Managerial-Economics-munotes

Page 1

1 1

INTRODUCTION TO MANAGERIAL
ECONOMICS
Unit Structure
1.1 Scope and Meaning
1.2 Methods of Managerial Economics
1.3 Dominic Salvatore Model of Application Economics to business
decision making
1.4 Scarcity, Choice a nd Production possibility Curve
1.5 Summ ary
1.6 Questions
1.7 References
1.0 OBJECTIVES
 To study the scope and meaning of Managerial economics
 To understand various methods of managerial economics which
organizations use
 To understand the Dominic Salvatore Model of Application
Economics to busin ess decision making
 To understand the problem of scarcity and usefulness of production
possibility curve
1.1 SCOPE AND MEANING
Economics can be explained as the study of optimum resource allocation
to meet demands. It deals with the following questions. Wh at to produce?
How to produce? How to distribute? In other words, the production,
consumption and distribution of goods. It also deals with the utilization
and availability of resources which are mostly scarce in the environment.
Hence the above questions are difficult to answer. Therefore, decisions
regarding the utilization of resources that are scarce have to be taken
carefully. Economics provides the methodology to answer these
fundamental questions. Economics examines in detail the action of
individual decision -making firms, organisations or economy which
contribute to the forces of demand and supply. munotes.in

Page 2

Managerial Economics

2 Managerial economics on the other hand explains the use of economic
methods in order to make decisions. Managerial decision making is an
important part of Managerial Economics. It is primarily science applied to
the decision -making process.
The decision -making process is faced by individuals as consumers and
producers along with the economy as a whole. Whether you are the owner
of a small company or the cha irman of a large global organisation, or a
non-profit organization, Managers in these respective Institutions must
understand the market forces which create opportunities as well as
problems for running businesses.
1.2 METHODS OF MANAGERIAL ECONOMICS
In or der to be in a posi tion of ideal decision making, a firm must utilize
various methods and techniques to solve business problems.
Following are some methods that organisations need to evaluate as per
situations that apply to their respective business.
1. The S cientific Method or Experimental Method
This method is concerned with observed fact which are classified in a
systematic manner,and which includes trusted method for the discovery of
accurate information. It is amode of examination by which scientific and
systematic information is arrived at. Scientific method alone can bring
about confirmation in the validity and reliability of conclusions because it
concentrates on controlled experi ments and studies the behaviour of
different elements in a very simplifie d environment.
The experimental method may be usefully applied to those aspects of
managerial decision making that call for accurate and logical thinking. But
sometimes the experimental methods are of limited use to managerial
economics as the economist ca nnot apply experimental methods to the
same level and in the same way as a physicist can in physical sciences.
The above method is of limited use because it is difficult to carry out
experiments to test the validity of managerial behaviour, as it deals wit h
human aspects &behaviour which is complex and extremely difficult to
measure.
2. The Statistical Method.
Statistical method is a mechanical process especially designed to facilitate
the analysis of the large amounts of quantitative data. Through this
method , the data is classified, tabulated, compared, correlated and then
finally interpreted to support decision making.
The aim of statistical method is to facilitate comparison, study
relationships between the two phenomena and to understand the
complicated da ta for the purpose of analysis Many a time comparison
must be made between the changes and the results which are due to the
changes in time, frequency of occurrence, and many other factors. munotes.in

Page 3

Introduction to Managerial
Economics
3 Statistical methods are used for such comparison among past, prese nt and
future estimates.
Statistical approach is useful for the study of manage ment, economics, etc.
and it is very helpful to different sectors like bankers,planners,
speculators, researchers, etc. Though statistical methods are crucial to
managerial ec onomics, they should be used with care. Statistical method
helps us to seek regularities and patterns in economic data and allows us to
arrive at generalizations that cannot be reached by any other method.
3. Method of Intellectual Experiment
The basic proble m in managerial economics is to find out the nature of
any relationship between different variables such as cost, price and output.
The real world is also equally complex. It is influenced by many factors
such as physical, social, temperamental and psychol ogical. It is difficult to
locate any order, sequence or law in such a confused and complex
structure. Hence it is essential for the managerial economist to consult in
model building.
At times, to analyse behaviour we use various models. A model may be in
the form of diagram, a verbal description or a mathematical description.
Since they are an approximate representation of reality, they help us in
understanding the different forces of the complex world of reality through
estimation. Model building is more useful in mana gerial economics, as it
helps us to know the actual socio -economic relationship existing in a firm.
4. The Method of Simulation
This method is an extension of the intellectual experiment. This method
has gained popularity with the devel opment of technology, computer
software and hardware, and other similar equipment along with internet
services. We can programme a complex system of relationship with the
help of this method. Computer is not only used for scientific or
mathematical applications, but it may also be used for some business
applications, docu ment generations and graphical solutions.
A manager must take numerous decisions in the management of business
which may be small or large, simple or complex. They must ensure that
once the deci sion is taken, it is to be implemented within the minimum
time, cost and resources The existing technology will help the manager to
understand busi ness problems in a better manner and increase his ability to
solve the business problems facing him in the m anagement of business
activities.
5. The Descriptive Method
This method is simple and easily applicable to different business
problems, especially those problems existing in developing countries. It is
a fact -finding method related mainly to the present and b asic overviews
through the cross -sectional study of the present situation. munotes.in

Page 4

Managerial Economics

4 This method is mainly concerned with the collection of data and to some
extent, the descriptive method is also concerned with the interpretation of
data. In order to apply the descr iptive method, the data should be accurate,
fair and quantifiable to some extent
Since the descriptive method relates to the cause and the effect of the
collected facts, it is necessary for it to make comparisons between one
situation with the other and am ong different aspects of the same situation.
Thus, situational comparability is an important element of this method.
1.3 DOMINIC SALVATORE MODEL OF APPLICATION
ECONOMICS TO BUSINESS DECISION MAKING

Fig. 1.1
FIGURE 1: The Nature of Managerial Economics Managerial
economics refers to the application of economic theory and decision
science tools to find th e optimal solution to managerial decision problems.
The above figure shows us how decision problems can be solved in
different ways. An organization can solve its management decision
problems by the applying The Economic Theory and the tools of Decision
Science.
Microeconomics and Macroeconomics come under the purview of
Economic Theory. Microeconomics is the study of the economic
behaviour of an individual decision -making unit. For example, business
firms and owners, individual customers, small or medium enterprises etc.
Whereas macroeconomics is the study of the total level of output, income,
employment, consumption, investment, prices, all the above with regards
to economy is viewed as a whole.
Even though the microeconomics theory is the most importan t factor in
managerial economics, the macroeconomics factors of an economy such
as the total demand in an economy, rate of inflation, general interest rates
existing in the markets are also important. This is because a business or an munotes.in

Page 5

Introduction to Managerial
Economics
5 organization operates within such micro and macro factors and business
decisions must be taken by considering all these important elements in
order to make a sound assessment. Hence different Economic Theories
usually begin with a model that is tried and tested. These models mu st be
studied in order to apply its theory. Important details must be identified
from these models. For example, the theory of the firm assumes that the
firm seeks to maximise its business profits and based on which it takes
decisions on how much to produc e, what is the market structure how many
resources to allocate. While the firm may have many other aims, profit
maximisation model correctly predicts the behaviour of firms and
therefore we accept the model. Hence the methodology of economics is to
accept a theory or a model if it predicts correctly and if the predictions
follow logically from the assumptions.
Just as Managerial Economics is closely related to Economic theories, it is
also linked to Economic Sciences. Here the various tools of mathematical
economics and econometrics are used. They help to construct and estimate
decision models aimed at determining the optimal performance of the
firm, in other words, how the firm can achieve its goals in the most
efficient manner. To do this, mathematical eq uations are used to formalize
the economic models proposed by various economic theory. Econometrics
applies statistical tools to real world data to help estimate theories for
forecasting. In simple terms with the help of various economic theories
and scien tific and mathematical calculations, managers are in sound
positions to make suitable decisions for their organisations. This creates a
situation of optimal solution to managerial decision problems.
For example, economic theory suggests that the quantity demanded ( Q) of
a commodity is a function of or depends on the price of the commodity
(P), the income of consumers ( Y), and the price of related (i.e.,
complementary and substitute) commodities ( PC and PS, respectively).
Assuming constant tastes, we may s uggest the following formal
mathematical model:
Q = f(P, Y, P P)
By collecting data on Q, P, Y, PC, and PS for a particular commodity, we
can then estimate the econometric relationship. This will permit the firm to
determine how much Q would change by a change in P, Y, PC, and PS,
and to forecast the future demand for the commodity. This information is
essential for management to achieve the goal or objective of profit
maximisation for the firm in the most efficient manner. To conclude,
managerial economi cs refers to the application of economic theory and
decision science tools to find the optimal solution to managerial decision
problems.

munotes.in

Page 6

Managerial Economics

6 1.4 SCARCITY, CHOICE A ND PRODUCTION
POSSIBILITY CURVE
Scarcity and Choice.
Economics is fundamentally about scarcity and choice. Choosing how to
allocate limited resources to each area of a business is a crucial decision -
making process. The choice is the decision made by managers and
organisations after careful evaluation of resources and alternatives and
expected conse quences after such allocation, both for present and future.
Meaning of Scarcity
The basic meaning of Scarcity is lack of supply. In economics it refers to
when the demand of a resource, product or service is greater than its
available supply.
Every Economi c civilisation faces the problem of allocation of resources
which are insufficient to meet the overall demand. They must use these
resources in such a way that the best welfare of the society is taken into
consideration. The economists are forced to decide how best to assign the
resources in the best possible manner so that the society continues to
operate in a peaceful and practical manner.
Concept of Scarcity
1. A scarcity of resources arises when the resources or means to fulfil an
end are either limited or costly.
2. Scarcity is an economic problem. It calls for the economic allocation
of scarce resources to fulfil unlimited wants or needs.
3. Free natural resources could also become scarce resources due to the
additional costs of obtaining them and consuming t hem. Scarcity also
arises in the case of an increase in demand of a product or a service in
comparison to its availability in the market.
4. In simple terms, money and time are among the most scarce resources.
People have too little of time, money, or both. P eople who have little
or no work would have abundant time, but little money to pay for their
basic necessities. People who have professionally demanding jobs
might have enough earnings for retirement, but yet insufficient time to
eat and rest or for entert ainment.
5. Scarcity of a commodity or resource is relative to its demand. A
resource which is of no use or not known to the people would not be
scarce even when it is limited in nature.
Production Possibility Curve
The production possibility curve is a graph that shows the different
combinations of the quantities of two goods that can be produced in an
economy at any point of time, subject to limited availability of resources. munotes.in

Page 7

Introduction to Managerial
Economics
7 In other words, this curve shows that if we want to have more of one good,
we must have less of another good due to limited availability of resources.
To understand this concept further we must first understand the concept of
opportunity cost.
Opportunity Cost
It refers to the “opportunity cost” of a resource, that is the value of the
next-highest -valued alternative use of that resource . If, for example, you
spend time and money going to a mall or a restaurant, you cannot spend
that time at home reading a book, and you can't spend the money on
something else. Hence it the value of the nex t best alternative to any
decision you make.

Figure 1.2 above: Production possibi lity curve (PPC)
The PPC curve is graphed as a curve, or an arc. On such a graph, one of
the commodities is shown on the x -axis, while the other is shown on the y -
axis. The entire curve is made up of points at which the two commodities
are being produced i n different amounts, most efficiently using the limited
resources that they require.
The above graph shows the production possibilities frontier for a particular
country’s economy. In this example, the two commodities that that
country produces are food (F ) and clothes (C). (This is, of course, a highly
simplified illustrative view of an economy, just for the purposes of
understanding the production possibility curve.
Point A on the X axis shows the production level of clothes alone in an
economy. Point B o n the Y axis indicates the production level of only food
in the same economy.
Point C on the curve is one possible combination of levels of production
of both food and clothes in the same economy. Point D is another
combination of these production levels ( 50F, 150C. Point E shows
inefficient utilization of resources or unemployed resources, i.e. a case in munotes.in

Page 8

Managerial Economics

8 which the output is less than what it has the potential to produce. Point F
shows an unattainabl e level of production, based on current resources,
which means that it is outside the capac ity of the economy.
If the country wants to produce more food, they must produce fewer
clothes, based on limited resource availability. Likewise, if they want to
produce more clothes, they must produce less food. The government must
assess the opportunity cost of producing more of one or the other. The
graph above demonstrates this trade -off. If this country wants to increase
the production of food from 50 to 75 units, this requires sacrificing the
production of 50 units of clothes. And if this country wa nts to increase the
production of clothes from 100 to 150 units, they must sacrifice the
production of 25 units of food.
An outward shift of the production possibilities frontier is only possible if
the country discovers new resources or there is an improv ement in
technological development. Furthermore, an inward shift is also possible.
This can happen if there is a natural or human -made disaster, like a
hurricane destroying a factory and machinery.
Assumptions to the PPC curve
The PPC curve assumes that on e commodity’s production must decrease
to allow the increased production of another commodity. The curve studies
the combination of only two goods or services. While plotting the points
on the graph, we assume that all available resources are fully employed
into production and that the technology and production techniques remain
unchanged for the sake of the graph analysis. We also assume that
technology is used efficiently, and the resources are fixed and unchanged.
Importance of the PPC curve
As available resources of an economy are always limited in nature, The
PPS curve helps to decide the commodities most beneficial to the
economy. The curve helps in determining what quantity of goods should
be produced, among different available alternatives.
1.5 SUMMAR Y
1. Managerial decision making is an important part of Managerial
Economics. It is primarily science applied to the decision -making
process.
2. In order to be in a posi tion of ideal decision making, a firm must utilize
various methods and techniques to so lve business problems.
3. The Scientific method or Experimental method is concerned with
observed fact which are classified in a systematic manner, and which
includes trusted method for the discovery of accurate information.
4. Statistical method is a mech anical process especially designed to
facilitate the analysis of the large amounts of quantitative data. munotes.in

Page 9

Introduction to Managerial
Economics
9 Through this method, the data is classified, tabulated, compared,
correlated and then finally interpreted to support decision making.
5. Model building is more useful in mana gerial economics, as it helps us
to know the actual socio -economic relationship existing in a firm.
6. The Simulation method is an extension of the intellectual experiment.
We can programme a complex system of relationship with the help of
this method.
7. The Descriptive method is simple and easily applicable to different
business problems, especially those problems existing in developing
countries. It is a fact -finding method related mainly to the present and
basic overviews throug h the cross -sectional study of the present
situation.
8. According to Dominic Salvatore, a n organization can solve its
management decision problems by the applying The Economic Theory
and the tools of Decision Science.
9. The basic meaning of Scarcity is lack of supply. In economics it refers
to when the demand of a resource, product or service is greater than its
available supply.
10. The production possibility curve is a graph that shows the different
combinations of the quantities of two goods that can be producedin an
economy at any point of time, subject to limited availability of
resources.
1.6 QUESTIONS
1. Explain the meaning and scope of managerial economics.
2. What are the various managerial methods organizations use to solve
their business problems?
3. Explain the Salvatore’s model in business decision making.
4. Discuss the production possibility curve in relation to scarcity of
resources.
1.7 REFERENCES
 Managerial Economics Principles and Worldwide Applications
EIGHTH EDITION Dominick Salvatore Distinguished Professor of
Economics and Business Fordham University Siddhartha K. Rastogi
Associate Professor (Economics) Indian Inst itute of Management,
Indore
 Managerial economics D.D. Chaturvedi, S.L. Gupta
 Intelligenteconomist.com
 munotes.in

Page 10

10 2
CONSUMER BEHAVIOR - I

Unit Structure
2.1 Introduction
2.2 Types of Demand
2.3 Factors/Determinants influencing demand
2.4 Demand Function
2.5 Linear demand function & linear demand curve
2.6 Law of demand
2.7 Consumer Surplus
2.8 Summary
2.9 Questions
2.0 OBJECTIVES
 To study different types of demand
 To understand the factors determinants of demand
 To understand the concept of demand function
 To understand the difference between linear dem and function and
linear demand curve
 To study the Law of demand
 To study the concept of Consumer’s surplus
2.1 INTRODUCTION
Demand is the number of individuals that are willing and able to purchase
things at a variety of prices throughout a particular time period. Demand
for any item indicates customers' desire to get the product, as well as their
willingness and capacity to pay for it.
The consumer's demand for a particular commodity is determined by its
price, the prices of related commodit ies, the income of consumer, and
their likes and preferences. When one or more of these factors changes, it
is probable that the amount of the product purchased by the customer will
vary as well. If other products' pricing, the consumer's income, and their munotes.in

Page 11

Consumer Behavior - I

11 likes and preferences stay constant, the quantity of a commodity that the
consumer ideally purchases becomes entirely reliant on its price. The
demand function is the relationship between a consumer's optimum
quantity selection and the price of an item. A desire that is accompanied
with a willingness to acquire and the capacity to pay is called as Demand.
Demand = Desire + Willingness + Ability
Demand Definition:
According to Benham “the demand for anything at a given price is the
amount of it, which will be bought per unit of time at that price”
In ordinary terminology, demand refers to a desire. Desire is a strong drive
for something. Demand in economics refers t o a desire that is
accompanied with a willingness and capacity to pay.
2.2 TYPES OF DEMAND
Demand is often categorised according to a set of attributes, including the
type of the product, its actual use, the population of users, and the
suppliers of the go ods. Demand for a certain product varies according on
circumstance. As a result, businesses should be certain about the sort of
demand for their goods.
The following paragraphs describe the many types of demand.
i. Individual and Market Demand:
This term r efers to the categorization of a product's demand according to
the numbers of customers in the market. Individual demand is defined as
the quantity desired by an individual for a product at a certain price and
time period. For instance, Mr. A requires 100 units of a product at a price
of Rs. 12 per unit over the period of a week.
Individual demand for a product is determined by the product's pricing,
the customer's income, and the consumer's tastes and preferences. On the
other hand, market demand is define d as the quantity demanded for a
commodity by all individuals at a certain price and time.In basic words,
market demand is the total of the individual demands of all customers over
a certain time period and at a specified price, assuming that all other
variables remain constant.
For instance, there are three wheat customers utilising monthly 10 Kgs, 20
Kgs and 30 Kgs of wheat respectively. Through this it can be said that the
monthly market demand for wheat is 60 Kgs.
ii. Firm and Industry Demand:
This t erm refers to the market -based categorisation of demand. The desire
for a firm's product at a certain price during a specified time period is
referred to as firm demand. For instance, Suzuki automobiles are in high
demand therefore it is firm demand. The a ggregate amount of all firms' munotes.in

Page 12

Managerial Economics

12 demand for items within a certain industry is referred to as industry
demand.For instance, in India, the demand for automobiles from different
brands such as Mahindra, Maruti, Honda represents the industry's
demand.
iii. Dire ct and Derived Demand:
It involves categorization of demand according to its dependence on other
items. Direct demand or Autonomous demand refers to desire for a
product that is unrelated to the demand for other items. The autonomous
demand occu rs as a res ult of an individual ’s internal desire to consume the
goods.
For instance, demand for food, housing, clothing, and automobiles is
direct demand, since it originates as a result of customers' biological,
physical, and other human requirements. By contrast, derived demand is
the desire for a product that comes as a result of the demand for other
items. Also in example of demand for petrol, diesel, and other lubricants is
dependent on vehicle demand. Apart from that, raw material demand is
derived, since it is based on the manufacturing of other goods.
Additionally, demand for alternatives and complementing items is
generated.
iv. Perishable and Durable Goods Demand:
This term refers to the categorisation of demand according to the way
things are used. The comm odities are classified as perishable or durable.
Perishable or non -durable items are those that are intended for a single
usage. For instance, cement, coal, gasoline, and food. Durable products,
on the other hand, are those that may be used again.
For inst ance, clothing, shoes, machinery, and structures. Individuals'
immediate needs are met by perishable commodities. However, durable
products meet both current and future consumer need. As a result, buyers
choose sturdy things based on their durability. Addi tionally, durable items
need replacement due to their continued usage. Demand for perishable
items is very volatile and is determined by current prices of commodities
and consumers' income, tastes, and preferences, while demand for durable
goods is more st able over time.
v. Demand in the Short and Long Term:
This term refers to the categorization of demand by time period. Short -
term demand refers to the desire for items that are intended to be utilised
for a short period of time or in the immediate future. This demand is
contingent upon customers' present tastes and preferences.
For instance, demand for umbrellas, raincoats, sweaters, and long boots is
cyclical in nature. Long -term demand, on the other hand, refers to the
desire for things over a longer time period. Durable things, in general,
have a long life. The long -term demand for a product is determined by a
variety of variables, including technological advancements, th e nature of munotes.in

Page 13

Consumer Behavior - I

13 competition, promotional efforts, and the availability of replacements. A
company's ability to create a new product requires an understanding of
both short - and long -term demand ideas.
2.3 FACTORS/ DETERMINANTS INFLUENCING
DEMAND
The price of an item, its perceived quality, advertising, income, consumer
confidence, and changes in taste and fashion all influence demand for that
commodity.
We may examine either an individual demand curve or the economy's
overall demand.
• The individual demand curv e depicts how much individuals are willing
to pay for a certain amount of a product.
• The total of all individual demand curves will be the market demand
curve. It depicts the amount of an item that customers want to purchase
at various prices.
1. Price a s a factor leading to movements in demand curve:
A movement in the Demand Curve is caused by a price fluctuation. Price
has a greater impact on certain commodities than on others.
• When the price of sugar rises and since it is a necessity good, demand
falls only to a little extent. Hence it can be said as having inelastic
demand.
• When the price of a specific brand of softdrinkrises, there will be a major
drop in its demand as consumers will opt for its cheaper alternatives,
here the demand is called as e lastic.

Fig. 2.1
In the above diagram, when the original price was P 1, the demand of the
commodity was Q 1. As the prices rises from P 1 to P 2, the demand falls munotes.in

Page 14

Managerial Economics

14 from Q 1 to Q 2. The combinations of these two move ments give us the
demand curve which is downward sloping from left to right. There exists
only one demand curve on which the movements take place due to change
in price.
2. Non -price factors leading to shifts in demand curves:
This happens when buyers are willing to purchase a smaller or larger
quantity of goods for the same price. This change in demand occurs due to
changes in other factors apart from price or non -price factors.

