying market

conditions, obvious to all the firms

123

The critical requirement for being a leader is the ability to interpret

market conditions and propose price changes that other firms are

willing to follow

End Chapter quizzes

Q.1. Banking Sector is an example of

(a) Perfect Market

(b) Monopolistic Market

(c) Oligopoly Market

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(d) Monopoly Market

Q.2 Which is not the characteristic of a perfect market

(a) Large number of small buyers and sellers

(b) Restricted entry and exit

(c) Homogeneous Products

(d) Free mobility of factors of production

Q.3. Profit maximizing condition for a firm is

(a) MR=MC.

(b) MR>MC

(c) MR<MC

(d) MC = AC

Q.4. In a Monopoly market, Barriers to Entry may be existing due to

(a) Control of scarce resources or input

(b) Technological superiority

(c) Patents

(d) All of the above

Q.5. Sweezey’s Model of Kinked Demand Curve determines

(a) Price Rigidity in Oligopoly market

(b) Price discrimination in Monopoly market

(c) Profit maximizing Output in Oligopoly market

(d) Profit maximizing Output in Monopoly market

Q.6. A formal organization of sellers that seeks to restrict

competition is known as

(a) Sellers Association

(b) Cartel

(c) Trade Union

(d) Trade Association

125

Q.7. Which condition is false in case of a monopoly firm to earn

excessive profits over a long period

(a) Only one firm produces the product

(b) Low cross elasticity of demand between the monopolist’s product

and any other product; that is no close substitute products.

(c) Free entry of new firms

(d) Substantial barriers to entry that prevents competition from

entering the industry.

Q.8. Price Discrimination under Monopoly is not possible if

(a) Different markets are separable.

(b) Elasticity of demand is same in different markets.

( c) Market is imperfect.

(d) Elasticity of demand is different in different markets.

Q.9. In a Perfectly competitive market, in long run, firm earns

(a) Abnormal Profits

(b) Supernormal Profits

(c) Normal Profits

(d) Economic Profits

Q.10. Demand curve of a firm in perfect competitive market is

(a) Upward sloping

(b) Downward sloping

(c) Horizontal

(d) Vertical

126

Key to End Chapter Quizzes

Chapter –I Managerial Decision Making

1 (b ); 2(a ); 3(c ); 4(a ); 5(a ); 6(c ); 7(b ); 8(b ); 9(a ); 10(d )

Chapter –II Business Forecasting

1 (c ); 2(a ); 3(d ); 4(d ); 5(d ); 6(a ); 7(d ); 8(b ); 9(b ); 10(c )

Chapter –III Demand Analysis

1 (b ); 2(a ); 3(b ); 4(b ); 5(c ); 6(d ); 7(a ); 8(b ); 9(c ); 10(b )

Chapter –IV Cost Analysis

1 (b ); 2(a ); 3(a ); 4(c ); 5(a ); 6(b ); 7(c ); 8(a ); 9(b ); 10(a )

Chapter –V Production Analysis

1 (c ); 2(b ); 3(b ); 4(b ); 5(a ); 6(d ); 7(a ); 8(d ); 9(c ); 10(b )

127

Chapter –VI Pricing Policy of the Firm

1 (b ); 2(c ); 3(c ); 4(b ); 5(b ); 6(b ); 7(a ); 8(d ); 9(c ); 10(a )

Chapter –VII Objectives of the firm

1 (b ); 2(b ); 3(b ); 4(d ); 5(d ); 6(b ); 7(a ); 8(b ); 9(b ); 10(b )

Chapter –VIII Market Structure

1 (c ); 2(b ); 3(a ); 4(d ); 5(a ); 6(b ); 7(c ); 8(b ); 9(c ); 10(c )

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