Fig. 2.2
In the above diagram, when the original price was P, the demand of the
commodity was Q 0. As there occur changes in non -prices factors like
income, the demand increases from Q 0 to Q 1. Thus resulting to this
change, a new demand curve is drawn D’ which shows the shift in the
demand curve. The shift in the demand curve is due to the change in other
non-price factors. There exist two demand curves through which the
shiftcan be shown.
The demand curve might move to the right (or left) due to variety of
reasons:
1. Income - Consumers will be able to purchase more things as their
disposable income rises. Better earnings might be the result of a
multitude of factors, including higher salar ies and fewer taxes.
2. Credit options - If borrowing is simpler and less costly, people may be
enticed to purchase expensive products on credit, such as vehicles and
international vacations.
3. Quality - People are more likely to purchase something if the quality of
it improves, such as higher quality digital cameras.
4. Advertising may promote brand loyalty and demand for products. Coca -
Cola, for example, has grown worldwide sales by increasing its
advertising budget. munotes.in

Page 15

Consumer Behavior - I

15 5. Substitutes - An increase in the p rice of replacements, for example, if
the price of Samsung mobile phones rises, demand for Apple iPhones,
a key Samsung alternative, would rise as well.
6. Complements - The demand for complements will grow if the price of
complements falls. For example, l owering the price of the Play Station
2 will boost demand for compatible Play Station games.
7. Weather - During the winter, there will be a higher need for fuel and
warm clothing.
8. Expected price hikes in the future - A commodity such as gold may be
purchased for speculative purposes; if you believe it will rise in value
in the future, you will buy today.
9. Circumstances change - The Covid shutdown of 2020/21 resulted in a
huge drop in demand for leisure activities like as going to the movies,
but also resulted in a surge in demand for electronic items such as
televisions and Netflix subscriptions.
10. Economic cycle - Even if their income is stable, consumers will cut
down on spending during a recession. Because they are afraid of losing
their jobs, the y will adopt a risk -averse stance and cut down on their
expenditures. In an economic boom, confidence will be strong, and
earnings will rise, resulting in increased demand.
11. Wealth -effect - Households will be more inclined to spend if their
wealth incre ases (for example, if housing prices rise). This is due to
the fact that they may re -mortgage their home to get equity withdrawal
and/or because they will have greater confidence as a result of having
more assets.
2.4 DEMA ND FUNCTION
The relationship betwe en quantity demanded of a good and the
determinants influencing its demand can be expressed through a
mathematical function called as demand function.
Qdx = f (Px, Py, Y, T, A, N, E, O)
Where,
Qdx = Quantity demanded of a commodity X
Px = Price of the commodity X
Py = Price of related (Substitute or complementary) goods
Y = Income level
T = Tastes and preferences
A = Advertising
N = Population (Market size)
E = Expectations about future prices
O = other factors munotes.in

Page 16

Managerial Economics

16 2.5 LINEAR DEMAN D FUNCTION &LINEAR DEMAND
CURVE
A linear demand curve is a line that depicts the connection between a
product's or service's demand and its price. Everyone understands that
sales are related to price: the higher the price, the fewer items you can
anticipat e to sell. If you sell a product and have altered the price at least
once, you could theoretically use a linear demand curve to determine the
approximate number of units you could sell if the price were modified.
Simply plot the price on the y -axis (up and down) and the amount sold on
the x -axis (left to right), and then draw a line between both points on the
graph.

Fig. 2.3
The demand curve for the majority of goods is a downward sloping line ,
illustrating the inversely proportionate connection between price and
demand — the higher the price, the fewer things you sell. Occasionally,
the curve may flatten, indicating that any increase in price beyond a
certain point decreases demand to zero. Ac cording to Columbia
University, this is referred to as a horizontal demand curve, and it may
occur when customers can get the same product from a different source at
a cheaper price.
A vertical demand curve is also feasible; in this instance, regardless of the
price, the amount sold stays constant. These are uncommon, but may
contain life -saving medications. As long as people can afford the price you
charge, they will pay whatever amount is necessary.
Demand Function in Linear Form:
A function is a mathemat ical statement that expresses a connection
between two or more variables and has a cause and effect link. Similarly,
the word "demand function" emphasizes the relationship between the
quantity demanded (dependent variable) and the factors that influence
product demand (independent variables). In other words, the demand
function expresses the effect of numerous demand variables on the desire
for a product, such as price, customer income and habits, and level of life. munotes.in

Page 17

Consumer Behavior - I

17 A linear demand function is an algebraic expression that may be used to
calculate demand curves without drawing a demand function graph. It
refers to the demand function in which, regardless of the level of the
dependent variable, the change in the dependent variable is constant for a
unit change in the independent variable. In the short run, the demand
function expresses the connection between aggregate demand for a
product and its price, while maintaining the other demand determinants
constant. In the long run, however, a demand function demonst rates a link
between a product's aggregate demand and a variety of demand variables,
such as price, consumer income, standard of living, and price of
alternatives.
The demand function in case of short run will be;
DX = f(P X)
where,
DX represents dependent variable
Pxrepresents independent variable
f indicates functional relationship
The above equation indicates that quantity demanded (Dx) is a function of
price (Px) for product X. This asserts that if the price of product X
changes, the demand for product X will likewise vary. The demand
function, on the other hand, does not interpret the amount of change in
demand caused by a change in the price of the product.
The mathematical equation can be used to understand the quantitative
relationship between demand and price. Although there is no standard
method to express a demand function, they often have the form;
Qd = a – b(P)
where,
P is the price
Qd denotes the quantity demanded
a denotes external variables influencing demand other than price and
b denotes the slope of the demand curve i.e it indicates how the price
influences the qua ntity demanded.
Fox instance, the value of a is given as 200 and that of b is 10, with these
values the demand equation can be written as;
Qd = 200 – 10(P) which can be further simplified with the help of
following illustration.
munotes.in

Page 18

Managerial Economics

18 Price (P) Demand equation i s given
as,
Qd = 200 – 10(P) Quantity Demanded
Qd
1 Qd = 200 – 10 (1) 190
2 Qd = 200 – 10 (2) 180
3 Qd = 200 – 10 (3) 170
4 Qd = 200 – 10 (4) 160

Qd = a – b(P) is a helpful function for estimating demand as and when
there is a change in the price. According to EconomicsHelp.org, if one
need to determine the price in order to attain a certain quantity desired,
then the following formula can be used;
P = a - b(Q d),
where "a" is the intercept at price zero and "b" indicating the slope of the
demand curve.
2.6 LAW OF DEMAND
The relationship between the quantity demanded and the price of a
commodity is described by the law of demand. It argues that when the
price of a product rises, so does its demand, while the other factors remain
constant. As a result, there exists an inverse relationship between a
commodity's price and its quantity demanded.
“The greater the amount to be sold, the smaller must be the price a t which
it is offered in order that it may find purchasers; or in other words, the
amount demanded increases with a fall in price and diminishes with a rise
in price” -Marshall .
According to Robertson, “Other things being equal, the lower the price at
which a thing is offered, the more a man will be prepared to buy it.”
According to Ferguson, “Law of Demand, the quantity demanded varies
inversely with price.”
The law of demand explains the relationship between demand and the
price of the commodity. It states that price influences the demand of a
product hence price is a dependent variable and demand is an independent
variable which can be seen from the following function;
Dx = f(P x)
where,
Dx represents demand of a commodity X
Pxrepresents price of a commodity X
f indicates functional relationship munotes.in

Page 19

Consumer Behavior - I

19 Other demand factors (apart from price) should be held constant in the law
of demand, since demand is sensitive to a variety of effects. Allowing all
variables to change simultaneously may work against the la w. Certain
notions, such as demand schedule, demand curve, and demand function,
may assist in learning the law of demand.
Demand Schedule :
A demand schedule is a table that illustrates the relation between price and
quantity demanded. It represents the am ount of a product that a person or a
group of people want at a specific price and time.

Fig. 2.4
1. Individual Demand Schedule:
The individual demand schedule is the tabular representation of all the
units of a com modity demanded at various prices and time period.
Price of a commodity (Rs.
per unit) Quantity Demanded (Monthly units
requirement)
10 65
20 55
30 45
40 35
50 25

Individual demand curve illustrate the influence of changing prices on
consumers' purchasing behaviour, rather than on the overall demand for a
product. It shows the gap in demand by contrasting the product's pricing.
Additionally, it indicates that when p rices rise, the quantity demanded
decreases and vice versa.
2. Market Demand Schedule:
An aggregate amount required by people at various prices and times is
shown in a table called a market demand schedule. As a result, it indicates
the market's desire for a product at various price points. Individual
demand schedules may be aggregated to create the market demand
schedule. munotes.in

Page 20

Managerial Economics

20 Price of a
commodity
(Rs. per
unit) Individual
Quantity
Demanded
by A
(Monthly
units
requirement) Individual
Quantity
Demanded
by B
(Monthly
units
requirement) Individual
Quantity
Demanded
by C
(Monthly
units
requirement) Market
Demand
(Monthly
units
requirement) 10 6 9 5 20
20 5 8 4 17
30 4 7 3 14
40 3 6 2 11
50 2 5 1 8

Thus the market demand schedule was derived by adding all the individual
demand schedules. There exists an inverse relation between Market
demand schedule and price of a commodity.
Demand Curve:
The demand curve illustrates the demand schedule graphically . It is
created by graphing the price and quantity demanded. On a demand curve,
the Y -axis represents the price, while the X -axis indicates the quantity
demanded. R.G Lipsey described demand curve as "the curve which
shows the relationship between the pric e of a commodity and the amount
of that commodity the consumer wishes to purchase is called Demand
Curve."
Individual demand curves and market demand curves are two distinct
forms of demand curves. Individual demand curves are used to illustrate
individual demand schedules, while market demand curves are used to
illustrate market demand schedules.

Fig. 2.5
Individual Demand Curve munotes.in

Page 21

Consumer Behavior - I

21 In the above figure DD curve shows the in verse relationship between price
and quantity demanded at different price levels. By joining various
combinations the DD curve has been obtained which is termed as the
individual demand curve.

Fig. 2.6
Market Demand Curve
Assumptions in the Law of Demand:
The law of demand examines the relationship between changes in demand
and changes in price. In other words, the law of demand's central premise
is that it examines the influence of price on the demand for a product
while m aintaining other demand determinants constant.
However, some assumptions underpin the law of demand, including the
following:
i. Assumes constant consumer income. When an individual's income
improves, his or her desire for items increases as well, this vio lates the
law of demand. As a result, the consumer's income should remain
stable.
ii. Assumes that the consumer's tastes stay constant.
iii. Believes that fashion does not change, since if it did, consumers would
stop purchasing out -of-style things.
iv. As sumes no change in the population's age structure, size, or gender
ratio. This is because as the population grows, the number of
purchasers rises, thus affecting the demand for a product.
v. Restrains innovation and new product variants on the market, whic h
may have an effect on demand for the present product.
vi. Restrains changes in the income distribution.
vii. Prevents any change in the fiscal policies of a nation's government that
would decrease the influence of taxes on product demand.
Apart from thes e factors, the rule of demand presupposes that the universe
is static and that individuals consume items at a set pace and price in the
market. These assumptions no longer hold true in a changing environment.
munotes.in

Page 22

Managerial Economics

22 Exception to the Demand Law:
Until now, we have established that there is an inverse connection between
a product's demand and price. According to the universal rule of demand,
a rise in the price of a product reduces demand for that commodity, and
vice versa. However, there are certa in cases where a decrease in price
results in a decrease in demand, while an increase in price results in an
increase in demand. This is a paradoxical scenario and is seen as an
exception to the rule of demand. In plain terms, an exception to the rule of
demand refers to circumstances in which the law of demand does not
apply. When exceptions occur, the demand curve has an upward slope and
is referred to as the unusual demand curve.
1. The Giffen Paradox:
This is one of the most significant criticisms of th e law of demand. The
Giffe n Paradox was coined by Sir Robert Giffen, who divided products
into two categories: poor goods and superior goods, which were together
referred to as Giffen goods. Affordably priced potatoes and vegetable
ghee, for example, are e xamples of inferior items whose demand falls with
a rise in consumer wealth.
Because these commodities are of poor quality, the demand for them
diminishes as a result of an increase in the income of the consumer
population. Aside from that, as long as the high-priced items are of great
quality, the demand for these things will rise as well. For example, coffee
is seen as superior as tea, while tea is regarded as inferior to coffee. In the
event that the price of any of these commodities rises, customers wil l raise
their demand for tea in order to meet their needs while still paying the
same amount.
2. Products that are believed to be necessary for the consumer are referred
to as " necessity products ." The demand for necessities does not grow or
decrease in re sponse to an increase or reduction in the price of such
necessities. Example: Salt is a need good whose use cannot be raised if the
price of salt lowers in the marketplace. Consequently, in such a situation,
the rule of demand does not apply.
3. Prestige C ommodities : These are goods that are believed to be a
prestige symbol, such as diamonds, among other things. The demand for
these commodities stays constant regardless of whether their prices are
raised or lowered. There is no application of the law of dem and in this
situation.
4. In this context, speculation refers to a consumer's expectation about
how the price of a product will vary in the future. If the price of a product
is predicted to grow in the future, then the demand for the commodity rises
in the current condition, which is in contravention of the law of supply and
demand.
5. Customers who are psychologically biased : This is an example of one
of the most significant exceptions to the law of demand. Customers' views munotes.in

Page 23

Consumer Behavior - I

23 of the pricing of a goods vary d epending on the product. A common
misconception among buyers is that a cheap price indicates poor quality of
a certain item. However, this is not always the case. The demand for a
product naturally reduces as the price of a product falls, as a result of th is.
6. Brand Loyalty : This refers to a consumer's preference for a certain
brand above other brands. In response to a rise in the price of a particular
brand, consumers are less likely to switch. For example, if a customer
liked to wear Levi's jeans, he wo uld continue to buy them regardless of if
the price of Levi's pants increased. The law of supply and demand cannot
be applied in such a circumstance.
7. A scenario in which the law of demand is not applicable is referred to as
a "emergency situation ." A sh ortage and uncertainty in the supply of
commodities are common in times of crisis such as war and natural
disasters such as floods and earthquakes. Consumers, under such
circumstances, prefer to stockpile a huge number of items, regardless of
the cost at w hich they are sold.
2.7 CONSUMER SURPLUS
When a consumer purchases an item, his surplus is the difference between
the price he pays for that thing and the amount he would be prepared to
pay if he had to go without it. When the price that consumers pay for a
product or service is less than the price that they are willing to pay, this is
referred to as a consumer surplus. In other words, it is a measure of the
extra advantage that customers obtain as a result of paying less for
something than they would have been prepared to pay otherwise. It is
based on t he economic theory of marginal utility, which states that
consumer surplus refers to the extra pleasure a customer obtains by
purchasing one more unit of an item or service. Depending on an
individual's unique preferences, the utility a product or service offers will
differ from one person to the next. The region between the equilibrium
price and the demand curve on a supply and demand curve is known as the
demand curve.
Consumer surplus is defined as the area below the downward -sloping
demand curve, or the amount a consumer is willing to spend for given
quantities of a good, but above the actual market price of the good, as
depicted by a horizontal line drawn between the y -axis and the demand
curve on a graph of consumer surplus. It is possible to compute c onsumer
surplus on either an individual or aggregate basis, depending on whether
the demand curve is individual or aggregated in nature. Consumer surplus
always grows when the price of a thing lowers, and it always decreases
when the price of a good goes u p. munotes.in

Page 24

Managerial Economics

24

Fig. 2.7
Is it possible for businesses to minimise consumer surplus?
1. If a firm has market power, it has the ability to minimise consumer
excess. As a result, they are able to increase prices beyond the level of
competitive equilibrium. A monopoly allows a company to maximise
revenues by minimising consumer surplus.
2. Engaging in price discrimination is another method of reducing
consumer excess. Consumers from various demog raphics are charged
varying costs. Inelastic demand will cause the consumer surplus of those
who have it to be decreased. Customer surplus cannot be totally eliminated
without first -degree price discrimination on the part of the company,
which entails char ging the consumer the highest price they are willing to
pay.
3. In order to develop market dominance, a company may promote in
order to build brand loyalty, which would cause demand to become more
inelastic.
What is the relevance of the consumer surplus in today's world?
• In competitive marketplaces, corporations are required to maintain prices
as low as possible in order to allo w consumers to accumulate consumer
surplus. In the absence of competition in markets, the consumer surplus
would be less and inequality would be larger.
• A decrease in consumer surplus leads to an increase in producer surplus
and an increase in inequality .
• A decrease in consumer surplus allows consumers to buy a broader
variety of items.
2.7 SUMMARY
Demand is the number of individuals that are willing and able to purchase
things at a variety of prices throughout a particular time period. A linear
demand curve is a line that depicts the connection between a product's or munotes.in

Page 25

Consumer Behavior - I

25 service's demand and its price. The relationship between the quantity
demanded and the price of a commodity is described by the law of
demand. When a consumer purchases an item, his surplu s is the difference
between the price he pays for that thing and the amount he would be
prepared to pay if he had to go without it.
2.8 QUESTIONS
1. What is Demand? Explain its types.
2. What are the various factors affecting demand?
3. Elaborate the linear demand function and linear demand curve.
4. Write in detail the law of demand.
5. Explain the concept of consumer surplus.







munotes.in

Page 26

26 3
CONSUMER BEHAVIOR II

Unit Structure
3.1 Introduction
3.2 Significance of elasticity of demand for businessman
3.3 Types of elasticity of demand
3.4 Demand Forecasting
3.5 Summary
3.6 Questions
3.0 OBJECTIVES
 To understand the significance of the concept of elasticity of demand
for businessmen
 To study various types of elasticity of demand
 To study and understand the significance and methods of demand
forecasting
3.1 INTRODUCTION
From demand function we know that there are various determinant of
demand such as price, income, Promotions, substitute price etc. Quantity
demanded is related to these determinants in various fashions. Law of
demand tells us that relationship between pric e and quantity demanded is
inverse. We could understand the direction of change from law of demand
but we could not know the magnitude of change. E.g. suppose price of
apple increases its quantity demanded would fall.
Now consider a case when we have 500 kgs of apple. On routine basis
apple demand in particular part of Mumbai is 400 kgs at Rs 100 per kg.
Here our stock is 500 kgs and quantity demanded is 400 kgs and if we
want to sell the 500 kgs of apple we know that we want to reduce price of
apples. But how much price to be reduced so as to sell entire 500 kgs is
still not known from law of demand. Here we should have additional
information like pace or rate of change i.e. response of quantity demanded
to respective change in price. Our objective is to s ell 500 kgs of apple then
how much price to be charged so that all 500 kgs of apple could be sold.
The amount is less than 100 but exact amount can be finalized based on munotes.in

Page 27

Consumer Behavior - II

27 data of response of quantity demanded to price. This response is known as
elasticity o f demand.
Demand elasticity is defined as ratio of percentage change in quantity
demanded to percentage change in determinant of demand. It is sensitivity
shown by quantity demanded to changes in variables like price, income ,
promotions and other factors.
3.2 SIGNIFICANCE OF ELASTICITY OF DEMAND FOR
BUSINESSMAN
The firm is engaged in producing or procuring goods and services and
distributing to its customers at profit. Quantity demanded depends on
various factors, few of the factors like price of the produ ct and expenses
on advertising are wit hin control of organization while others such as
income and prices of substitute and competitive products are not within
the control of organization. On account of fluctuations in demand all
aspects can’t be accommodated in production and other functions of
organization but it is necessary to understand the impact on quantity
demanded. The elasticity of demand concepts helps business manager
primarily in making changes in price so as to stimulate demand i n favor of
company.
Fate of any company depends largely on total sale of final product
ensuring revenue generated. Any variations are closely monitored by
manger of firm. From qualitative study of law of demand manager is able
to understand direction of ch ange. From quantitative study of elasticity of
demand manager is able to understand the magnitude of that change. The
quantitative study helps in finding out, if we change price by 10% then
resultant change in to quantity demanded can be 10%, 20% or 5%. Th e
concepts of elasticity of demand addresses this issue and helps business
manger to understand effect of changing factors of demand and its result
on quantity demanded.
Consider an example where there are three 5 star hotels in Kalina Mumbai
offering sim ilar services and similar rates. Hotel A is strategically located
near Mumbai university campus and has higher occupancy of rooms as
compared to rest of two. Here hotel B & C based on their occupancy rates
needs to reduce the rates so as to attract more cu stomers, so the discounts
on room fares are different in Hotel A, B, and C. We can trace similar
situation for pricing of fashion garments differently on different websites
and showrooms. Raymond may offer different discounts at same time for
end of season sale in different showrooms in various cities. Such situation
is very often in almost all business firms due to fluctuations of demand
and inventory level. The revenue and profitability of the firms largely
depends on its pricing strategy. The concept of elasticity of demand helps
business manager to address this issue. It is helpful in determining the
prices so as to increase revenue and profit. It is equally helpful in uplifting
the overall efficiency of organization by promoting the use of
underutilize d resources by reducing price of its goods resulting in to
increased demand. Few organizations with higher capacity and lower munotes.in

Page 28

Managerial Economics

28 market demand as compared to their capacity can plan to reduce the price
so that their sales increase. In case of companies runnin g short of capacity
as compared to market demand, pricing can be increased so that overall
profit can be increased. The price elasticity of demand helps manager in
understanding how much a consumer will move away from the goods and
services when its price increases. From all these examples it is very clear
that the concept of elasticity of demand is highly useful for managers
working in all types of firms. It is equally applicable to product companies
like hp, dell, Sony, LG and service companies like Jio, Airtel, HDFC bank
and Tata play etc.
3.3 TYPES OF ELASTICITY OF DEMAND
As discussed earlier, the elasticity refers to response in quantities
demanded to respective change in determinant of demands. The elasticity
of demand can be calculated for all of its determinants. The major types of
elasticity of demand are as follows,
1. Price elasticity
2. Income Elasticity.
3. Cross Elasticity
4. Promotional Elasticity.
Let us discuss each one of these in details.
3.3.1 Price elasticity of demand .
Amongst all types of elasticity of demand, price elasticity of demand is
crucial and most important as firms do have better control on pricing as
compared to rest of the factors determining demand. Price elasticity of
demand is defined as ratio of percenta ge change in quantities demanded to
percentage change in price. It is generally negative as price and quantity
demanded are inversely proportional to each other. It is given by
expression
=

Here ΔQ - Change in quantity demanded given by Q1 -Q2
ΔP - Change in price, given by P1 -P2
Therefore, Expression for income elasticity can be written as follows,


The price elasticity can be calculated by various methods such as point
method and arc method.
munotes.in

Page 29

Consumer Behavior - II

29 3.3.2 Degree of elasticity
As discussed earlier, elasticity refers to response, it must be understood
that role or utility of e very goods and services is not same. Exactly
according to this consumer response to change in price does not remain
same to all types of goods and services, in addition to this we must
understand that even for same goods or services upon consumption
consum er may behave differently at the different price and consumption
level but this type of response to price change is not as significant as
response based on price based on utility. Similar type of degrees does exist
for all type of elasticity such as Income , elasticity, cross elasticity and
promotional elasticity. For the sake of simplicity we here discuss only
levels of degrees of demand elasticity of price
a) Perfectly Inelastic demand
b) Inelastic demand
c) Unitary elastic demand
d) Elastic demand
e) Perfectly elastic d emand
Let us discuss each of these in detail.
3.3.2.1 Perfectly inelastic demand
This is situation where we make changes in to price but resultant quantity
demanded neither increases nor decreases. This is basically hypothetical
situation. In this situation Ep=0.
We derive this from basic expression of elasticity of demand that is
Price elasticity of Demand = % Change in Quantity demanded / % Change
in price of goods
Here as we know the situation % change in quantity demanded =0
therefore
Ep=0/Px, therefore, Ep=0 where Px - % Change in Price.
This situation can be well understood with t he help of following graph munotes.in

Page 30

Managerial Economics

30

Fig 3.1: Perfectly Inelastic demand
The above graph shows quantity demanded on X axis and price on Y axis,
we may see that demand curve for this situation is straight standing line
representing th ere is no change in quantity demanded irrespective of
changes in to price.
3.3.2.1 Inelastic demand
This is situation where we make changes in to price but resultant changes
in quantity demanded are less than the changes in price of products. We
can trace such situation generally in all need based products such as
medicines, essential food items like rice, salt and sugar where consumers
response to change in price is very low or negligible. In this situation
0sign as negative sign only indicates inverse relationship, here we are more
interested in understanding the response shown and not the direction)
We derive this from basic expression of elasticity of demand that is
Price elasticity of Demand = % Change in Quantity demanded/ % Change
in price of goods
Here as we know the situation % Change in price is more than % change
in quantity demanded
Therefore,
Ep=Qx/Px, Where
Qx- % Change in Quantity Demanded
Px- % Change in Price. e.g. con sider Qx=5% and Px=20%
Here Ep=5/20=0.25 which is less than 1.
Qx< Px therefore Ep<1 munotes.in

Page 31

Consumer Behavior - II

31 This situation can be well understood with the help of following graph

Fig 3.2: Inelastic Demand
The above graph shows quantity demanded on X axis and price on Y axis,
we may see that demand curve for this situation is steeper representing
there is less change in quantity demanded as compared to larger change in
to price.
3.3.2.1 Unitary elastic deman d
This is situation where we make changes in to price and resultant changes
in quantity demanded are exactly same as changes in price of products.
This is basically hypothetical situation. In this situation Ep=1 (we are
considering magnitude of elasticity and not the negative sign as negative
sign only indicates inverse relationship, here we are more interested in
understanding the response shown and not the direction)
We derive this from basic expression of elasticity of demand that is
Price elasticity of Demand = % Change in Quantity demanded/ % Change
in price of goods
Here as we know the situation % Change in price is less than % change in
quantity demanded
Therefore,
Ep=Qx/Px, Where
Qx- % Change in Quantity Demanded
Px- % Change i n Price. e.g. consider Qx=10% and Px=10%
Here Ep=10/10=1 Qx= Px therefore Ep=1
This situation can be well understood with the help of following graph munotes.in

Page 32

Managerial Economics

32

Fig 3.3: Unitary Elastic Demand
The above graph shows quantity demanded o n X axis and price on Y axis,
we may see that demand curve for this situation is exactly 45 degree line
representing there is exactly same change in quantity demanded as
compared to change in to price.
3.3.2.1 Elastic demand
This is situation where we make changes in to price and resultant changes
in quantity demanded are more than changes in price of products. We can
trace such situation generally in all lifestyle products such as motorcycle,
shoes, mobile phones etc, where consumers response to change in price is
more. We may see that end of season sale and other discount offers are
generally made in this category of items. We may also say that most of the
goods under corporate management fall under this category. Industrial
goods popularly known as B2B go ods also follow this type of degree as
even the demand remains constant at industry level; firm may get
additional quotas only with very less discounts. In this situation Ep>1 (we
are considering magnitude of elasticity and not the negative sign as
negativ e sign only indicates inverse relationship, here we are more
interested in understanding the response shown and not the direction)
We derive this from basic expression of elasticity of demand that is
Price elasticity of Demand = % Change in Quantity deman ded/ % Change
in price of goods
Here as we know the situation % Change in price is less than % change in
quantity demanded
Therefore,
Ep=Qx/Px, Where
Qx- % Change in Quantity Demanded
Px- % Change in Price. e.g. consider Qx=5% and Px=20% munotes.in

Page 33

Consumer Behavior - II

33 Here Ep=25/10=2 .5 which is more than 1.
Qx> Px therefore Ep>1
This situation can be well understood with the help of following graph

Fig 3.4: Elastic Demand
The above graph shows quantity demanded on X axis and price on Y axis,
we may see that demand curve for this situation is having less slope and
more flatter representing there is more change in quantity demanded as
compared to lesser change in to price.
3.3.2.1 Perfectly elastic demand
This is situation where we make do not make any changes in to price but
resultant changes in quantity demanded are there even though rest of the
factors are kept constant. This is hypothetical situation. In this situation
Ep=∞
We derive this from basic ex pression of elasticity of demand that is
Price elasticity of Demand = % Change in Quantity demanded/ % Change
in price of goods
Here as we know the situation % Change in price is less than % change in
quantity demanded
Therefore,
Ep=Qx/Px, Where
Qx- % Change in Quantity Demanded
Px- % Change in Price. e.g. consider Qx=5% and Px=0%
Here Ep=5/0= ∞ as anything divided by 0 is ∞ munotes.in

Page 34

Managerial Economics

34 This situation can be well understood with the help of following graph


Fig 3.5 Perfectly Elastic Demand
The above graph shows quantity demanded on X axis and price on Y axis,
we may see that demand curve for this situation is sleeping line
representing there is change in quantit y demanded even if there is no
change in to price.
3.3.3 Price elasticity and revenue
As we know total revenue is given by price multiplied by number of units
sold, TR=P*Q, here we need to add MR and AR. MR is marginal revenue
is calculated as additional r evenue generated for one more unit sold. It is
given by expression MR= ∆TR/ ∆Q. Here Average revenue is given by
total revenue divided by number of units sold. It is given by expression
AR= TR/Q = QP/Q = P average revenue is equal to price. Consider
follow ing tables for supply schedule.
Point P Q TR AR MR
1 10 4 40 10 -
2 9 6 54 9 14
3 8 8 64 8 10
4 7 10 70 7 6
5 6 12 72 6 2
6 5 14 70 5 -2
7 4 16 64 4 -6
Table3.1: Revenue for linier demand curve munotes.in

Page 35

Consumer Behavior - II

35

Fig: 3.6: Linear demand curve and corresponding AR, MR and TR
values
From table 3.1 and graph 3.6 we can conclude that marginal revenue is
highest at the starting but it goes on decreasing and point will come where
marginal revenue falls under negative territory (At price Rs 6 in above
table) total revenue is maximum at this corresponding level (Rs 7 2 in this
case). Total revenue start decreasing beyond this point indicating losses.
Consider following example for perfectly competitive firm
P Q TR AR MR
10 0 0 0 -
10 5 50 10 10
10 10 100 10 10
10 20 200 10 10
10 40 400 10 10

Table 3.2: Revenue for firm in perfectly competitive market munotes.in

Page 36

Managerial Economics

36

Fig 3.7: Horizontal demand curve and corresponding AR, MR and
TR values
From table 3.2 and fi gure 3.7 we can infer that for a firm in perfectly
competitive market its revenue increases as its volume increases. Here
industry demand remains constant and your supply schedule shows that
marginal revenue and average revenue for the firm remains constan t as the
price in this case is determined by market forces. Here total revenue
increases with increase in total number of units sold as the price remains
constant. We can conclude in following manner.
1. Decrease in Price: - Increase in total revenue . (Elastic Demand)
2. Increase in Price: - Decrease in total revenue.(Elastic Demand)
3. Decrease in Price: - Decrease total revenue . (inelastic Demand)
4. Increase in Price: - Increase in total revenue.(inelastic Demand)
3.3.4 Income Elasticity of Demand
Income elas ticity of demand refers to response of quantity demanded to
changes in average income of the consumers. It is given by following
expression, munotes.in

Page 37

Consumer Behavior - II

37
=

Here ΔQ - Change in quantity demanded given by Q1 -Q2
ΔI - Change in average income of consumers. Given by I1 -I2
Therefore, Expression for income elasticity can be written as follo ws,


We know that as the average income increases, quantity demanded by
market increases and vice a versa. Income elasticity is generally positive
in nature. We may see this situation in consumption driven economy of
India. We know that number of cars, white goods, housing units, FMCG
and other product sell in India is on rise , this increased consumption may
point towards increase in average income of Indian in last few decades on
account of multiple efforts by all governmen t coupled with efficient
private sector management. Exactly opposite to this situation we may
notice that in few of the economies for certain period at the time of
recession and high inflation in economy, real income decreases leading
towards lesser consum ption by people. Income elasticity also has various
degrees as mentioned in price elasticity so degree of resp onse for various
categories of i tems is not same ev en if we may observe change in i ncome
level.
3.3.5 Cross Elasticity of Demand
Cross elas ticity of demand refers to response of quantity demanded for
item x to changes in price of item y. It is given by following expression,
=

Here ΔQx - Change in quantity demanded for product x given by Q1 -Q2
ΔPy - Change in price for product y. Given by P1 -P2
Therefore, Expression for income elasticity can be written as follows,


The cross elasticity may be positive or negative based on type of
relationship between the two products. The association between two
products is important in many cases e.g. fuel prices and automobile sale.
There are many such situations where increase o r decrease in price of one
product may lead to increase or decrease of quantity demanded for another
item. We may categories products as complimentary products, competing
products and substitute products, the cross elasticity for the categories can
be deri ved from same expression as the values for change will be different
in various categories. munotes.in

Page 38

Managerial Economics

38 3.3.5.1 Cross Elasticity for complimentary products
Complimentary products refers to set of products which goes together to
make a usable preposition for consumers e.g. Sim card and mobile phone
or petrol and motor cycle. We know that as the internet data charges are
drastically reduced after launch of Reliance Jio, it resulted in rapid
increase in sell of android based smart phones. We can again trace the
similar s ituation in automobile industry, whenever petrol and diesel prices
sharply increases we can see reduction in growth of automobiles, we may
see positive growth in automobile sector even in increasing fuel prices but
this growth is on account of increase in Income.
For such category cross elasticity is negative as price increase in
complimentary products results in reduced quantity demanded for other
products and vice a versa.
3.3.5.2 Cross Elasticity for competing products
Consider an example of a college canteen having 500 students consuming
carbonated drink Pepsi or Coca cola. Both are priced at Rs 20 for 200 ml
pet bottle, out of 500 students 250 choose Pepsi daily and 250 choose
Coca Cola. Now a sales manager of Pepsi st arts giving two rupees
discount on each bottle making effective price of Pepsi at Rs 18. Now
quantity demanded for pepsi increases as result of decrease in price and
now 300 students choose Pepsi out of 500, remaining 200 still choose
Coca Cola. In the cas e of Coca Cola even the price and other factors does
not change quantity demanded decreases as a result of decrease in price of
Pepsi. Cross elasticity in this case would be positive as the relationship is
direct that means for competing produ cts, whenever price increases for
product , quantity demanded for its competing product increases.
3.3.5.3 Cross Elasticity for substitute products
Substitutes refer to alternate products satisfying similar want. Here we can
take a example where student want to trav el to Delhi from Mumbai,
current price of t rain 2 AC class is at Rs 3000/ - and fare of airplane is at
Rs 5000/ -. An airline manager observe lower occupancy in non peak hours
and offers a discount of Rs 1500 on this route now few of the passenger
earlier tr aveling by train will choose to travel by Plane. In this example
even if there is no change in price or fare of train, there is decrease in total
number of passengers. The cross elasticity for substitute products is
positive as price increase in another pr oduct will lead to increase in
demand for your product and vice a versa.
3.3.6 Promotional Elasticity of Demand
Various determinants of demand such as income, price of complimentary,
substitute and competing products are not controlled by firm. To increase
or decrease in price is not the solution in short run as the dynamics
associated with price change and consumer behavior are different. The
first step any company would like to do is increase the advertising of the
product or to do some sort of sales prom otion activity to overcome the munotes.in

Page 39

Consumer Behavior - II

39 market imbalance occurred and resulted in decrease in companies sell in
short run . The promotional elasticity refers to response of the change in
quantity demanded to the change in advertising budget. Whenever
advertising bud get increases, quantity demanded would also increase and
vice a versa. Promotional Elasticity is positive as relationship is direct in
nature.
Promotional elasticity of demand refers to response of quantity demanded
for increase in adverting budget. It is given by following expression,
=

Here ΔQx - Change in quantity demanded for product x given by Q1 -
Q2
ΔA - Change in advertising budget. Given by A1 -A2
Therefore, Expression for income elasticity can be written as follows,


3.4 DEMAND FORECASTING
Demand forecasting refers to predicting future market requirement for
products based on scientific methods. “Demand forecasting is defined as
the process of making estimations of future customer demand over a
defined period, using historical data and other information.” Proper
demand forecasting gives businesses valuable in formation about their
potential in their current market and other markets, so that managers can
make informed decisions about pricing, business growth strategies and
market potential.
3.4.1 Significance of demand forecasting
Let us consider following thre e cases
1. Virat is senior manager in Company A, he focused on making more
products irrespective of market demand. Products manufactured will be
distributed to market but few of the product remains unsold and
requirement from retailers about the products redu ces lowering down the
dispatch, this situation will lead to piling of finish goods inventory
blocking warehouses and stoppage of production, on the other hand his
money requirement towards resource acquisition is more as compared to
peers as he produced mo re products than the peers As price in market is
function of industry cost and not the firm cost and price remaining
constant. Here company A invested more amount and sold similar volume
in the market, this situation leads to stoppage of production after s ome
time making it difficult even to meet working capital requirements. Here
return on investment reduces for company A and management control also munotes.in

Page 40

Managerial Economics

40 reduces, top management of com pany A is very upset with Virat as he
ended with overproduction.
2. Rahul is seni or manager in company B, he takes lessons from this
situation and work defensively in operations, he consumes lesser resources
and irrespective of market demand he produces less number of units. He is
very happy that warehouses are not blocked and market r equirement is
there. H is stock is sold out in the market immediately leading towards
additional requirements from retailers. As he do not have sufficient stock
of product with him he is not able to deliver as per requirements. In this
situation retailers s witch to competing brand from company C which
promises consistent supply. M anagement learns about these things. They
are very upset with Rahul because it is very difficult to get customers and
Rahul has lost customers. Apart from this Rahul kept lot of sca rce
resources either idle or underused leading to underproduction.
3. Sachin is smart manager in company C, he forecast demand and
make the production in anticipation of demand. He produces products as
many required in market. Whiledoing so his control on inv entory, working
capital production planning, logistics and supply chain, manpower is
stronger as demand and supply are consistent with less variations.
Retailers are happy with company C as they get the products on th rightv
and right quantity as required by them, they make stronger relations with
company C. Simmilarly management is happy with Sachin as he has made
good profit even with lesser fund r equirement. Company C promoted
Sachin to higher post with good pay hike as he has made right volume of
produc tion. He has also made optimal utilization of scarce resources.
From above mentioned three cases it is clear that performance of company
C with smart manger Sachin is better than that of company A & Company
B with Virat and Rahul. Sachin has forecasted demand and made the
production in anticipation of demand. He got re warded and his company
made better profits and better control over operations as compared to
competitors.
3.4.2 Methods of demand forecasting
a. Survey of Buyers Intention : It is also known as consumers’
expectations or opinions survey. The most commonl y used method for
estimating demand in short run is to ask customers what they are planning
to buy in forthcoming period, usually a year. It is commonly used method
for sales forecasting involving direct interviews of customers. A sale is the
result of con sumer intention to buy the product. Many companies conduct
periodical survey of consumers’ buying interest to know when and how
much they will buy. Application of this method is more in Industrial
marketing rather than consumer marketing as preciseness abo ut intentions
of buying is more with Industrial buyers. It can be conducted at sample
level or census survey.
b. Collective opinion Method: Companies having wide distribution
and sales personnel network can use this method. Under this method sales
person opin ion is collected about future requirement of companies munotes.in

Page 41

Consumer Behavior - II

41 products . Sometimes, it is also called as composite of sales force opinion
or sales force estimate method. Company can ask, either all or some of the
salesmen, to estimate demand for a given time. Each sales representative
estimates how much each current and prospective customer will buy the
company’s product. Here, for estimating the future demand, the
company’s sales force opinions are taken as a base. Since salesmen have
direct and close contact with customers, competitors, dealers, and overall
market environment, they can provide more realistic forecast. Personal
biases of the sales force are nullified after data collection. Impact of many
macroeconomic changes may not be known to all sales people th at impact
is understood after collection of forecasting data.
c. Expert Opinion Method: Professional market experts have precise
knowledge about various factors of demand. Their experience and
expertise and access to information help to arrive at industry de mand for
future date. Interviews and questionnaires are helpful tools for collecting
unbiased data from these sources. Company can also take assistance of
experts to obtain forecasts. The experts include dealers, suppliers,
distributors, consultants, and trade associations. These experts supply their
estimate individually or jointly in form of the pooled individual estimate.
Along with the estimates, they also underline certain assumptions.
Company contacts them periodically or occasionally for their opini ons
regarding level of company sales in the future. Some companies buy
economic and industry forecasts from well -known economic firms. E.g
there are few experts having sound knowledge of energy Industry,
companies which depend on this Industry can take adv ice from them about
future demand. This is applicable even to Jewelry brands so as to
understand price fluctuation in gold in future and demand associated with
each of the price band can be understood. As compared to few other
methods it is much faster. Pe rsonal biases can be there which may
influence the forecast.
d. Controlled Experiments: It is popularly known as test marketing. It
is an experimental method. Opinions are not considered but the real
experiment is made. This is most reliable method. It is bas ed on the actual
study of market situation. In this method, neither buyers are asked to
reveal their intention nor experts are contacted to give their opinion on the
future sales, but a direct market test is conducted. Direct market test is
desirable in ca se of a new product and existing products as well as existing
products in new channel or territory. The method is used to measure
consumers’ and dealers’ reactions in handling, using, and repurchasing the
product. Information regarding trial, first time pu rchase, repeat purchase,
etc. can help in more accurate estimate of sales for a given time however
major drawback of this method is that, it is conducted in controlled
situation (laboratory experiment), the real position cannot be measured;
and if it is co nducted in natural setting (field experiment), impact of
extraneous factors cannot be estimated.
e. Barometric method – In barometric method, demand is predicted
on the basis of past events or key variables occurring in the present. This
method is also used t o predict various economic indicators, such as saving, munotes.in

Page 42

Managerial Economics

42 investment, and income. This technique helps in determining the general
trend of business activities. For example, suppose government allots land
to the XYZ society for constructing buildings. This ind icates that there
would be high demand for cement, bricks, steel and aggregates. The main
advantage of this method is that it is applicable even in the absence of past
data. However, this method is not applicable in case of new products. In
addition, it lo ses its applicability when there is no time lag between
economic indicator and demand.
f. Statistical methods: These methods use some statistical technique
to find out demand forecasts.
 Trend Projections –Trend projection or least square method is the
classical method of business forecasting. In this method, a large amount of
reliable data is required for forecasting demand. In addition, this method
assumes that the factors, such as sales and demand, respon sible for past
trends would remain the same in future. In this method, sales forecasts are
made through analysis of past data taken from previous year’s books of
accounts. In case of new organizations, sales data is taken from
organizations already existin g in the same industry
 Graphical method: It is the simplest statistical method in which the
annual sales data are plotted on a graph, and a line is drawn through these
plotted points. A free hand line is drawn in such a way that the distance
between points and the line is the minimum. In this method, it is assumed
that future sales will assume the same trend as followed by the past sales
records. Although the graphical method is simple and inexpensive, it is not
considered to be reliable. This is because th e extension of the trend line
may involve subjectivity and personal bias of the researcher.
 Fitting trend method: This implies a least square method in which a
trend line (curve) is fitted to the time -series data of sales with the help of
statistical techn iques.
Linear trend – S = a + bT;
Exponential trend – S = aTb
(S = annual sales, T = time, a & b are constants)
 Regression analysis –It is alsovery popular method of demand
forecasting. In regression method, the demand function for a product is
estimated w here demand is dependent variable and variables that
determine the demand are independent variable
 Simple regression:
 If only one variable affects the demand, then it is called single variable
demand function. Thus, simple regression techniques are used.
 Y = a + Bx
munotes.in

Page 43

Consumer Behavior - II

43  Multiple regression:
 If demand is affected by many variables, then it is called multi -
variable demand function. Therefore, in such a case, multiple
regression is used.
 Y = a + b 1X1 + b 2X2
Here, Y = Variable dependent on X (estimated demand)
X = Independent factor/variable
a & b are constants
All professionally managed companies make the use of tools and
techniques from demand elasticity and demand forecasting.
3.5 SUMMARY
 From law of demand we could understand direction of change in
quantity demanded on account of change in price but we need demand
elasticity for decision making. Demand elasticity is ratio of percentage
change in quantity demanded to percentage change in determinant of
demand .
 Demand elasticity can be calculated for all the determinants of
demands such as price, income, price of the related products and
promotions. It is called as price elasticity, income elasticity, cross
elasticity and promotional elasticity respectively.
 The firm m ay have control on only few factors such as price and
promotions nut they do not have much control on income and price of
related goods.
 Elasticity can have various degrees. Need based product are inelastic
in nature and life style products are elastic in nature. Other degrees
such as perfectly inelastic , perfectly elastic and unitary elastic can be
discussed but their applicability is res tricted to very few products.
 There is strong relationship between price and revenue, for elastic
products increase in prices results in decrease in revenue and vice a
versa whereas for inelastic products increase in price will result in
increase in revenu e.
 Demand forecasting refers to predicting market requirement at future
time frame based on some methods. There are various methods of
demand forecasting such as survey methods and statistical methods.
Accurate demand forecasting helps business manager to plan for
production in efficient way with better control and better ROI.

munotes.in

Page 44

Managerial Economics

44 3.6 QUESTIONS
1. What do you mean by demand elasticity? Explain its significance for
business manager.
2. Elaborate various methods of demand elasticity with their mathematical
expre ssions.
3. What are various degrees of demand elasticity? Explain their
application areas.
4. What is the significance of demand forecasting for running the business
successfully?
5. Explain various methods of Demand forecasting.





munotes.in

Page 45

45 4
SUPPLY
Unit Structure
4.0 Objectives
4.1 Introduction
4.2 Concept and Definition of Supply
4.3 Factors Affecting/ Determinants of Supply
4.4Alternative Ways of Expressing Supply
4.4.1 Supply Function
4.4.2 Supply Schedule
4.4.3 Supply Curve
4.5 Law of Sup ply
4.5.1 Assumptions of the Law of Supply (ceteris paribus)
4.5.2 Exceptions to the Law of Supply
4.6 Movement along a Supply Curve and Shifts in Supply Curve
4.7 Equilibrium Price
4.8 Determination of Equilibrium Price and Quantity
4.8.1 Market Period Pr ice Determination
4.8.2 Short Period Price Determination
4.8.3 Long Period Normal Price Determination
4.9 Effect of Changes in Demand & Supply on Equilibrium Price
4.9.1 Change in Demand
4.9.2 Change in Supply
4.9.3 Simultaneous Changes in Demand and Suppl y
4.10 Summary
4.11 Key Words
4.12 Answers to Self Assesment Test
4.13 Further Readings munotes.in

Page 46

Managerial Economics

46 4.0 OBJECTIVES
After studying this unit, you should be able to:
 Understand the meaning of supply
 State the law of supply
 Know the factors affecting or determinants of s upply
 Understand the various types of elasticity of supply
 Explain how market equilibrium is reached.
 Understand that supply is an independent economic activity but it is
based on the demand for commodities
 Explain how the market price is determined by the interaction of
demand and supply
4.1 INTRODUCTION
In the previous modules, we have studied about the various aspects of an
important economic function ‘Demand’. Demand types, demand function,
elasticity of demand, demand forecasting etc. has been discusse d in these
modules. Demand and supply are the two basic tools of economics.
Demand for a good, as seen in modules 3 –4, draws from the theory of
consumers’ behaviour. Supply of a good is derived from the theory of firm
behavior (and the behaviour of factors of production) which is based on
the firms’ objectives, their production functions (technologies), inputs’
prices (or inputs’ supplies), firms’ organizations (single or multiple
product firms), size and integration, government regulations, etc. In the
demand theory, consumers were the only behavior unit and thus the
demand function was relatively easy to derive systematically. However, in
the supply theory, behavior of several units (such as firms, workers,
savers, investors and governments) are involved a nd thus it is hard to
derive the supply function in that unique fashion. It is true that economy
runs on demand but that demand has to be fulfilled with corresponding
supply as well. Say, if there is a huge demand for automobiles in an
economy, there has t o be corresponding supply to fulfil that demand. If
adequate supply is not there, then the demand would not be fulfilled.
4.2 CONCEPT AND DEFINITION OF SUPPLY
When you ask to the producer: how much quantity of a commodity he is
willing to sell? The obvious reply will be the ‘it depends on the price’. At
the higher price, he will be willing to sell more quantity, while at lower
price, he will be willing to sell less quantity. Accordingly, supply of a
commodity refers to a schedule (or a table) showing variou s quantities of a
commodity that the producers are willing to sell at different possible
prices of the commodity at a point of time. Thus, the “supply” of a munotes.in

Page 47

Supply

47 commodity includes the various amounts of a commodity which are
supplied at different prices. Suppl y is different from the stock. Stock is the
total quantity of goods, which is stored in the warehouse, but it will not be
offered for sale. Hence supply is only a part of stock which is offered for
sale. The concept of supply should be studied from the man ufacturer point
of view.
For example, Ram Corporation may produce 60,000 laptops, but it may
only sell 40,000 laptops. Here, we consider the 60,000 laptops which the
firm offers for sale and not the 40,000 laptops actually sold. Therefore, we
only study a s to what is offered for sale. Here 60,000 laptops is t he stock
and 40,000 laptops is the sale. In another example, the ‘supply’ of coal
does not mean the amount of coal lying underground waiting to be mined.
It mean that supply of coal is the amount of co al which owners are willing
to put on the market at various prices.
Like demand, we cannot speak of supply without specifying some price.
Two important points which are true for supply are:
(i) Supply refers to what producer’s offer for sale at a given pri ce. What
they offer for sale may not actually get sold.
(ii) Supply is a flow concept. The quantity supplied is so much per unitof
time, per day, per week, per month or per year.
Supply can be studied individually and collectively. The individual
supply is the supply of a product in some amount by an individual
producer or firm at a particular price during a given period of time.
Market supply , on the other hand, is the specific quantity of output that
all the producers are willing and able to make availab le to consumers at a
particular price over a given period of time. In one sense, supply is the
mirror image of demand. Individuals’ supply of the factors of production
or inputs to market mirrors other individuals’ demand for these factors.
For example, if we want to rest instead of weeding the garden, we hire
someone: we demand labour. For a large number of goods, however, the
supply process is more complicated than demand.
In the words of Dooley, “The law of supply states that other things being
equal the higher the price, the greater the quantity supplied or the lower
the price, the smaller the quantity supplied.”
According to Lipsey, “The law of supply states that other things being
equal, the quantity of any commodity that firms will produce and offer f or
sale is positively related to the commodity's own price, rising when price
rises and falling when price falls.”
According to Meyers , “we may define supply as a schedule of the amount
of goods that would be offered for sale at all possible prices at anyo ne
instant of time, or during anyone period of time, for example, a day, a
week, and so on, in which the conditions of supply remain the same.”
munotes.in

Page 48

Managerial Economics

48 4.3 FACTORS AFFECTING/ DETERMINANTS OF
SUPPLY
Innumerable factors and circumstances could affect a seller’s wil lingness
or ability to produce and sell a good. Some of the more common factors
are:
a) Price of the Product (Own Price) is the most important determinant
of supply of a product. Normally, a large quantity of a product is
supplied at a higher price and a smal ler quantity of a product is
supplied at a lower price. The relationship between the price and the
quantity supplied of a product, keeping other factors constant, has been
conventionally expressed by the law of supply.
b) Prices of Related Products also deter mines the supply of a produc.
The related products include both substitutes and complementary
products. The supply of one product may change as a result of a
change in the price of some other product.
c) Prices of Factor Inputs has an inverse relationship wit h the supply of
a product. It means that as the price of factor inputs increases, the cost
of production must go up which results in decrease in the supply of the
product produced. Hence, prices of factor inputs are the important
determinant of supply.
d) Change in Technology is the most important determinant of the
supply of products. Changes in technological advances with
innovations or inventions result in the production of new products,
new efficiency levels of production, etc. As a result these
technologi cal advancements will bring in more supply of products to
the market.
e) Time Periods is also related supply of a product. Marshall classified
markets on the basis of time. The time periods include very short
(market) period, short period, long period and ver y long (secular)
period market. The pricing process can be studied under these time
period markets depending upon whether suppl y conditions have time
to make no adjustment, some adjustment of labour and other variable
factor and full adjustment of all fact ors and all costs.
f) Government Policy regulation is also another important determinant
of supply of a product. Government regulatory measures include
imposition of heavy taxes, price regulation, etc. Based on these
regulations, the producers or sellers can either increase or decrease the
sales of their products. The imposition of a sales tax or an excise duty
causes a downward shift in supply and the grant of subsidy by the
government increases supply.
g) The Natural Factors like flood, drought, etc. also gover ns the supply
of a product. Normally, poor monsoons may lead to poor power
generation. This will, in turn, affect the production in the agricultural
sector and also in other sectors. munotes.in

Page 49

Supply

49 h) Goal of the firm also determines the supply. If goal of the firm is to
maximisation of revenue or sales rather than of profits, supply would
be larger. If goal of the firm is to maximisation of profits, more
quantity of the commodity will be offered at a higher price.
i) Number of firms producing a particular commodity increases, the
market supply would increase. Thus, number of firms in particular
industry also determines the supply.
j) Business expectations of future prices also determine supply. In
situations of bullish expectations, investment tends to rise and supply
starts risin g. Accordingly, quantity supplied rises even when own price
of the commodity remains consta nt. During inflation, sellers anticipate
further rise in prices in future and would reduce supply.
k) Other Factors may include like, fear of war or depression, weather
conditions (flood, drought etc.), inequalities of income, means of
transport and communications, agreements among producers,
Epidemics (unexpected situations), etc.
4.4 ALTERNATIVE WAYS OF EXPRESSING SUPPLY
Supply of commodity/ies by an individual producer / firm or the mark et/
industry as a whole can be conventionally expressed in three alternative
forms, which are as follows:
 A supply function
 A supply schedule
 A supply curve
4.4.1 Supply Function
The supply of a good depends on many factors. These include the own
price (price of the good itself), price of the other related goods, changes in
technology, price of the inputs or the factors of production, government
policies and taxes and others. It is the functional relationship of quantity
supplied and facto rs affecting the supply. It can be either with respect to
one producer (individual supply function) or to all the producers in the
market (market supply function).
Individual Supply Function
Individual supply function refers to the functional relationship between
supplyand factors affecting the supply of a commodity. It is expressed as:
Sx= f (P x, Po,Pf, St, T, G) Where,
Sx = Supply of the given commodity x;
Px= Price of given commodity x;
Po = Price of other goods; munotes.in

Page 50

Managerial Economics

50 Pf = Prices of factors of production;
St = State of technology;
T = Taxation policy;
G = Goals of the firm.
Market Supply Function
Market supply function refers to the functional relationship between
market supply and factors affecting the market supply of a commodity. As
discussed before, mark et supply is affected by all the factors affecting
individual supply. In addition, it is also affected by some other factors like
number of firms, future expectations regarding price and means of
transportation and communication.
Market supply function is expressed as:
Sx = f (P x, Po, Pf, St, T, G, T, G, N, F, M)Where,
Sx = Market supply of given commodity x;
Px = Price of the given commodity x;
Po = Price of other goods;
Pf = Prices of factors of production;
St = State of technology;
T = Taxation policy;
G = Goals of the market;
N = Number of firms;
F = Future expectation regarding P x;
M = Means of transportation and communication.

4.4.2 Supply Schedule
A supply schedule is a tabular statement that shows different quantities of
commodities that are offered by the firm in the market for sale at different
prices at a given time. It describes the relationship between quantities
supplied of a good in response to its price per unit, while all non -price
variables remain unchanged. A supply schedule has two column s, namely
(a) Price per unit of the commodity (P x)
(b) Quantity supplied per period (S x)
The supply schedule is a set of pairs of values of P x and S x. There are two
types of supply schedule, namely
 Individual Supply Schedule
 Market Supply Schedule munotes.in

Page 51

Supply

51 Individual Suppl y Schedule
It relates the supply of a good or service by one firm at different prices,
other things remains constant or equal. Table 4.1 shows that as the price of
good X increases from Rs. 10 to 60 the corresponding supply of the
commodity increases from 1000 units to 6000 units.
Table 4.1: Individual Supply Schedule for Commodity X
Price per unit of Commodity X
(Px) Quantity Supplied of Commodity X
(Units)(S x)
10 1000
20 2000
30 3000
40 4000
50 5000
60 6000

Market Supply Schedule
The market supply schedule, on the other hand, like market demand
schedule is thesum of the amounts of good supplied for sale by all the
firms or producers in the market at different prices duringa given time. Let
us assume, there are two producers for a good (Table 4.2). At price Rs. 10
per unit, producerA sells 1000 units and producer B offers 2000 units.
Hence the total market supply at Rs. 10 per unit is 3000. Asprice increases
from Rs 10 to Rs. 50, the market supply increases from 3000 units to
11000 units.
Table 4.2: Market Supply Schedule for Commodity X
Price per unit of
Commodity X
(Px) Quantity
Supplied by
Producer A (S xa) Quantity
Supplied by
Producer B (S xb) Market
Supply (S x=
Sxa+ Sxb)
10 1000 2000 3000
20 2000 3000 5000
30 3000 4000 7000
40 4000 5000 9000
50 5000 6000 11000
60 6000 7000 13000


munotes.in

Page 52

Managerial Economics

52 4.4.3 Supply Curve
The supply curve is a graphic presentation of the information given in
supply sc hedule showing various quantiti es of a commodity offered for
sale at different possible prices of that commodity. It shows the positive
relationship between price of a commodity and its quantity supplied.
Higher the price of the commodity or product, the greater will be the
quantity of supply offered by the producer forsale and vice versa, other
things remains constan t. There are two types of supply curve aspects,
namely
 Individual Supply Curve
 Market Supply Curve
Individual Supply Curve
Individual supply curve is a graphic presentation of supply schedule of an
individual firm in the market. Sloping upwards, it indicat es positive
relationship between price of a commodity and its quantity supplied as in
Fig. 4.1.

This figure is drawn on the basis of individual supply schedule of table
4.1.The curve has a positive slope, showing that quantity supplied
increases in respo nse to increase in own price of commodity, and it
decreases in response to decrease in own price of the commodity. Thus,
when the price is Rs. 10 per unit, the firm is ready to sell 1000 units of the
commodity. And, when the price is Rs. 20 per unit, the f irm is ready to sell
2000 units of the commodity and so on.
Market Supply Curve
Market supply curve is a graphic presentation of market supply schedule.
It is supply curve of the industry as a whole. It is divided by way of
horizontal summation of supply c urves of all the forms in the industry. munotes.in

Page 53

Supply

53











These figures are drawn on the basis of market supply schedule of table
4.2. A and B segments of Fig. 4.2 show individual supply curves of firm
A and B while segment C shows market supply curve. It shows that when
the price is Rs. 10 per unit, the firms are ready to sell (1000+2000) units=
3000 units of the commodity. And, when the price is Rs. 20 per unit, the
firms are ready to sell (2000+3000) units= 5000 units of the commodity
and so on.
munotes.in

Page 54

Managerial Economics

54 Why Does the Supply Curve Slope Upwards?
The reasons behind the positive relationship between the price and the
quantity supplied of a good are as follows:
(a) An increase in production and thus an increased supply can only occur
at a higher price because of the law of diminishing returns.
(b) By selling at a higher price, the producer is able to make greater
profits. Thus with an increase in price, the producer increases the quantity
supplied.
4.5 LAW OF SUPPLY
It is observed in markets that when high price o f commodities are offered
to sellers. They increase the quantity supplied of these commodities and
when the level of prices decreases, the sellers decrease the quantity
supplied. This behaviour of seller is called law of supply. The law of
supply states th at other things remaining the same, the higher the price of a
commodity the greater is the quantity supplied. The logic is easy to
understand. Price of the product is revenue to the supplier; therefore
higher price means greater revenue to the supplier and hence, greater is the
incentive to supply. At the same time, higher profits also attract new firms
to the market. The law of supply can be understood with the help of
supply schedule and supply curve (already explained above). Therefore we
can say that the re is a positive relationship between the quantity that
suppliers are willing to sell and the price level. Thus, according to the law
of supply, the quantity supplied of a commodity is positively related to
price. Because of this direct or positive relatio nship between price and
quantity supplied of a commodity the supply curve slopes upward to the
right. For example, if the price of wheat increases in comparison to
sugarcane, producers would produce more of wheat as compared to
sugarcane.
Ssx= f (Px)
The a bove function shows that there exists a relationship between the
supply of a good and the price of the good, ceteris paribus . This
relationship explains the law of supply. Accordingly, other things
remaining the same, the quantity supplied of a good increa ses when the
price of the good increases and decreases when the price decreases.
4.5.1 Assumptions of the Law of Supply (ceteris paribus)
Important assumptions of the law of supply are as follows:
1. There is no change in the price of factors of production.
2. There is no change in the level of technology used in the production or
other process.
3. There is no change in the goal of the firm. munotes.in

Page 55

Supply

55 4. There is no change in business expectations.
5. There must not be any kind of change in government policies/
regulations.
6. There i s no change in competitors’ actions on product differentiation
and their prices.
4.5.2 Exceptions to the Law of Supply
The positive relationship between own price and quantity supplied of a
commodity may not always hold good or may not firmly hold good in
certain situations as under:
1. It does not apply strictly to the agricultural products whose supply is
governed by natural factors. If due to natural calamities, there is a fall
in the production of wheat, then its supply will not increase, however,
high the price may be.
2. Supply of goods having social distinction will remain limited even if
their price tends to rise.
3. At a given point of time, sellers may be willing to sell more of a
perishable commodity even at a lower price.
4. Future expectations in the fall o r rise in the price level. If prices are
expected to fall, the sellers sell more at present; and if prices are
expected to rise, they will sell only less and store it.
5. Changes in the level of technology will create changes in tastes and
preferences of the consumers that, in turn, affect the existing firms.
The existing firms with obsolete technology may be willing to sell
more at lower porices to clear their inventory.
6. Changes in weather, national and international disturbances will
also influence the suppl y of products. This will alter the shape of the
supply curve, i.e., slopes downwards from left to right.
7. Backward Sloping Supply Curve : When wages of labourers in an
industry or a firm rise to a level where the labourers get maximum
satisfaction level, the n they will work less than before in order to have
more leisure time. The supply curve in such a situation is backward
sloping.
8. Market power: If the supply side of the market is controlled by a
small number of sellers then the law of supply might not operat e. For
example, in case of monopoly (single seller) may not necessarily offer
a larger quantity even though the price is higher. Market control by the
monopolist allows it to set the market price based on demand
conditions and fix the quantity supplied wit hout cost constraints being
imposed from the supply side.
9. In other market structures like oligopoly and monopolistic
competition , sellers might be facing more competition, thereby munotes.in

Page 56

Managerial Economics

56 offering to sell larger quantities at lower prices and negating the law of
supply.
10. Legislation Restricting Quantity: Suppliers cannot offer to sell more
quantities at higher prices where the government has put regulations
on the quantity of the good to be offered or the price ceiling at which
the good is to be offered in market. P roducers are unable to play with
either of the factors on their own.
4.6 MOVEMENT ALONG A SUPPLY CURVE AND
SHIFTS IN SUPPLY CURVE
Movement along a supply curve refers to extension or contraction of
supply in response to change in own price of the commodity , other
determinants of supply remaining constant. Extension of supply implies
increase in quantity supplied when own price of the commodity increases.
Contraction of supply implies decrease in quantity supplied when own
price of the commodity decreases.
Shifts in supply curve refers to increase or decrease in quantity supplied
even own price of the commodity remains constant. These are caused by
the other determinants of supply other than on price of the commodity.
Increase in supply implies a forward shif t shift in supply curve: quantity
supplied increases even when own price of the commodity is constant.
Decrease in supply implies a backward shift in supply curve: quantity
supplied decreases even when own price of the commodity is constant.
Movement alo ng a Supply Curve: Extension or Contraction of Supply
Movement along a supply curve, caused by change in own price of the
commodity are often studied as:
(a) Extension of Supply: An expansion or extension of supply is a rise in
the supply of the good as a r esult of an increase in the price of the good.
Price (P x) Units (S x) Description
10

50 10

50 Rise in Own Price of the Commodity

Extension of Supply
munotes.in

Page 57

Supply

57

Fig. 4.3: Extension of Supply
Figure 4.3 depicts the effect of a increase in price on change in s upply.
Initially, the producer is on the supply curve SS at point A supplying OQ 0
units of commodity at price OP 0. An increase in the price of the good to
OP 1 leads to an increase in the quantity supplied of the good to OQ 1 and
the producer attains point B on the supply curve SS. This is called an
extension of supply.
(b) Contraction of Supply: A contraction of supply is a decrease in the
supply of the good as a result of a fall in the price of the good.
Price (Px) Units (Sx) Description
50

10 50

10 Fall in Own Price of the Commodity

Contraction of Supply


Fig. 4.4: Contraction of Supply munotes.in

Page 58

Managerial Economics

58 Figure 4.4 depicts the effect of a decrease in price on change in supply.
Initially the producer is on the supply curve SS at point A supplying OQ 2
units of commod ity at price OP 0. A fall in the price of the good to OP 1
leads to a decrease in the quantity supplied of the good to OQ 1 and the
producer attains point B on the supply curve SS. This is called a
contraction of demand.
Shift in Supply Curve: Increase or Dec rease in Supply
Shift in supply curve refers to a situation of increase or decrease in
quantity supplied of a commodity even when own price of the commodity
remains constant. It is caused by factors other than own price of
commodity. The shift in supply can be of two types. :
(a) Increase in Supply: An increase in supply is an increase in the supply
of the good as a result of a change in any of the factors, which influence
the supply other than the price of the good itself.
Price (Px) Units (Sx) Description
10

10 10

50 No Change in Price of the Commodity

Increase in Supply


Fig. 4.5: Increase in Supply
Figure 4.5 shows an increase in supply. Initially, the producer is on the
supply curve SS supplying OQ 0 units of the good at the price P. An
increase in supply leads to an outward movement in the supply curve from
SS to SS1. An increase in supply implies that at the same price P, a larger
quantity of the good is supplied which increases from OQ 0 to OQ 1.
(b) Decrease in Supply: A decrease in supply is a decrease in the supply
of the good as a result of a change in any of the factors, which infl uence
the supply other than the price of the good itself.

munotes.in

Page 59

Supply

59 Price (Px) Units (Sx) Description
10

10 50

10 No Change in Price of the Commodity

Decrease in Supp ly


Fig. 4.6: Decrease in Supply
Figure 4.6 shows a decrease in supply. Initially, the producer is on the
supply curve SS supplying OQ 0units of the good at the price P. A decrease
in supply leads to an inward movement in the supply curve from SS to
SS1. A decrease in supply implies that at the same price P, a smaller
quantity of the good is supplied, which decreases from OQ 0to OQ 1.
SELF ASSESMENT TEST (A)
1. Fill in the blanks with appropriate words:
(a) __________ the amount of a product that would be of fered for sale at
all possible prices that could prevail in the market.
(b) According to the __________, sellers will generally offer more for sale
at high prices and less for sale at lower prices.
(c) ______________ is a listing of the various quantiti es of a particular
product supplied at all possible prices in the market.
(d) Prices and quantities are said to have a direct relationship because they
move in the _______ direction.
(e) _____________________ is what we call the graphical representation
of the supply schedule.
(f) The supply curve is always _______ sloping.
(g) A combination of all of the individual supply curves is called a
__________________. munotes.in

Page 60

Managerial Economics

60 (h) A change in ____________ indicates a change in the amount supplied.
This shows a movement _ ______ the supply curve.
(i) A change in ____________ occurred when producers offer different
amounts of products for sale at all possible prices in the market.
(j) A _______ shift indicates an increase in supply and a ______ shift
indicates a decrease in supply.
2. State true or false for the following statements:
(a) Supply is a positive function of price.
(b) A trader has 10 bags of cement in his store. This represents supply of
cement.
(c) A supply schedule is a table that represents the various amounts of
goods available for supply at various prices.
(d) When quantity demanded is more than quantity supplied, the prices
tend to fall.
(e) The supply curve of a good shifts to the right when prices of other
goods rise.
3. Match the following terms with thei r respective definition:
I. Quantity Supplied A. A graphical object showing the relationship
between the price of a good and the amount that sellers are willing and
able to supply at various prices.
II. Supply Curve B. The claim that, other things being e qual, the quantity
supplied of a good increases when the price of that good rises.
III. Supply Schedule C. The amount of a good that sellers are willing
and able to supply at a given price.
IV. Law of Supply D. A table showing the relationship between th e
price of a good and the amount of it that sellers are willing and able to
supply at various prices.
4. Answer the following:
 Define the concept supply and the law of supply.
 Explain the factors affecting the supply in the market with an
examples.
 Assume yourself as a manager of any FMCG firm. In what ways
supply analysis is important
 for you?
 Distinguish between extension and contraction of supply on the one
hand and increase and decrease of supply on the other with
illustrations.
 Discuss Supply function. Also write about the determinants of supply.

munotes.in

Page 61

Supply

61 4.7 EQUILIBRIUM PRICE
After a detailed analysis of demand and supply, we are now in a position
to understand market dynamics. So far we have understood how price
affects demand and supply; but with this knowle dge one cannot explain
how price is determined. Till now, price has been assumed to be given.
Now let us elaborate on how price is determined in the market by
interaction of demand and supply.
The buyer represent the demand side of the market. Every ration al buyers
aims at maximizing his satisfaction by purchasing more at a lower price
and less at a higher price. This is called demand behaviour of a buyer i.e.
law of demand. The seller represents the supply side in the market. Every
rational seller aims at maximizing his profit by selling more at a higher
price and lesser at a lower price. This is called supply behaviour of a seller
i.e. law of supply. The objectives of consumers (buyers) and firms (sellers)
are opposed to each other. This leads us to examin e the actual price
charged and quantity sold in particular market.
There is only one price at which the objectives of sellers and buyers meet
together. Equilibrium occurs when the quantity demanded of a good in the
market over a certain time is equal to th e quantity supplied of the good
over the same time. At that point, the quantity of a commodity demanded
by the buyer is equivalent to the quantity that the seller is willing to sell.
This price is called the equilibrium price and it occurs at the point of
intersection of the supply curve and the demand curve. The equilibrium
quantity is that quantity at which the equilibrium exists.
Interaction of demand and supply to reach equilibrium is shown in Figure
4.7.

Figure 4.7: Equilibrium Point
Graphically, the i nteraction of supply and demand curves will indicate the
equilibrium point (E). munotes.in

Page 62

Managerial Economics

62 If market price is OP 1, the quantity demanded by consumers is OQ 1, while
the quantity which producers wish to supply is OQ2. There is thus a
surplus of Q 1Q2 at this price. It i s well known that a surplus leads to a
downward pressure on price and so market price will fall. At the lower
price of OP 2, the quantity supplied is OQ 1, while the quantity demanded is
OQ 2. There is, therefore, a shortage at this price, represented by Q 1Q2.
This shortage tends to put an upward pressure on price and market price is
expected to rise.
There is only one price, at which the quantity supplied is equal to the
quantity demanded, there is no surplus or shortage, no rise or fall of price -
OP e. It is thus referred to as the equilibrium position.
4.8 DETERMINATION OF EQUILIBRIUM PRICE AND
QUANTITY
In context of demand and supply, equilibrium is a situation in which
quantity demanded equals quantity supplied and there is no incentive to
buyers and seller s to change from this situation. The market clears itself
and becomes stablei.e. at the market equilibrium, every consumer who
wishes to purchase the product at the market price is able to do so, and the
supplier is not left with any unwanted inventory.
Law of demand and law of supply explain separately the ‘plans’ of
consumers as to how much they would buy at a given price and the ‘plans’
of producers as to how much they would offer for sale at the given price.
Although the demand would be very high at low er prices but in practice
consumers may never get the opportunity to buy the product at that low
price because suppliers are not willing to supply at that price. Similarly,
although suppliers may be prepared to offer a large amount for sale at a
high price , they may not be able to sell it at all because the consumers are
not willing to buy at that price.
The demand for a product and the supply of a product are two sides of the
market, and it is necessary to bring these together to establish equilibrium
in the market which is the point where both the sides of the market are
satisfied simultaneously.
This can be better understood with the help of the following illustration:
There are 1000 individuals in the market with identical demand schedules
for good x, Ddx = 10−Pxand 100 identical producers in the market with the
identical supply schedules for good x, Ssx = −20+20Px. Determine the
equilibrium price and equilibrium quantity for good x.
Market demand schedule: DD x = 1000 (Dd x)
= 1000 (10 −Px)
= 10,000 −1000 P x
Market supply curve for good x: SS x = 100 (Ss x) = −2000 + 2000 P x. munotes.in

Page 63

Supply

63 Table 4.3 depicts the market demand and supply schedules while Fig. 4.8
shows the equilibrium.
Table 4.3: Market Demand and Supply Schedules
Px DD x SSx
5 5000 8000
4 6000 6000
3 7000 4000
2 8000 2000


Figure 4.8: Determination of Equilibrium
Graphically, equilibrium occurs at the price P x equal to Rs. 4 and quantity
Qx equal to 6000.
Mathematically to determine the equilibrium:
DD x = SS x
10,000 − 1000 P x= −2000 + 2000 P x
3000 P x= 12, 000
Px= Rs. 4
Substituting the equilibrium price into the demand or supply equations:
DD x= 10,000 − 1000 Px
= 10,000 − 1000 (4)
= 6000
Or
SSx= −2000 + 2000 Px
= −2000 + 2000 (4)
= 6000 munotes.in

Page 64

Managerial Economics

64
Further the equilibrium price and quantity can be determined for differ ent
periods as under:
A. Market Period Price Determination
B. Short Period Price Determination
C. Long Period Normal Price Determination
4.8.1 Market Period Price Determination
In order to determine prices under market period, Dr. Marshall divided
commodit ies into two categories:
1. Perishable Goods
2. Durable Goods
Perishable Goods
In simple terms, goods which cannot be stored for some time are called the
perishable goods. Fresh vegetables, milk etc. are included in this category.
Supply of such goods at any given time is fixed. If demand increases
supply cannot be increased so quickly. There fore, it is demand that plays
a dominant role in the determination of price.
In fig. 4.9, quantities of perishable goods is measured on horizontal axis,
price on verti cal axis. SS is the supply curve. It sig nifies the fact that
supply of perishable goods remains fixed. DD is the original demand
curve which shows the equilibrium at paint E. Thus, OP is the equilibrium
price. Now, suppose, if in the very short period dema nd increases and
assumes the form of D 2D2.
The equilibrium will also shift to E 2. It depicts that with the increase in
demand the price increases to OP 2. On the contrary, if the demand falls
from DD to D 1D1,the equilibrium will shift to E 1 from E side by side price
will fall from OP to OP 1.

Fig. 4.9 Fig. 4.10 munotes.in

Page 65

Supply

65 Durable Goods
Durable goods are those which can be reproduced or those can be stored.
Like perishable goods, the supply o f durable goods is not vertical
throughout the length. Firms selling such goods have a minimum reserve
price. They will not sell goods at less than the reserve price. These goods
are like wheat, soap, oil etc.
In fig. 4.10, MPS is the market period supply curve where OQ 0 is the
stock of the commodity. To start with the demand for the commodity is
shown by D 1D1 where the price is OP 1 and quantity supplied is OQ 1. Q1O0
stock will be held back. If the demand is D 2D2, the whole stock will be
sold out at OP 0 price. But in case the demand is D 2D2, the equilibrium will
be at E 2 and the price will be OP 2 where the entire output is sold.
At OR price i.e. ‘the ‘Reserve Price’ the entire output is held back. But
from R to E o, as the price rises, the quantity supplied a lso rises.
4.8.2 Short Period Price Determination
Price determination in the short period has been explained with the help of
Fig. 4.11.

DD is the demand curve of the industry. MPS is the market period supply
curve while SRS is the short run supply curve of the industry.
Initially, OP is both the market price as well as the short run price. At
price OP the individual firm will adjust its output OX. At equilibrium
level of output OX, price is equal to its marginal cost and marginal cost
curve cuts the MR c urve from below.
The firm enjoys normal profits. Now, suppose demand increases from DD
to D 1D1 and the industry is in equilibrium at point E 1 which determines the
price OP 1. The new price OP 1 is less than the new market price i.e., OH. munotes.in

Page 66

Managerial Economics

66 The reason is being that in the short run marginal cost curve rises as more
is produced. Thus, the individual firm will take price OP 1 and will produce
OX 1 level of output at which price OP 1 equals the marginal cost and the
firm enjoys supernormal profits.
On the other hand, if the demand curve falls to D 2D2 the new equilibrium
will be established at E 2 and the price will falls to OP 2. But in the short
period the firm will contract output by reducing the employment of labour
and other variable factors. Therefore, the new equil ibrium level
established at E 2 will determine the price OP 2 and the firms will produce
OX 2 level of output. But, it is worth mentioning here that price OP 2 does
not cover the SAC and the firms operating in the industry incur losses.
4.8.3 Long Period Norma l Price Determination
Normal price comes to prevail in the long period. It is also called long
periodprice. Normal price is influenced more by supply than demand.
According to Marshall, “Normal price is that price which tends to prevail
in a market when fu lltime is given to the forces of demand and supply to
adjust themselves”. Thus, it is clear from the definition that normal price is
one that tends to prevail in the long period. It is not a real price.
Under perfect competition, the long run supply gets s ufficient period to
adjust itself to the changed conditions in demand. If supply is less than
demand, price will rise. Thus, total supply will increase and all the
producers will get normal profits only.
If supply is more than demand, price will fall and p roducers suffer losses.
Some of the producers may leave the industry under pain of loss. Thus,
total supply will decrease and once again price will rise to its normal level.
This has been illustrated with the help of fig. 4.12 below:

In fig. 4.12, we hav e taken output on X -axis and price on Y -axis.
Industry’s demand curve DD and long run supply curve LRS cut at point
E which determines OP price and OM output. If price by the industry is
raised to OP 1, the demand isOM2 and supply is OM 1Since D

Page 67

Supply

67 fall to OP. On the other hand, if price is OP 2, in this case Sbecause at OP 2 price, supply is ON 1 and demand is ON 2. This will raise
price to OP.
A firm under perfect competition in the long run is in equilibrium at
output where Price= MC= Mini mum LAC. This point is shown by E. It
shows that the firm is making just normal profits. If the price is above the
minimum long run average cost, the firms will be making super -normal
profits.
In the figure, if the price is OP 1, in that case the firm will be producing
OQ 1output and would be making super normal profits. These super -
normal profits will lure the new firms to enter the industry. With this, the
supply of the industry would increase which would reduce the price and
hence the existing firms will b e left only with normal profits.
Q1 the other hand, if the price is OP 2, in that case the firms will be in
equilibrium at E 2and hence the firm would be producing OQ 2. In this case
the firm will be sustaining losses as ARthe firms will exit from the industry. This will reduce the supply which in
turn would raise the price and hence the existing firms will be left with
normal profits only.
4.9 EFFECT OF CHANGES IN DEMAND & SUPPLY ON
EQUILIBRIUM PRICE
The equilibrium price rem ains constant only if all other things influencing
demand and supply remains constant. But, if there is a change in these
factors, the effect of these changes would increase, decrease or leave the
equilibrium price unaffected. The effect of these changes c an be studied in
the following three categories:
1. Change in demand
- Increase in demand
- Decrease in demand
2. Change in supply
- Increase in supply
- Decrease in supply
3. Simultaneous changes in demand and supply
4.9.1 Change in Demand
Changes in demand take place due to changes in the price of related
goods, income, consumers’ tastes and preferences, etc. To study the
changes in demand, we assume that the supply curve remains constant and
the only demand increases or decreases.
munotes.in

Page 68

Managerial Economics

68 Increase in Deman d
This is when the demand curve increases (shifts to the right) and supply
curve remains constant.
This has been illustrated with the help of fig. 4.13 below:

Fig. 4.13
If there is a rise in the price of a substitute good, the demand curve will
shift t o the right. Thus, the demand curve shift from D to D’ with the
supply curve remains constant. We notice that the equilibrium price also
increases from P to P’. This is because when the demand increases, the
supply is short of the demand and hence, the pri ce will go to OP’. With the
rise in price, supply will also go up and the new equilibrium would be
reached at point E’. At this point, OP’ is the price and OQ’ is the quantity
demanded and supplied.
Thus, as the demand curve shift to the right i.e. demand increases, supply
being constant, the equilibrium price and quantity also increases.
Note the distinction between change in quantity demanded and change in
demand. Change in quantity demanded occurs only when there is change
in the price. Thus, the chang e in the price -quantity schedule brings
movement on the demand curve, whereas the changes in the other
determinants (namely income, tastes, price of the substitutes, etc.) shifts
the demand curve as a whole.
Decrease in Demand
This is a case when the deman d curve decreases (shift to the left), supply
curve remaining constant. This has been illustrated with the help of fig.
4.14 below: munotes.in

Page 69

Supply

69

Fig. 4.14
If there is a fall in the price the price of a substitute goods, the demand
curve will shift to the left. Thus, the demand curve shifts from D to D”
with the supply curve remaining constant. We notice that the equilibrium
price decreases to P” to P.
This is because, as the demand increases, the supply is greater than hence,
the price falls from OP to OP”. With the f all in price, supply will also fall
from OQ to OQ” and the new equilibrium would be reached at point E”.
At this point, OP” is the price and OQ” is the quantity demanded and
supplied.
Thus, as the demand curve shift to the left i.e. demand decreases, suppl y
being constant, the equilibrium price and quantity also decrease.

4.9.2 Change in Supply
Changes in supply take place due to change in cost of production,
technique of production etc. To study the change in supply, we assumed
that the supply curve incre ases or decreases while the demand curve
remains constant.
Increase in Supply
This is when the supply curve increases (shifts to the right) ,demand curve
remaining constant. This has been illustrated with the help of fig. 4.15
below: munotes.in

Page 70

Managerial Economics

70

Fig. 4.1 5
If there is a fall in the price of related goods, the supply curve will shift to
the right i.e., there will be an increase in supply. Thus, the supply curve
shifts from S to S’ with the demand curve remaining constant. We notice
that equ ilibrium price decreases fr om P to P’.
This is because, when the supply increases, the supply is greater than
demand and hence, the price falls from OP to OP’. With the fall in price,
demand will increase from Q to Q’ and the new equ ilibrium would be
reached at point E’. At this poi nt, OP’ is the price and OQ’ is the quantity
demanded and supplied.
Thus, as the supply curve shift to the right i.e. supply increases, demand
being constant, the equilibrium price decreases but the quantity increases.
Decrease in Supply
This is when the s upply curve decreases (shift to the left), demand curve
remaining constant. This has been illustrated with the help of fig. 4.16
below:


Fig. 4.16
If there is a rise in the price of related goods, the supply curve will shift to
the left i.e., there wil l be a decrease in supply. Thus, the supply curve shift
from S to S” with the demand curve remaining constant. We notice that
the equilibrium price increased from P to P”. munotes.in

Page 71

Supply

71 This is because, when the supply decreases, the supply is short of the
demand and he nce, the price rises from OP to OP”. With the rise in price,
demand will decrease from Q to Q” and the new equlibrium would be
reached at point E”. At this point, OP” is the price and OQ” is the quantity
demanded and supplied.
Thus, as the supply curve shi ft to the left or decreases, demand being
constant, the equilibrium price increase but the quantity decreases.
4.9.3 Simultaneous Changes in Demand and Supply
So far, we have discussed the effect of changes, either in demand or
supply, on the equilibrium p rice and quantity. Now, we moved to a
situation when both, demand and supply increase or decrease at the same
time. We can study this under six broad categories as follows:
1. If demand and supply increases in the same proportion
2. If demand and supply de creases in the same proportion
3. If the increase in demand is more than the increase in supply
4. If the decrease in demand is more than the decrease in supply
5. If the Increase in demand is lesser than the increase in supply
6. If the decrease in deman d is lesser than the decrease in supply
If Demand and Supply Increases in the Same Proportion
When the increase in demand is equal to the increase in supply, the
equilibrium price remains the same but the quantity increases. This has
been illustrated with the help of fig. 4.17 below:

Fig. 4.17
If Demand and Supply Decreases in the Same Proportion
When the decrease in demand is equal to the decrease in supply, the
equilibrium price remains the same but the quantity decreases. This has
been illustrated wit h the help of fig. 4.18 below: munotes.in

Page 72

Managerial Economics

72

Fig. 4.1 8
If the Increase in Demand is m ore than the Increase in Supply
When the demand increases in a greater proportion in relation to the
increase in supply, then the equilibrium price increases from OP to OP'
and the e quilibrium quantity increases from OQ to OQ'. This is because,
when supply does not increase in the same proportion with the demand,
then, there will be a short supply which will lead to an increase in price
and due to the increase in price, the demand wil l fall to some extent and
demand will reach a new equilibrium point at E' where demand will be
equal to supply.
Thus, the increase in quantity is more than the increase in price. This has
been illustrated with the help of fig. 4.19 below:

Fig. 4.1 9
If the Decrease in Demand is m ore than the Decrease in Supply
If the fall in demand is greater than the fall in supply, then the equilibrium
price will decrease. This is because, when supply decreases in a greater
proportion than demand, then there will be su pply in excess of demand
which will lead to a decrease in the price and due to the decrease in the
price, demand will rise to some extent and the demand reach a new
equilibrium point at E', where demand will be equal to supply. munotes.in

Page 73

Supply

73 Thus, the decrease in quanti ty is more than the decrease in the price. This
has been illustrated with the help of fig. 4.20 below:

Fig. 4. 20
If the Increase in Demand is Lesser than the Increase in Supply
When the supply increases in a greater proportion in relation to the
incre ase in demand, then the equilibrium price decreases from OP to OP"
and the equilibrium quantity increases from OQ to OQ". This is because,
when supply increases in a greater proportion than that of demand, then
there will be a fall in price, due to which t here will be an increase in
demand and demand reaches a new equilibrium at E", where demand will
be equal to supply.
Therefore, the increase in quantity is more than the fall in price. This has
been illustrated with the help of fig. 4.21 below:

Fig. 4. 21
If the Decrease in Demand is l esser than the Decrease in Supply
If the supply decreases in a greater proportion in relation to the decrease in
demand, the equilibrium price will increase. This is because, there will be
a rise in price due to which there will be a decrease in demand and munotes.in

Page 74

Managerial Economics

74 demand reaches a new equilibrium at E', where demand will be equal to
supply.
Thus, the increase in quantity is lesser than the fall in price. This has been
illustrated with the help of fig. 4.22 below:

Fig. 4. 22
SELF AS SESMENT TEST (B)
1. Fill in the blanks with appropriate words:
(a) ________ is a situation where market demand is equal to market
supply.
(b) Equilibrium price may be determined through both _________ and
_________ .
(c) When there is increase in demand an d decrease in supply, equilibrium
price _________.
(d) As a result of increase in the number of firms there is an increase in
supply, then supply curve shifts towards __________ .
(e) In a perfectly competitive market, equilibrium occurs when market
demand ________ market supply.
(f)If the supply curve shifts rightward and demand curve shifts leftward
equilibrium price will be __________ .
(g) Due to rightward shifts in both demand and supply curves the
equilibrium price remains __________ .
2. State true o r false for the following statements:
(a)Equilibrium occurs when the quantity demanded of a good in the
market over a certain time is equal to the quantity supplied of the good
over the same time.
(b) A shift in supply curve is caused by a change in any of the factors,
which influence the supply other than the price of the good itself.
(c) An increase in production and thus an increased supply can only occur
at a higher price because of the law of the increasing returns. munotes.in

Page 75

Supply

75 (d) A expansion of supply is a decre ase in the supply of the good as a
result of a fall in the price of the good.
(e)Th e equilibrium price is that price at which the equilibrium exists. Th e
equilibrium quantity is that quantity at which the equilibrium exists.
3. Identify how each factor w ill shift the supply curve: right, left, or
move along.
Market Change
(a) Computers Price of memory chips decreases.
(b) Airline Tickets Government imposes a new tax on fuel.
(c) Milk Demand for milk increases.
(d) HomesPotential sellers expect home p rices to decline in six months.
(e) Cars A new engine design reduces the cost of producing
cars.
(f) Corn The price of wheat (a substitute in production
increases in price).
(g) Oranges A disease in Nagpur kills 25% of the orange crop.

4. Answer the fo llowing:
 What is market equilibrium and equilibrium price? Explain.
 What are the primary causes of changing the price of an item with
regards to its demand and supply?
 How do the equilibrium price and quantity of a commodity change
when price of input used in its production changes?
 Explain the simultaneous shifts of demand and supply curve in perfect
competition with the help of diagrams.
 Explain determination of equilibrium price and quantity.
4.10 SUMMARY
Supply means the quantity of goods offered for sa le at pre -determined
price at a certain point of time. It is the specific quantity of output that the
producers are willing and able to make available to consumers at a
particular price over a given period of time. Law of Supply states that a
firm will pr oduce and offer to sell greater quantity of a product or service
as the price of that product or services rises, other things being equal.Other
things include cost of production, change of technology, price of related
goods (substitutes and complements), p rices of inputs, level of
competition and size of indu stry, government policy and non -economic
factors. Supply of a good by an individual producer/firm or the
market/industry as a whole is conventionally expressed in three alternative
forms, namely a suppl y function, a supply schedule and a supply curve.
Supply of a product X (Sx) is a function of price of product (Px), cost of
production (C), state of technology (T), government policy regarding tax munotes.in

Page 76

Managerial Economics

76 and subsidies (G), other factors like number of firms (N). Supply for a
good can change in two ways i.e. firstly a producer moves from one point
to another on the same supply curve (Movement along supply curve) and
secondly, when the entire supply curve shifts its position (Movement from
one supply curve to the o ther). Price is determined by the two forces of
demand and supply, in a free market. A point of balance, where demand
equals supply is known as market equilibrium. The market price, or
equilibrium price, is determined by the interaction of demand and suppl y
at a given time with given conditions of demand and supply. The
equilibrium price remains constant only if all other things influencing
demand and supply remains constant. But, if there is a change in these
factors, the effect of these changes would incre ase, decrease or leave the
equilibrium price unaffected. The effect of these changes can be studied in
the following categories namely increase in demand, decrease in demand,
increase in supply, decrease in supply and simultaneous changes in
demand and sup ply.
4.11 KEY WORDS
 Ceteris Paribus: Ceteris paribus or caeteris paribus is a Latin phrase,
literally translated as “with other things the same” or “all other things
being equal or held constant”.
 Change in Quantity Supplied: A movement along a supply curv e
resulting from a change in a good’s price.
 Change in Supply: A movement or shift in an entire supply curve
resulting from a change in one of the non -price determinants of supply.
 Determinants of Supply: Changes in non -price factors that will cause
an ent ire supply curve to shift (increasing or decreasing market
supply); these include 1) the number of sellers in a market, 2) the level
of technology used in a good’s production, 3) the prices of inputs used
to produce a good, 4) the amount of government regu lation, subsidies
or taxes in a market, 5) the price of other goods sellers could produce,
and 6) the expectations among producers of future prices.
 Equilibrium Price: It is the price where quantity demanded is equal
to quantity supplied.
 Law of Supply: Law of supply states that other factors remaining
constant, price and quantity supplied of a good are directly related to
each other. In other words, when the price paid by buyers for a good
rises, then suppliers increase the supply of that good in the marke t.
 Market Equilibrium: Equilibrium occurs when the quantity
demanded of a good in the market over a certain time is equal to the
quantity supplied of the good over the same time. munotes.in

Page 77

Supply

77  Quantity Supplied: The amount of a good or service that sellers are
willing t o sell at a specific price; quantity supplied is represented in a
graphical model as a single point on a supply curve.
 Shift in Supply: when a change in some economic factor (other than
price) causes a different quantity to be supplied at every price.
 Supp ly Curve: A supply curve is the curve showing relationship
between the quantities supplied of a commodity by the producer at
alternative prices.
 Supply Curve: A line that shows the relationship between price and
quantity supplied on a graph, with quantity supplied on the horizontal
axis and price on the vertical axis.
 Supply Schedule: A table that shows a range of prices for a good or
service and the quantity supplied at each price.
 Supply: Willingness and ability to produce a specific quantity of
output av ailable to consumers at a particular price over a given period
of time.
 Surplus: At the existing price, the quantity supplied exceeds the
quantity demanded; also called ‘excess supply’.
4.12 ANSWERS TO SELF ASSESMENT TEST
(A)
1. (a) Supply (b) law of suppl y (c) Supply schedule (d) Same (e)
Individual supply curve (f) upward (g) market supply curve (h)
quantity supplied; along (i) supply(j) right; left
2. (a) True (b) False (c) True (d) False (e) True
3. I. C II. A III. D IV. B
(B)
1. (a) Market equ ilibrium (b) demand; supply (c) rises
(d) Right (e) is equal to (f) decreasing (g) same
2. (a) True (b) True (c) False (d) False (e) True
3. (a) Right (b) Left (c) Along -Greater (d) Right
(e) Right (f) Left (g) Left
4.13 FURTHER READINGS
 Ahuja , H.L. & Ahuja, A. (2014). Managerial Economics: Analysis of
Managerial Decision - Making ; New Delhi: S. Chand & Company Ltd.
 D. N. Dwivedi. Managerial Economics , Vikas Publishing, New Delhi.
 Dr.Atmanand. Managerial Economics , Excel Books, Delhi. munotes.in

Page 78

Managerial Economics

78  M. L. Triv edi (2002). Managerial Economics: Theory & Applications ,
2nded.,McGraw -Hill.
 Malcolm P. McNair and Richard S. Meriam. Problems in Business
Economics , McGraw -Hill Book Co., Inc.
 Nick Wilkinson (2005). Managerial Economics: A Problem -Solving
Approach , Cambri dge University Press.
 P L Mehta. Managerial Economics , Sultan Chand& Sons.
 Piyali Ghosh Geetika and Purba Roy Chowdhury. Managerial
Economics , McGraw -Hill.
 Thomas J. Webster (2003). Managerial Economics: Theory and
Practice , Academic Press.
 Thomas. Manageri al Economics: Concepts and Applications ,
McGraw -Hill.
Online Links:
 http://www.netmba.com/econ/micro/supply -demand/
 http://www.b asiceconomics.info/supply -and-demand.php
 http://ingrimayne.com/econ/DemandSupply/OverviewSD.html
 http://tutor2u.net/economics/revision -notes/as -markets -equilibrium -
price.html
Bibliography
 G. S. Gupta. Managerial Economics , McGraw -Hill.
 General Economics for CA -CPT 2e , Pearson, Delhi.
 General Economics , The ICAI, New Delhi.
 Piyali Ghosh Geetika and Purba Roy Chowdhury. Managerial
Economics , McGraw -Hill.
 T.R.Jain& O.P. Khanna. Managerial Economics , VK Global
Publications, Delhi.
 T.R.Jain&V.K.Ohri. Introductry Micro economics , VK Global
Publications, Delhi.
 Vanita Agarwal (2016). Managerial Economics , Pearson Education
India.


munotes.in

Page 79

79 5
PRODUCTION FUNCTION
Unit Structure
5.1 Introduction
5.2 Meaning
5.3 Cobb & Douglas Production Function
5.4 Types of Production Function
5.5 Significance of Production Function
5.6 Total Product, Average Product and Marginal Product
5.7 Isoquant Analysis
5.8 Iso-cost Analysis
5.9 Summary
5.10 Questions
5.0 OBJECTIVES
 To understand the meaning of production function
 To study Cobb -Douglas production function
 To study various types of production function
 To understand the significance / importance of production function
 To study various concepts such as Total Product, Average Product and
Marginal Product
 To study Iso -quant analysis
 To study Iso -cost analysis
5.1 INTRODUCTION
Firm and Industry produces goods and services to satisfy human wants.
When we go to the market to buy commodities, it is the production
function which fulfills the supply of the goods and services. A producer
combines various factors of inputs to convert those into output. Goods and
services are demanded by consumers.
munotes.in

Page 80

Managerial Economics

80 In the form of output, after converting input, the producer plays an
important role in providing supply for the goods and services demanded by
the consumers. Production function performs a significant role in this area.
We can say that by changing the form of physical utilities, a producer
creates utilities in the form of a p roduction function. Thus, the production
function is all about creation or adding utilities. In this chapter, we will
study about production function in detail.

Fig. 5.1 : Firm and Industry
5.2 MEANING
In economics, the production function plays an important role. Firm and
industry transforms the inputs into outputs. The functional relation between
inputs and outputs is known as production function. It expresses the
relationship between physical inputs and outputs. In simple words, it
studies the relationship between investment and production.
Firm purchases inputs and sells outputs. Inputs are the things which are
purchased by the firm calling it investment and output is sold by the firm.
Thus, the production function studies the functional relationship betwe en
inputs as investment and output as production. To make the concept of
production function more comprehensive, the element of time and
technology can be also added.
In a broader way, the production function expresses the functional
relationship between p hysical inputs and outputs for a particular period of
time under given technology. State of technology is an important element
of production function as improvement in technology brings new
production techniques and on the basis of that, large output can b e
produced.
There are two important points which must be considered while studying
production function - munotes.in

Page 81

Production Function

81 1) Production function is determined by the state of technology.
2) Production function refers to a period of time i.e.., short run or long
run.

Fig.5.2: Functional relationship between inputs and
outputs

Fig.5.3: Important consideration of Production Function
If there are two factors as inputs: Labour (L) and Capital (K), production
function can be expressed in an algebraic equation as -
Q = f {L,K}
Wher e as,
Q = Quantity of output of a commodity L = Units of labour employed
K = Units of capital employed
With the help of this equation, we can simply state that the quantity of
output depends upon the quantity of labour and capital employed by the
firm in p roduction.
There are various assumptions like in production function, the factors of
production are perfectly homogenous. It also refers to a constant state of
technology and relates to a specific period of time. It is also assumed that
the firm/industry u ses the most efficient method of production and perfect
competition is assumed in the market.
munotes.in

Page 82

Managerial Economics

82 5.3 COBB AND DOUGLAS PRODUCTION FUNCTION
In 1928, Charles Cobb and Paul Douglas gave this production function.
This production function takes into consideration two f actors of input -
Labour and Capital. It is based on the empirical studies of the American
manufacturing industry. This production function advocates that about
2/3rd of increase in production is due to labour and 1/3rd is due to capital.
This function exh ibits constant returns to scale.
Cobb -Douglas production function is, Q = L2/3 C1/3
Where Q is Output, L is the quantity of labour and C is the quantity of
capital.
Criticism of Cobb - Douglas production function
01. This function considers only two factor inputs - labour and capital
and ignores others. Other factors are equally important.
02. It assumes constant returns to scale which may not be possible. In
the production function, increasing or decreasing returns to scale is
application.
03. The function assumes perf ect competition in the market which is
unrealistic.
04. This function ignores plant to plant and firm to firm variations.
05. All labour units are considered to be homogenous which is not always
true and practical.
5.4 TYPES OF PRODUCTION FUNCTION
On the basis of time , there are mainly two types of production function -
Long run production function and short run production function.

Fig.5.4: Types of Production Function

munotes.in

Page 83

Production Function

83 01. Long run Production Function
This production function studies the output behaviour in the long run in
relation to the changes in factor inputs. In the long run, all the factors
become variable. In the long run, the production can be increased. It
studies the impact on output as in the long run all the factors of production
can be changed simultaneously and in the same proportion.
A firm can expand or contract its operations. In the long run, we have
returns to scale. For example, we can build a plant in the long run by
employing all inputs in the same proportion.
02. Short run production function
This produ ction function examines the production function when only one
factor is variable, keeping quantities of other factors fixed. In simple
words, a short run production function deals with the functional
relationship of input -output, when production is increas ed by changing the
quantity of one input.
In the short run, all the factors of production cannot be increased or
decreased simultaneously. As mentioned earlier, to study long run
production function we have returns to scale. To study short run production
function, we have a law of variable proportion.
5.5 SIGNIFICANCE OF PRODUCTION FUNCTION

Fig.5.5: Significance of Production Function
munotes.in

Page 84

Managerial Economics

84 01. Efficient method of production
Production function helps firms and industries to use the most efficient
method of production by studying the functional relation between inputs
and outputs. It also enables producer to choose the optimum level of
technology for production
02. Cost reduction
With the help of combinations of various inputs and outputs, a firm by
proper planning can reduce the cost of production. This function will show
the important leads in the various mixture of physical inputs and outputs
which will help firms to reduce the production cost.
03. Study of variations
Production function study is based on industry variations. Knowledge of
this function is essential as it will help firms to optimize the resources as
per the nature and characteristics of their industries.
04. Revenue maximization
With the assistance of production function knowledge, a producer can
minimise losses of the firm. The loss control will help firms to maximize
the revenue. Adoption of the right technology will help producers to make
the right decisions.
05. Optimum utilization of resources
Production function refers to the given period of time. It is also deter mined
by the state of technology. These two important parameters along with the
right selection of inputs will help producers to optimum utilize resources of
the firm.
06. Helpful in Price -output decisions
As regards to pricing and output of a product, the pro duction function helps
managers to make decisions. It is to be noted the price output decisions
made by a firm also depend on the type of market structure. It means the
degree of competition prevailing in the market.
5.6 TOTAL PRODUCT, AVERAGE PRODUCT AND
MARG INAL PRODUCT
To understand the concept of production function, it is important to
understand the concept of total product (TP), average product (AP) and
marginal product (MP). We will see in detail how these concepts
contribute in the area of production fu nction. munotes.in

Page 85

Production Function

85
Fig.5.6: Total product, Average product and Marginal Product
01. Total product (TP)
Total product is the sum total of output of all the workers. It is the
aggregate produced when all inputs are employed. In other words, total
product refers to the to tal volume produced by a firm using given inputs. It
refers to a given period of time.
It is simply the output produced by all the employed workers. As the
variable factor increases, the total product also increases. With the help of
this understanding, we can analyse the behaviour of the total product in
production function. With the different levels of scale, the TP will behave
in this direction that can be analyzed with the help of this table.
Table 5.1 Behaviour of Total Product
Particular Description
Increasing returns to scale TP increases at an increasing rate
Constant returns to scale TP increases at constant rate
Decreasing returns to scale TP increases at a diminishing rate
Negative returns to scale TP falls


munotes.in

Page 86

Managerial Economics

86 It can be expressed as -
TP = Ave rage product X Variable factors employed OR
TP = Σ Marginal Product
02. Average product (AP)
Average product is calculated by dividing the total product with the
variable factors. It can be defined as the output per unit produced when
fixed factors are held co nstant. It is the output produced per unit by the
labour employed.
It is simply the number of units produced by comparing the total product
and the number of inputs needed to produce a commodity. Higher the
average product, higher is considered the product ivity of inputs. As the
variable factor increases, the average product also increases.
Table 5.2 Behaviour of Average product
Particular Description
Increasing returns to scale AP increases at a slower rate than MP Constant returns to scale AP increases insignificantly
Decreasing returns to scale AP falls
Negative returns to scale AP falls but remains positive

It can be expressed as -
AP = Total product/Units of variable factor input
03. Marginal product (MP)
Marginal product is an additional output gener ated by employing an
additional unit of variable input. It denotes the additional units produced by
employing additional units of variable input i.e. labour.
Marginal product means the additional output as a result of employing
additional units of input. When an extra factor input is used, the addition
to the total product is known as marginal product.
Table 5.3 Behaviour of Marginal product
Particular Description
Increasing returns to scale MP increases faster than AP
Constant returns to scale MP is als o constant
Decreasing returns to scale MP falls more compare to AP
Negative returns to scale MP becomes negative
munotes.in

Page 87

Production Function

87 It can be expressed as -
MP = Change in output / Change in input OR
MP = ᐃ Total Product / ᐃ Variable Factor
Table 5.4 Relationship between Total Product, Average Product and
Marginal Product
Units of
Labour
Employed Total
Product
(TP) Average Product
(AP)
(TP/Units of
Labour
employed) Marginal
Product
(MP) Returns to
Scale
1
2 100
250 100
125 100
150 Increasing
Returns
3
4 400
550 133.33
137.5 150
150 Constant
Returns to
scale
5
6
7 650
700
700 130
116.67
100 100
50
00 DiminishingReturns to
Scale
8 650 81.25 -50 Negative
Returns to
Scale

With the help of this tabl e, we can determine the relationship between Total
Product, Average Product and Marginal Product.

0 2 4 6 8 10

Fig.5.7 : Units of Labour and Total product munotes.in

Page 88

Managerial Economics

88
Fig.5.8: Units of Labour and Average product

Fig.5.9: Units of Labour and Marginal product

Fig.5.10: Relationship between TP, AP and MP

munotes.in

Page 89

Production Function

89 5.7 ISOQUANTS AND ISOCOST ANALYSIS
5.7.1 INTRODUCTION
Isoquant and iso -cost analysis is used in the theory of production function.
This term is also known as Iso-product, Equal -produc t or Production
indifference curve .It shows a technical relation between the inputs and
outputs. With the help of an isoquant curve, how inputs are converted into
output is depicted. The theory of isoquant curve is similar to the theory of
indifference cu rve. Indifference curve theory was used to provide various
combinations of goods to consumers which yield equal amounts of
satisfaction. Isoquant theory deals with the combinations of inputs which
are capable of producing the same level of output.
The ind ifference curve deals with theory of consumer behaviour. The
isoquant curve deals with the theory of production behaviour. This theory
is an extension of the Indifference curve. It is shifted from the theory of
consumption to the theory of production.
5.7.2 MEAN ING
The term isoquant comprises two words - iso and quant. Iso means equal
and quant means quantity. Thus, it means equal quantity or equal output.
Isoquant may be defined as the curve which shows the various
combinations of two inputs giving the same leve l of output. We can say
labour and capital are the two inputs which are used to produce different
combinations of output.
An isoquant curve represents all those combinations of inputs which are
competent of producing the same level of output. An isoquant c urve
represents all those combinations which produce the same level of output,
the producer is indifferent between them. That's why this curve is also
called the production indifference curve. Like, indifference curve isoquant
curve also slopes from left to right. The slope expresses the Marginal Rate
of Technical Substitution (MRTS).
Marginal rate of technical substitution shows how one input can be
substituted for another while holding the constant output.
5.7.3 DEFINITIONS
“The Iso-product curve shows the diff erent input combinations that will
produce a given output.”
- Prof. Samuelson
“An Iso-quant is a curve showing all possible combinations of inputs
physically capable of producing a given level of output.” - Ferguson
5.7.4 ASSUMPTIONS
01. Only two factors i.e Labour and Capital are used to produce a
commodity. munotes.in

Page 90

Managerial Economics

90 02. Factors of production are divisible in nature.
03. Production function is of variation nature rather than fixed
proportion/. The substitution between two the two factor inputs is
technically possible.
04. The technique of production is known or assumed to be constant.
05. It is assumed that all combinations produce the same level of output.
The concept of isoquant is made clear with the help of isoquant schedule
and graph.
Table 5.5 Isoquant Schedule
Combination Units of Ca pital Units of Labour Marginal Rate of
Technical Substitution(MRTS)
A 20 1 -
B 16 2 4:1
C 13 3 3:1
D 11 4 2:1

Fig.5.11: Isoquant Curve
The table shows that the combinations of two inputs i.e. labour and
capital yield the same level of output. Thus, the output of 200 units can be
produced by combining.

munotes.in

Page 91

Production Function

91 1) 1 unit of labour and 20 units of capital
2) 2 unit of labour and 16 units of capital
3) 3 units of labour and 13 units of capital
4) 4 units of labour and 11 units of capital
Each of the factor combinations A ,B,C, D produce the same level of
output, say 200 units. When we show them in a graph, we get an isoquant
curve as shown in the figure.
5.7.5 Isoquant Curve
An isoquant curve shows the various combinations of factor inputs which
produce the same level of output. It represents all those combinations of
two inputs which are capable of producing the same level of output. There
is a continuous substitution of one input.
5.7.5.1 PROPERTIES OF ISOQUANT CURVE
01. Isoquant curves slope downward from left to right
The slope o f the isoquant curve is downward from left to right. This
property of isoquant curve can be explained with the help of marginal rate
of technical substitution. In order to maintain the same level of output, with
the increase in the quantity of one factor o f production the quantity of the
other factor has to be decreased. If this thing will not be applied, the
quantity of the output will increase in some combinations.

Fig.5.12: Downward slope from left to right
02. Two isoquant curves do not intersect each other
The second property of the isoquant curve is about their non -intersection
nature. Two isoquant curves do not intersect each other. If two isoquant
curves intersect each other, it means that the firm will not have the same munotes.in

Page 92

Managerial Economics

92 level of output. With the same combination of the factors, the firm will get
different amounts of total output.

Fig. 5.13 : Two Isoquant Curves do not intersect
C stands for Capital and L stands for Labour
03. Isoquant curves are convex to the origin
Due to the marginal rate of technical substitution, isoquant curves are
always convex to the origin and not concave. The tendency of marginal
rate of technical substitution is decreasing in nature which means increase
in labour will result in the decrease in capital. But, the sacrifice of labour
goes on diminishing. Due to this feature, the isoquant curve has a convex
shape. A concave shape means increasing the marginal rate of technical
substitution which is against the assumption.



Fig.5.14: Isoquant curves are convex
04. Higher is quant means higher level of output
This property implies that the higher isoquant curve represents higher
output. Since more units of one factor or the other factor are involved on a
higher IQ curve, the higher isoquant curve depicts a higher level of output.
The u pper curve produces more output. More combinations of factors
produce a higher level of output. munotes.in

Page 93

Production Function

93

Fig.5.15: Higher Isoquant curve gives higher output
5.8 ISO-COST ANALYSIS
The iso -cost analysis can be done with the help of an iso -cost line. The iso -
cost line i s similar to the budget or price line. This line shows the
various combinations of factors that will result in the same level of total
cost. This line shows the different combinations of two factors at the same
cost a firm can obtain. Iso -cost lines corres pond to different levels of
combinations at the same cost for the firms.
The Iso -cost line represents the amount of money on factor input an
organization is willing to spend. It shows the different combinations of
factors a firm can purchase at a certain a mount of money. Iso -cost analysis
may be defined as the line which shows the different combinations of two
factor inputs which a firm can purchase at the same cost. It is the locus of
points of all different combinations of labour and capital.
5.8.1 ISOCOS T SCHEDULE
The following schedule depicts the various combinations of labour and
capital a firm can avail -
Table 5.6 Combinations of Labour and Capital
Combination Units of Labour
@ Rs. 10 Units of Capital
@ Rs. 20 Total expenditure
A 10 00 100
B 06 02 100
C 04 03 100
D 02 04 100
E 00 05 100

munotes.in

Page 94

Managerial Economics

94 From the above schedule, we can see the various combinations of Labour
and capital. The total expenditure incurred is Rs. 100. While, the
combinations from A to E depicts the various combinations of labour and
capital a firm can avail. In this case, a firm is willing to spend Rs. 100 on
the combination of Labour and Capital.
5.9 SUMMARY
● The functional relation between inputs and outputs is known as
production function. It expresses the relationship between physical
inputs and outputs. In simple words, it studies the relationship between
investment and production.
● Production function is determined by the state of technology and it also
refers to a period of time i.e short run or long run.
● In 1928, Charles Cobb and Paul Doauglas gave this production
function. This production function takes into consideration two factors
of input - Labour and Capital.
● Total product is the sum total of output of all the workers. Average
product is calculated by dividing the total product w ith the variable
factor and Marginal product means the additional output as a result of
employing additional units of variable input.
5.10 QUESTIONS
01. What is the Production Function? Give the assumptions and
significance of the Production Function.
02. Define Production Function.
03. Explain the concept of TP, AP and MP.
04. Explain Cobb -Douglas Production Function along with its limitations.
05. What is the Production Function? Give the assumptions and
significance of the Production Function.
06. Define Production Func tion.
07. Explain the concept of TP, AP and MP.
08. Explain Cobb -Douglas Production Function along with its limitations.

munotes.in

Page 95

95 6
LAWS OF RETURNS TO SCALE,
ECONOMIES AND DISECONOMIES OF
SCALE
Unit Structure
6.1 Introduction of Laws of Returns to Scale
6.2 Economies and Diseconomies to Scale
6.3 Solutions to Diseconomies of Scale
6.4 Summary
6.5 Questions
6.0 OBJECTIVES

 To study the meaning and types o f the Law of Returns to scale
 To study various types of economies and diseconomies of scale
 To study the solutions to correct diseconomies of scale
6.1 INTRODUCTION
In the short run, we have laws of variable proportion. In the long run, we
have a law of retur ns to scale. The law of returns to scale is applicable in
the long run. Economists use this phrase to describe the behaviour of
output in the long run in relation to the changes in the factor inputs. This
law explains the proportional change in output with respect to
proportional change in input. In the short run by keeping one factor
variable and other factor inputs fixed, we can get increasing returns to
scale to some extent.
In the long run, all factors input become variable. No factor input can be
fixed . It refers to increase in output due to an increase in all the factor
variables. The degree of change in output is due to degree of change in
input. munotes.in

Page 96

Managerial Economics

96

Fig.6.1: Theories of Production Function
6.1.1 DEFINITION
“Returns to scale relates to the behaviour of total output as all inputs are
varied and is a long run concept”
6.1.2 SSUMPTIONS

Fig.6.2: Assumptions
01. Applicable in long run
The law of returns to scale is applicable in the long run where all the
factors of production become variable. The concept of production is
studied in the long run. In the long run,the plant or operation size can be
varied.
02. All factors vary
In the long run, all factors are assumed to vary. In the long run, all
factors input become variable.
munotes.in

Page 97

Law of Returns to scale
Economies and Diseconomies
to Scale

97 03. Homogenous
All the variable factors of production are assumed to be homogeneous.
04. Factors vary in equal proportion
It is assumed that all the variable factors vary in equal proportion.
05. Constant and optimum technology
The technology in this law is assumed to remain constant. It is also
assumed that the producer is using the optimum one.
06. Physical units
Only physical inputs and outputs are considered in this law. The
monetary benefits attached with the factors are ignored.
6.1.3 TYPES OF LAW OF RETURNS TO SCALE

Fig.6 .3: Scales of laws of returns








munotes.in

Page 98

Managerial Economics

98 In the long run, there are three types of returns to scale -
Table 6.1 Three types of returns to scale
Units of
Labour Units
of
Capital Combination Marginal
product Total
product Scales
1 5 1+5 10 10 Increasing
Returns to
Scale
2 10 2+10 20 30 Increasing
Returns to
Scale
3 15 3+15 30 60 Increasing
Returns to
Scale
4 20 4+20 30 90 Constant
Returns to
Scale
5 25 5+25 30 120 Constant
Returns to
Scale
6 30 6+30 20 140 Decreasing
Returns to
Scale
7 35 7+35 10 150 Decreasing
Returns to
Scale munotes.in

Page 99

Law of Returns to scale
Economies and Diseconomies
to Scale

99

Fig. 6 .4: Returns to Scale
01. Law of increasing returns to scale
In increasing returns to scale, output increases more than proportionately.
It is a situation where the output increases more than the factor inputs. A
firm achieves increasing returns to scale due to sp ecialization and division
of labour. As the firm expands, it enjoys internal economies of scale.
For example, if there is an increase of 10% in factors input but the
increase in output is 30%, it is said to be increasing returns to scale.
02. Law of constant returns to scale
In this scale, the increase in factor inputs is proportional to the change in
output. Constant returns to scale are where the inputs and outputs are
increased in the same proportion. In this scale, output increases in the
equal proportion t o input factors.
For example, if there is an increase of 10% in factors input and the
increase in output is also 10%, it is said to be a case of constant returns to
scale.
03. Law of decreasing returns to scale
Diminishing returns to scale refers to a situatio n where the increase in
output is less than the increase in input. Diminishing returns to scale are
where inputs are increased but the increase in output is less than the
increase in factor inputs.
For example, if there is an increase of 10% in input and t he increase in
output is only 5%. It is said to be a case of decreasing returns to scale.
munotes.in

Page 100

Managerial Economics

100 6.1.4 OPTIMUM STAGE OF OPERATION
A rational producer will seek to produce in which stage is an important
question. A producer in the long run will not produce in stage thr ee. In
stage three, the marginal product is falling. A rational producer will not
produce in stage one. The marginal product is not optimally utilized in
stage one. A rational producer will produce at stage two. In stage two,
marginal product is constant a nd the first stage economies have been
extended.
6.2 ECONOMIES AND DISECONOMIES OF SCALE
Large scale production usually helps firms in reducing the cost of
production especially the fixed cost. The concept of economies of scale
and diseconomies of scale deals with the concept when a firm opts for
large scale production. Due to large scale production, the drop in the cost
of production of the firm leads to economies of scale. When the increase
in output leads to increasing cost per unit, this is said to be a sit uation of
diseconomies of scale.
If a firm is working on a large scale, it can be economical or sometimes
can give uneconomical results. The study of economies and diseconomies
of scale is important to increase benefits and decrease the disadvantages
attac hed to it. To study, economies and diseconomies are further divided
into two parts - Internal and External.
6.2.1 ECONOMIES OF SCALE
By the expansion of their production in the long run, a firm can utilize
the cost advantages. These cost advantages result in eco nomies to scale.
When a firm takes advantage of decreasing cost due to large scale
production in the long run, this is said to be economies of scale.
Therefore, the benefits of large scale expansion are known as economies
of scale. Economies of scale is a long term subject. A firm achieves
economies of scale when there is an increase in the sales of an
organization. The firm enjoys large scale production and drop in cost of
production especially fixed cost per unit. Due to lowering cost, a firm can
save and invest more. By availing raw material in bulk, a firm can get
better discounts from the suppliers.
The concept of economies of scale is further divided into two parts -
Internal and External Economies. munotes.in

Page 101

Law of Returns to scale
Economies and Diseconomies
to Scale

101

Fig. 6.5: Economies of scale and its types
01. Internal Economies
These economies, as the name suggests, arrive within the firm and are for
the firm only. When the output increases leading to decrease in cost of
production, a firm utilizes internal economies of scale. These economies
arise due to many internal factors which are within the organization and
are controllable in nature like entrepreneur skills and abilities, technical
scale, managerial skills of managers, skilled labour, marketing skills etc.
These are the real economies that arise when the firm ex pands its
business. These economies are the results of growth and development of
the firm. A firm enjoys internal economies of scale through the following
sources -

Fig. 6.6: Sources of Internal economies of Scale
01. Managerial Economies
These economies arise due to the scope of employing qualified, well
skilled and trained employees. A firm by employing skilled employees
can create these economies. It occurs when large firms can afford
specialists and experts of management. With the growth and
development, a firm can take the help of these specialists. munotes.in

Page 102

Managerial Economics

102 02. Labour Economies
With the expansion in the scale of production, many labour economies
like specialization, new inventions, efficient production and time saving
production occurs. A large scale production firm can create labour
economies. A large firm needs a large number of workers. As per their
skills and specialization, they are allotted work. Workers who are skilled
and trained in their operations save time and money for the organization.
03. Risk Bearing Econom ies
A big firm can average out the risk because of having better command
over its resources. It can diversify the risk by compensating the loss
through the profit of another service. With the multi product and diverse
production capabilities, a firm enjoys the economies of risk bearing.
04. Technical Economies
A firm producing output at large scale is linked to technical economies.
With the increase in scale of operation, a firm needs to use more efficient
and specialized forms of capital equipment and machiner y. Specialized
kind of capital equipment and machinery helps firms to produce larger
outputs at lower unit cost.
05. Marketing Economies
A firm can take the benefits of economies of scale when they increase
their budget. At a lower price, they can buy raw mate rial in bulk. By
setting up branches, they can spread their market. Many big firms are
taking the benefits of having large scale businesses.
06. Commercial Economies
Commercial economies deal with the overall benefits a firm can source
when it works at a large scale. Cheaper raw material is one of the benefits
a firm can enjoy if they purchase at bulk and at a discounted price. Output
with the help of marketing economies can be sold at a better price.
6.2.2 External Economies
External economies refers to those econom ies which are outside the
organization. Firms have no control over it as they are external in nature.
The sources and impact of these economies is common as the benefits
attached to these economies are availed by other firms as well. These
economies arise due to the growth and development of industrial areas.
All the firms belonging to this area take the benefits in general.



munotes.in

Page 103

Law of Returns to scale
Economies and Diseconomies
to Scale

103
Fig. 6.7: Sources of External Economies
01. Cheaper Raw Material
The expansion of an industry may result in various types of economi es.
One of the external diseconomies which a firm can enjoy is getting raw
material at cheaper rates. The expansion of an industry results in cheaper
sources of raw material, machinery and other capital equipment. The cost
of production is reduced because of cheaper raw materials. It also results
in exploration of new markets for the raw materials and other capital
equipment.
02. Development of Skilled Workers
The expansion of an industry also results in the development of skilled
workers. The workers get accus tomed to doing the various productive
works. Out of this, a worker learns various skills to do different kinds of
jobs.
03. Better Transportation
The external economies of an expansion of an industry also brings better
transportation facilities to a firm. With the growth and development of the
particular area, a firm and industry can avail and enjoy the benefits of
getting better transportation. Better transportation facilities greatly reduce
the cost of production of the firms.
04. Marketing Facilities
When an ind ustry expands, it usually results in many economies for the
firm. The demand for material and labour increases. With the expansion
of the large scale production, a firm can extend its marketing facilities.
Better and efficient marketing facilities ensure t he proper supply of goods
and services in the market. A firm can take the benefits of a market
network also.
munotes.in

Page 104

Managerial Economics

104 05. Growth of Ancillary Units
Ancillary units are small firms that produce and supply intermediate
goods to the large firm. The facilities at one place helps the firms to grow
and expand their operations. With the expansion of several firms of an
industry, many ancillary industries start specializing. They produce raw
material, tools, machinery in a specialized way. They offer the materials
or other thin gs at a low price because all these facilities help the firms to
develop and grow.
06. Cheaper Capital Equipments
Expansion of an industry also leads to availability of new and cheaper
sources of capital equipment. This expansion and exploration results in
reducing the cost of production. The reduction in cost of production results
in change in prices. Thus, the firms using these capital equipment will be
able to get them at lower prices.
07. Technological Economies
Development and expansion of an industry results in technological
economies. When an entire industry expands, for the said industry new
knowledge leads to new and improved kinds of machinery. It enhances
the productivity of the firms. It can also result in reduction of production
costs.
6.2.3 INTERNAL DISECONO MIES
Internal diseconomies are the diseconomies resulting from the internal
difficulties within the organization. Due to lack of supervision,
management and technical difficulties, these diseconomies are the factors
that raise the production cost. It impl ies all those factors which raise the
production cost. When the output increases beyond a certain limit, it
results in raising the cost of production. The following are considered as
the reasons/sources of internal diseconomies of scale -
Fig. 6.8: Sources of Internal Diseconomies

munotes.in

Page 105

Law of Returns to scale
Economies and Diseconomies
to Scale

105 01. Poor Communication
Poor communication is one of the important reasons for the creation of
internal diseconomies of scale in a firm. If the goals and objectives of the
production or any other activity is not communicated property, it will lead
to overproduction or under production. Both things are not good for the
firm and it leads to create diseconomies of scale.
02. Unwieldy Management
Managing large scale organizations is one of the difficult tasks. If a large
organization creates e conomies, its mismanagement can also create
diseconomies. One o f the main reasons for internal diseconomies is the
difficulty of managing large scale organizations. Coordinating the work of
different departments and sections can become pretty difficult.
Supervision also becomes challenging.
03. Technical Problems
Emergence of technical difficulties is another reason for the creation of
internal diseconomies. Technical improvements are possible upto a
certain point. Beyond this point, it can result in creating diseconomies.
Improved technology becomes uneconomical.
04. Labour Problems
In the form of non -cooperation from the labour class, labour problems can
be a reason for production lags affecting the economies of a firm.
Misunderstanding and communication gap can b e considered as the
potential reason for disagreement between the labour and management.
Bad working conditions, insufficient bonus and wages etc. can be
considered other reasons.
05. Location Problem
For the growth and survival of firms, location is an import ant element.
Wrong choice of location is considered as a detrimental factor for the
growth and development of a firm. Wrong location can cost firms to have
expensive raw material, unavailability of labour, high transportation costs.
Problem of unavailabili ty of inputs also creates internal diseconomies for
the firm.
06. Marketing Diseconomies
The further rise in the scale of production beyond an optimum point can
result in increasing the advertisement costs for the firms. Selling and
advertising diseconomies is bound to happen. Beyond a point, advertising
costs increases and the overhead of marketing increase more than
proportionately with the change
6.2.4 EXTERNAL DISECONOMIES
External diseconomies are not confined to any particular firm. These
economies are suffere d by all the firms. In an industry, all firms fall under munotes.in

Page 106

Managerial Economics

106 the preview of external diseconomies as they are outside the firm and
sometimes uncontrollable in nature. When an industry expands beyond
the certain limits then firms operating in that area suffer various types of
external diseconomies.
When many firms are localized at a particular place, these diseconomies
also come into operation. The following can be considered as the reasons
for external diseconomies.

Fig. 6.9: Sources of External Diseconomies
01. Changes in Government Policy
Due to changes in government policy, a firm suffers many
diseconomies. A firm is compelled to bring changes in the policy of
their operation due to the change prescribed by the government. If the
changes are not implemented pro perly b y the firm, it can cause them to be
in legal preview.
02. Logistics Problems
Another diseconomy which a firm is bound to face is logistic problem.
When many firms are localized in a particular area, it becomes difficult
for means of transport. Addition al burden of traffic in that area can create
logistic problems. It can also give rise to transportation costs due to high
demand.

munotes.in

Page 107

Law of Returns to scale
Economies and Diseconomies
to Scale

107 03. Calamities
Calamities also pose a threat to the working of the firms. Natural
calamities like floods, drought, earthquakes aff ect the day to day life of
people and the working of the economy. This also results in diseconomies
of scale to the firms
04. Problem of Raw Material
Because of the large demand for raw material, the problem of scarcity
arises. Firms experience great difficult ies in procuring raw material. Due
to large demand, the raw material not only becomes scarce but also
expensive. Besides, it also invites other problems.
05. Availability of Skilled Labour
Availability of skilled labour is another problem which a firm is likel y to
face. As, many firms are located at a particular place. They demand for
skilled and trained labour. The availability of skilled labour becomes
difficult and expensive and creates diseconomies.
06. Problem of Power and Finance
When many firms work in a par ticular firm, the problem of power and
finance also arise. Because of the large demand for power by the firms,
the problem of load shedding arises. Finance also becomes difficult and
expensive due to high demand.
07. Cost of Land
For the new firms, the cost of land becomes high. Significant external
diseconomies come into operation when many firms are localized at a
particular place. New firms entering this area may get the land at much
higher price.
Other diseconomies
Apart from the diseconomies mentioned abov e, the firms are likely to
face other diseconomies as well due to the following reasons
01. Changes in Global Policy Framework
02. Recessionary Markets
03. Levies and Taxes
6.3 SOLUTIONS TO DISECONOMIES OF SCALE
Diseconomies can be converted into economies if the firm ad opts various
measures. Internal diseconomies can be controlled as they are internal in
nature. With the help of some measures, its negative impact can be
reduced or stopped. But, the impact of external economies cannot be
reduced because the fall will be o n every firm. munotes.in

Page 108

Managerial Economics

108 Lowest average production cost is one of the solutions a firm may adopt
to decrease the impact of diseconomies. Generating demand for the
product in other nations can also help firms to diversify risk and manage
costs. Exploring new markets f or products and procuring raw material for
firms is also considered as one of the solutions to reduce the negative
impact of external diseconomies.
A firm can adopt healthy practices for human resources to ensure the
smooth communication and relations betw een workers and management. It
can solve the problem of unwieldy management. Problems which are
internal to organization are controllable in nature. A firm by assessing
them properly can take necessary measures to solve it.
Good connectivity with the emplo yees can also help in reducing the
diseconomies related to human resource management. Redesigning
business operations and strategies can also help firms in dealing with these
diseconomies in a better way. Effective supervision of labour can also
reduce the impact of diseconomies. Proper implementation of government
policy is another way out.
6.4 SUMMARY
● In the short run, we have laws of variable proportion. In the long run,
we have a law of returns to scale.
● The law of returns to scale explains the proportional change in output
with respect to proportional change in input. In the short run by
keeping one factor variable and other factor inputs fixed, we can get
increasing returns to scale to some extent.
● In the long run, there are three types of return to scale. They are
Increasing, C onstant and Decreasing returns to scale.
● When a firm takes advantage of decreasing cost due to large scale
production in the long run, this is said to be economies of scale.
Therefore, the benefits of large scale expansion are known as
economies of scale.
● A firm is likely to face diseconomies when an industry in a given area
expands beyond certain limits then firms operating in that industry
suffer diseconomies.
● A firm can adopt healthy practices for human resources to ensure the
smoo th communication and relations between workers and
management. It can solve the problem of unwieldy management.
Problems which are internal to organization are controllable in nature.
A firm by assessing them properly can take necessary measures to
solve i t.

munotes.in

Page 109

Law of Returns to scale
Economies and Diseconomies
to Scale

109 6.5 QUESTIONS
01. Explain in detail the law of returns to scale.
02. Explain in detail various economies and diseconomies to scale.
03. Explain the concept of economies to scale.
04. What are the solutions to diseconomies of scale for firms?


 


munotes.in

Page 110

110
7
REVENUE ANALYSIS, COST
ANALYSIS AND BREAK EVEN ANALYSIS

Unit Structure
7.1 Introduction
7.2 Accounting cost and Economic cost
7.3 Incremental cost and sunk cost
7.4 Fixed and Variable cost
7.5 Short and Long run Cost

7.6 Revenue Function

7.7 Break Even Analysis

7.8 Summary

7.9 Questions

7.0 OBJECTIVES

 To study different types of costs
 To understand the concept of revenue function
 To study the concept of Break even analysis
7.1 INTRODUCTION
Revenue is function of price in market and profit is function of price and
cost. Here price is determined in the market by many forces such as
market structure, demand and supply, manufacturing expenses, industry
competition and substitute availability. The market is highly sensitive to
price and price is function of market and industry dynamics. Firm do not
have great control on pricing as consumer sentiments are strongly
associated with price of product. Firm may face major loss of market share
if it will increase the price, but at the same time firm is answerable to its
investors for return on investment. This can be achieved with in depth
understanding of cost concepts and efficiently controlling cost of the
product and protecting competiveness of firm. Cost function is very
closely related with product ion function. Cost of producing products can
be different at different scale even though using similar resource
combinations. In depth analysis of cost function will lead to sustainable
profit management. Sustainable profit can be enhanced by studying munotes.in

Page 111

Revenue analysis, cost
Analysis and break even
analysis

111 various resource combinations and its impact on cost. Cost is such a
variable which can be controlled by firm.
Cost refers to expenses made to buy or gain some sort of resources. Cost
analysis refers to study of behaviour of cost in relation to one or more
production criteria. In the cost analysis various concepts associated with
cost such as accounting & economic cost, real cost& opportunity cost,
sunk cost, fixed cost, variable cost, total cost, average cost, marginal cost,
short run cost and long run cost ar e studied.
7.2 ACCOUNTING COST AND ECONOMIC COST
Accounting cost are all those expenses an entrepreneur will incur to
acquire outside resources to ensure the activities of business. The
entrepreneur will make payment to buy raw material, salaries of the
employees, utility bills and interest on borrowed capital from bank. All
such expenses where actual payment is made are recorded in books of
accounts and called as accounting cost. Accounting costs are explicit cost
where money is being paid to outsider supp liers against receipt of certain
goods or services. However to ensure production an entrepreneur also uses
his own resources such as own money, own building, own time. It is not
included in any type expenses and thus not recorded in any books of
accounts. Alternatively it is possible that if entrepreneur would not use the
resources in his own business, he could have earned return on it. He might
get rent of his owned building, he may get interest by bank for his own
money deposited in bank instead of invest ing in business and his services
to run the business can be used for some other business and he may get
some salary. All such expenses are included in economic costs. Economic
costs are accounting costs added by cost o9f own resources.
Consider following h ypothetical example.
Table 7.1: Accounting cost & Economic cost
Expenditure head Accounting Cost Economic cost
Capital Expenditure 50000 50000
Raw Material Purchase 15000 15000
Salary 5000 5000
Interest for bank 2000 2000
Utility payment 2000 2000
Own Salary 00 25000
Rent of building owned 00 10000
Revenue 100000 100000
Total Cost 74000 109000
Profit/ Loss 26000 (9000) Loss
munotes.in

Page 112

Managerial Economics

112 From the above example it is very clear that even if we saw profit in many
businesses in accounting term, we may incur l oss at the end. Hence it is
very important to analyse the businesses on economic front instead of
accounting cost only.
Explicit cost and Implicit Cost
Explicit costs are all those cost which are paid to outsider supplier. It does
not include cost of reso urces already owned by the firm. Whereas implicit
cost are those cost that includes cost of buying outside resources and cost
of internal resources of the firm.
Real cost & Opportunity Cost
Real cost are those costs which company incurs company making pay ment
to all such expenditure and these are recorded in accounting books.
Opportunity cost also known as alternate cost refers to benefits foregone
on the next best alternative. We know that resources are limited in nature
and wands are unlimited in nature. Here every one wants to maximise his
satisfaction by allocating scarce resources to a decision from lot of
available options. Here resources are scare in nature are having lot of
alternate uses. We can use same resource and gains out of each decision
will be different. You are choosing one option by rejecting rest of the
options. Here the next best alternate also gives you some benefits and you
are scarifies on that next best alternate by choosing to your decision. The
gains of next best alternate that you will not get are known as opportunity
cost or alternate cost.
Consider an example where you have 10 lakh rupees with you. You can
put this money in to bank and earn fixed interest may be 5% annually.
You have other option to start your business likely to give you 15% return
on the money invested. You may prefer to choose the second option and
put your money in business. Now while calculating the business returns
you should keep in mind that opportunity cost of money is 5% and income
from businesses must be higher than 5%.
7.3 INCREMENTAL COST AND SUNK COST
Incremental costs are related marginal costs. Incremental costs refer to the
additional cost incurred by firm as a result of business decisions. For
example, all costs such as replace worn out machine, b uy new production
facility, serve additional market and hire new media for advertisement are
considered as incremental costs. Sunk cost refer to those costs which are
already incurred and once and cannot be recovered. Example of sunk cost:
In recently tren ding franchisee businesses we need to do interior of store
which will be replaced by 5 years. Cost of interiors generally not
considered and divided over five years by all such businesses, we should
actually consider this sunk cost for calculating real pro fitability from
franchisee.
munotes.in

Page 113

Revenue analysis, cost
Analysis and break even
analysis

113 Historical costs and replacement costs
Companies incur cost in the past on the acquisition of productive assets
such as building, machinery, material handling vehicles etc. This cost is
called as historical cost where as replac ement costs refer to money
expenditure that has to be incurred for replacing an old asset. Instability in
prices make these two costs differ, other things remaining the same
inflation will increase replacement cost higher than historical costs.
Private cos ts and social costs:
Private costs are costs actually incurred may be explicit or implicit costs.
They normally figure in business decisions as they form part of the total
cost and are internalised by the firm. Social cost, on the other hand, refers
to the total cost borne by the society on account of a business activity and
includes private costs and external costs. It includes cost of resources the
firm is not required to pay price such as atmosphere, rivers, roadways, etc.
And the cost in term of disutil ity created such as air, water, sound and
environmental pollution.
7.4 FIXED AND VARIABLE COST
Fixed Cost
Fixed costs remains constant irrespective of volume of production. They
do not vary with output up to a certain level of output.
Fig 7.1: Fixed cost

These costs require a fixed expenditure of funds irrespective of level of
output, e.g. rent, property tax, interest and depreciation when taken as
function of time and not the output. However, these costs vary with the
size of the plant and are function of capacity. Therefore, fixed costs do not
vary with volume of production output within a capacity level. munotes.in

Page 114

Managerial Economics

114 As shown in curve 7.1, output is denoted on x axis and costs are marked
on y axis, fixed cost curve is parallel to x axis which means that it does not
increase or decrease with changes in output. T
Variable Cost
Variable costs are those costs which vary with volume of production. E.g.
wages of casual labour, raw material, electricity charges etc. these cost
vary directly and sometimes proportionate with the output.
Fig 7.2: Total Variable cost

In figure 7.2, output is marked on X axis and costs are represented on Y
axis, as shown in figure total variable cost increases increase in output, to
produce more number of products we will consume more raw ma terial and
more labour, this can be traced by increase in variable cost. However, the
pace of change in variable cost does not remains same, at the start the
variable cost increases at faster rate, it matures after some time and
remains constant for some m ore level of output production, further it again
increases at faster rate.
Total Cost
Total cost is summation of all expenditure such as fixed and variable
costs. These are all costs incurred on all resources necessary for
production at a given level of ou tput. Total cost is classified in total fixed
cost and total variable cost.
TC= TFC + TVC munotes.in

Page 115

Revenue analysis, cost
Analysis and break even
analysis

115

Fig: 7.3: Total cost
In figure 7.3, output is marked on X axis and costs are marked on Y axis.
We can see curves of fixed costs and variable costs are super impo sed on
the curve of total cost. Total costs start from point A on Y axis instead of
origin, this is because even if you don’t produce any units contribution of
fixed cost will be there so total cost starts from fixed cost curve at point A.
Further it is cl early seen that pattern of total cost is somewhat closer to
variable cost as total cost are addition of fixed cost and variable cost.
Average cost
Average cost refers to total cost divided by number of units. It can also be
calculated for fixed cost and va riable cost by dividing number of units to
total fixed and total variable cost. It is important as it gives you right idea
about cost of production and helpful in deciding price of the product. It is
given by,
Average cost AC = TC / Number of Units.
Avera ge Fixed Cost AFC = Total Fixed cost/ Number of units produced.
Average variable cost AVC = Total Variable cost/ Number of units
produced. munotes.in

Page 116

Managerial Economics

116

Fig 7.4: AVERAGE COST
In figure 7.4 output is marked on X axis and costs are marked on Y axis.
Average cost decrea ses with volume in production, a point will come
where average cost reaches to minimum level but beyond this point
average costs again increases. This can be associated with stages of
production where in second stage production costs is minimum, in stage 1
underutilisation results in higher costs. In stage III which exploits
resources is case of over utilisation, cost are higher in this case also.

Fig 7. 5
Figure 7.5 is expression for average fixed cost. On X axis output is
represented and on Y axis averag e fixed cost is shown, it is seen from
curve that average fixed cost reduces with increase in output, at larger munotes.in

Page 117

Revenue analysis, cost
Analysis and break even
analysis

117 volume average fixed cost are very less but they are very significant when
volume of production is very low.

Fig 7.6: Average variable cost
Figure 7.6 is expression for average variable cost. On X axis output is
represented and on Y axis average variable cost is shown, it is seen from
curve that average variable cost reduces with increase in output, it reaches
to one point when they are lowest b ut after this point average cost curve
start increasing again.
Marginal Cost
Marginal cost is addition in cost due to producing one more unit of output.
As the fixed cost remains the same, it is effectively change in total
variable cost.
MCn = TVCn - TVCn -1
MC = ∆ TVC/ ∆ q munotes.in

Page 118

Managerial Economics

118

Fig 7.7: Marginal cost
Figure 7.7 is expression for marginal cost. On X axis output is represented
and on Y axis marginal cost is shown, it is seen from curve that marginal
cost reduces with increase in output, it reaches to one point when they are
lowest but after this point average cost curve start increasing again. It is to
be noted that it reaches to lowest point earlier than average cost and pace
of increase is different in average cost and marginal cost.
.Table 7.2: Cost relations hip
I II III IV V VI VII VIII
Output Total
Fixed
Cost Total
variable
Cost Total
Cost Average
Fixed
Cost Average
variable
cost Average
total
cost Marginal
Cost
0 100 0 100 - - - -
1 100 50 150 100 50 150 50
2 100 78 178 50 39 89 28
3 100 98 198 33 33 66 20
4 100 112 212 25 28 53 14
5 100 130 230 20 26 46 18
6 100 150 250 17 25 42 20
7 100 175 275 14 25 39 25
8 100 204 304 13 26 38 29
9 100 242 342 11 27 38 38
10 100 300 400 10 30 40 58

munotes.in

Page 119

Revenue analysis, cost
Analysis and break even
analysis

119 In the table 7.2 various cost are presented and we can tr ace relationship
between various types of costs. The values of various types of costs are
presented with reference to volume. The values of output are taken from 0
units to 10 units and corresponding values of total fixed cost, total variable
cost, total c ost, average fixed cost, average variable cost, average total cost
and marginal cost are presented. Here we can infer that for 0 units of
production component of fixed cost remains which will lead to total cost
but remaining all other types of cost does n ot exists. The findings from
this table are as follows.
In the second column total fixed cost is presented, it remains constant over
entire volume of production.
In third column total variable cost is presented. Total Variable cost
increases with volume of production. It should be noted that pace of
increase in total variable cost is not same.
In the fo urth column total cost is presented. Total cost can be derived by
adding fixed cost and variable cost i.e. column number II & column
number III. Here total fixed cost also changes as volume of output
increases. The pace of change in total cost is exactly same as in variable
cost.
Fifth column gives values of average fixed cost which are derived by
dividing column number II by column number I. We can infer fro m this
table that average fixed costs are decreasing with the increase in volume.
The pace of decrease is faster at the starting and pace is reduced later on.
Average fixed cost nears to zero for higher volume but it never touches the
x axis and always in the positive region.
Further in the sixth column average variable cost are presented. The values
in the sixth column are calculate by dividing column number III by
column number I. AVC decreases at the starting and pace of reduction is
very high the pace r educes but still average variable cost reduces till point
corresponding to give output of sixth unit. It is constant for sixth and
seventh unit and after seventh unit it starts increasing, further it increases
with faster pace.
Seventh column shows values for average total cost, the values for average
total cost are calculated by dividing total cost by number of units
produced, i.e. column number IV divided by column number I. The table
shows that average total cost reduces with increase in volume the pace of
reduction in average variable cost reduces and at a point corresponding to
output of 8th unit average total cost reduces at 8th& 9th point AVC remains
constant and after point 9 average total cost start increasing. Again
attention must be given towards difference in average variable cost and
average total cost, at the start we will find that broader difference is there
in AVC and ATC this is on account of higher average fixed cost at the
starting later on as the average fixed cost decreases the differenc e in
average total cost and average variable cost narrowed down. munotes.in

Page 120

Managerial Economics

120 The last column represents values for marginal cost. Values in this column
are calculated by subtraction in IV column by the preceding value of the
total cost, simply value of marginal cost f or second unit can be calculated
by subtraction, value of total cost for II unit minus value of total cost for
Ist unit. E.g. MC for II unit= 150 -100 =50. The table shows that values of
marginal cost are reducing at very high speed at the starting and the pace
decreases, at point corresponding to value of forth unit is the lowest value,
after forth unit values of marginal cost increases and pace of increase is
faster at a later stage. This corresponds to law of diminishing marginal
returns.One more table is given for the study purpose of the students, few
places are blank in this table and student should calculate based on cost
relationships.
Table 7.3: Cost relationship (Exercise for students)
I II III IV V VI VII VIII
Output Total
Fixed
Cost Total
variab le
Cost Total
Cost Average
Fixed
Cost Average
variable
cost Average
total
cost Marginal
Cost
0 - 0 50 - - - -
1 - 50 - - - - -
2 - 78 - - - - -
3 - - 148 - - - -
4 - 112 - - - - -
5 50 130 - - - - -
6 - - - - - - 20
7 - 175 - - - - -
8 - - 254 - - - -
9 - 242 - - - - -
10 - 300 - - - - -

7.5 SHORT AND LONG RUN COST
Short run of the firm is run till at least one of the factor remains constant.
The scale or capacity of the plant remains constant in the s hort run. As
shown in figure 7.8 marginal c ost, average cost and average variable costs
curves are plotted on same graph. Here on X axis output is marked and on
Y axis costs are marked. It is seen from marginal cost curve and average
variable cost, when marginal cost curve cuts average variable cos t curve a
point will com e where marginal cost equals to average variable co st. It is
also noted that at this point that average variabl e cost are lowest at this
point. F urther average variable cost increases from this point. In this graph
average cost and average variable costs are also plotted, it is seen from
these two curves that at the starting distance between average cost and
average variable cost is high and this distance goes on reducing with munotes.in

Page 121

Revenue analysis, cost
Analysis and break even
analysis

121 increasing output. This is on account of reduction in ave rage fixed cost
over volume of production. At higher volume average variable cost is very
low this corresponds to smaller distance in average cost curve and average
variable cost curve.

Fig 7.8 : Short run cost
In figure 7.9 short run average cost curves are presented. Here SAC1
represents for scale 1, SAC2 represents higher scale of capacity and SAC3
represents third scale of production. OA level of output can be produced in
both 1 & 2 factories. The corresponding cost for similar level of output
OA in fi rst factory is AL and in second factory it is AH. We can infer
from this if we want to produce smaller level of output then smaller
factories should be preferred as variable cost are less in smaller factories
as compared to larger factories. But if we want to produce output OC, it
can be produced in both the factories 1 & 2 here the situation is exactly
reverse of first situation as variable cost in factory 1 will be CJ and
average cost in factory 2 will beCK. Here CK < CJ so it can be inferred
that average cost in factory 2 are less. If we want to produce higher output
then factories with larger capacities should be preferred. Similarly for
much higher output we should use much larger factory for minimum
possible costs.
munotes.in

Page 122

Managerial Economics

122

Fig 7.9 : Short run Average cost
Long Run Cost
In the long run all the factors of production varies, even the technology
and scale of production does not remains constant. New factories and
facilities are created in the long run to cater to increasing demand. Smaller
increase in demand can be catered by hiring few more labours in the
existing facilities but over a time you need to expand to new increased
facilities of production to cater to demand.

Fig 7.10 : Long Run Average cost
Long run cost analysis is basically analysis of total cost, average cost and
marginal cost. In the long run average variable cost is studied as the
volume of production is different.Long run cost curve is envelope of many
short run cost curve at different time and at different scale. LAC is munotes.in

Page 123

Revenue analysis, cost
Analysis and break even
analysis

123 actually a tangent draw n at all these SAC, LAC is tangent at point L, K, F
and J.Returns to scale can have three cases namely increasing returns to
scale, constant returns to scale and decreasing returns to scale. The
corresponding cost phenomenon is discussed as follows in each case.
From the definition of marginal cost and average cost, average cost is total
cost divided by number of units produced and marginal cost is cost due to
production of one additional unit.Using the same for long run in above
case, we find that average and marginal cost remains constant for constant
returns to scale. As he input doubles output also doubles TC will grow at
constant rate and long run average cost LAC remains constant.
As shown in figure, the long run average cost curve is drawn as to be
tangent to each of the short run average cost curve. Every point on the
long run average cost curve will be tangency point with some short run
AC curve. If the firm desire to produce any particular output, it then builds
corresponding plant and operate on t he corresponding short run average
curve. As shown in figure, for producing OQ2 level of output, the
corresponding point on LAC curve is K and the SAC2. If a firm desires to
produce output of OQ2 then firm will construct plant corresponding to
SAC2 and wil l operate on this curve at point K. Similarly firm will
produce other level of output choosing the plant which suits its
requirement of lowest possible cost of production. It is clear from the
figure that larger output can be produced at lowest cost with l arger
factories and smaller output can be produced at lowest cost by smaller
factories.
LAC curve is not tangent to the minimum points on SAC curves, when the
LC curve is declining; it is tangent to the falling portion of Sac curves.
When the LAC curve is rising, it is tangent to the rising portion of SAC
curves. The level of output OQ will touch at minimum point on SAC.
Thus, for producing output less than OQ at the lowest possible unit cost,
the firm will construct relevant plant and operate it at less th an its full
capacity, i.e. less than it minimum average cost of production,. On the
other hand for producing output large than OQ the firm will construct the
plant and operate it beyond its optimum capacity, OQ is the optimum
output. This is because OQ is being produced at minimum point on both
LAC & SAC curve. Other plants are either used at less than full capacity r
more than their full capacity, only SAC3 is being operated at minimum
point. This can be corresponds to increasing returns to scale and
decre asing returns to scale. The SAC3 corresponds to constant returns to
scale. Prior to this point we will find increasing returns to scale and after
this point we correlate with decreasing returns to scale.
The long run average cost curve is highly helpful t o the firms in planning
their facilities and planning operating level of these plants based on
desired level of output. The long run average cost curve helps the firms in
the choice of size of the plant for producing specific output at least
possible cost.
munotes.in

Page 124

Managerial Economics

124 Output A C
os
t
&
Re
ve
nue
X TFC TR 7.6 REVENUE FUNCTION
Revenue for the firm can be calculated by using expression
Revenue= Number of units sold*unit price of the product.
As discussed in the cost function we can calculate total revenue, marginal
revenue and average revenue. The differenc e lies in consid ering the price
of the product.













Fig 7.11 : Total Revenue Curve
As we know that price is a function of many variables based on industry
and market combined and firm do not have great control in finalisation of
price on ly thing firm can do is to monitor cost curves and correlate with
the corresponding revenue curve.
Figure 7.11 shows curve for revenue of the firm. On X axis output is
assigned and on Y axis cost and revenue are assigned. We can see that
revenue is zero w hen no units are produced and revenue curve starts from
origin, it goes on increasing with increase in sales.
7.7 BREAK EVEN ANALYSIS
From cost analysis we could know that the firm has various level of cost
and from revenue analysis we could know that rev enue is function of sales
price. Firm is keen on understanding its profitability and volume at which
it will get the maximum profit. Breakeven point is such point where firms
cost and revenue matches and there is situation of no loss or no profit. The munotes.in

Page 125

Revenue analysis, cost
Analysis and break even
analysis

125 firm must operate the beyond the point of break even for real profit. For
this purpose in the following figure total cost and total revenue curves are
superimposed with each other.

Fig 7.12 : Break even Analysis
Figure 7.12 shows curve for revenue & cost of t he firm. On X axis output
is assigned and on Y axis cost and revenue are assigned. It can be observe
from the figure that total cost of the firms starts from fixed cost line and
not the origin. Whereas revenue of the firm starts from origin as the sale of
very first unit. As we know that there is some fixed cost associated with
each firm therefore, firm must incur these cost for profitability. We can
see from the figure that firm will achieve a profitable zone where total
revenue line is above total cost li ne. The region of profit again goes in to
the line where company may incur loss. We may see that beyond
breakeven point company starts earning its profit. Beyond certain point
firm may aging go in loss zone because we know that long run average
cost curve is u shaped and therefore LAC increases beyond certain point,
but price is not the variable under control of the firm, we need to see
market demand and level of competition for pricing of the firm. Higher
cost decreases competitiveness of the firm.
Break e ven point is derived by the following expression
B.E.P= Fixed cost/ contribution
Where contribution= unit price – variable cost
Consider the following example,
The firm invest Rs 1,00,000. For fixed investment in plant for producing
ball pens. The variable cost of producing ball pens is Rs 5/ - and sales price
of the ball pen is Rs 10/ -. munotes.in

Page 126

Managerial Economics

126 We may calculate breakeven point as follows,
BEP= Fixed cost/ contribution and
Contribution= unit price – variable cost
Replacing the values,
Contribution = 10 -5 =5
Given fixed cost is 100000/ -
BEP = 100000 / 5 = 20000
From this example it is very clear that firm can have profit if it could sale
more than 20000 units. Similar BEP can also be calculated in days or
years based on daily sale of the product.
BEP is very signifi cant for analysing project at the initial stage. You may
have two projects available and want to choose one out of these two
projects, apart from other criterion project A will give BEP at 1.8 years
and project B gives you BEP at 2.3 years. Project A shoul d be preferred
over project B in this case as you will get your money invested earlier in
project A.
7.8 SUMMARY
The analysis of cost function, revenue functions and break even analysis
gives you to look at aspects of volume and profitability. Cost can be
accounting and economic cost, we should also see economic cost as it will
result in to real picture about profitability of business. Opportunity cost is
gains from next best alternate which you scarify. Fixed cost, variable cost
and total cost are compone nts of cost function based on factors. Fixed cost
is cost fixed assets where as variable cost of variable assets. Total cost
combination of both fixed cost and variable cost. Marginal cost refers to
additional cost due to producing one more unit and average cost refers to
total cost divided by number of units produced.
In short run plant capacity remains same and due to law variable
proportions we observe that cost reduces with increase in output till one
point but after this point cost start increasing. Sh ort run is also considered
as plant period as the plant capacity remains constant for short run. In the
long run, plant capacity also changes as firm may have additional units of
production. The factory and output level of the factory can be decided or
planned in the long run as we could compare relative short run cost curves,
their capacity level and effective cost for desired level of production. Long
run cost curve is envelope of many short run average cost curve and hence
we could understand comparative average cost of production in multiple
factories. For smaller level of output small factories can be used and for
larger level of production output scale of the factory should be larger.
munotes.in

Page 127

Revenue analysis, cost
Analysis and break even
analysis

127 7.9 QUESTIONS
1. Explain different types of costs in brief.
2. Diff erentiate between the following:
a. Accounting cost and Economic cost
b. Incremental and Sunk cost
c. Fixed cost and Variable cost
d. Average cost and Marginal cost
3. Discuss the revenue function.
4. Examine Break even analysis in detail.



munotes.in

Page 128

128 8
TYPES OF MARKETS
Unit Structure
8.1 Introduction
8.2Features of Perfect Competition Market
8.3 Price Determination under Perfect Competition Market
8.4 Features of Monopoly Market
8.5 Price Determination under Monopoly Market
8.6 Features of Monopolistic Market
8.7 Price Determination under Monopolistic Market
8.8 Features of Oligopoly Market
8.9 Price Determination under Oligopoly Market
8.10 Summary
8.11 Questions
8.0 OBJECTIVES
 To study the features and price determination under perfect
competition mar ket
 To understand the features and price determination under monopoly
market
 To study the features and price determination under monopolistic
market
 To study features and price determination of oligopoly market
8.1 INTRODUCTION
A market is a place where pe ople can come together to exchange products
and services. Typically, the parties involved are buyers and sellers. The
market may be physical, such as a retail shop, where people meet face to
face, or virtual, such as an online market, where buyers and sell ers may
not have direct physical contact. A market is a gathering place for buyers
and sellers to exchange or transact products and services. A market can be
physical, such as a retail establishment, or virtual, such as an e -retailer.
Physical sites where transactions take place can be used to depict markets.
Retail stores and other comparable enterprises that sell individual items to munotes.in

Page 129

Types of Market

129 wholesale markets that sell goods to distributors are examples of this.
They could also be virtual. Internet -based stores an d auction sites such as
flipkart and e -bay are examples of markets where transactions can take
place purely online with no physical contact between the parties involved.
Different Types of market:
The market is basically divided into two parts a) Perfect C ompetition b)
Imperfect Competition. Even there are different types of market available
in Imperfect Competition i) Monopoly ii) Monopolistic Competition iii)
Oligopoly

Fig 8.1
8.2 FEATURES OF PERFECT COMPETITION
MARKET
A perfect competition marketplace is one in which several enterprises
compete to sell the same product or service. Those things have piqued the
interest of a large number of clients. None of these companies can set a
price for their product or service without losing clients to competitors.
There are no barriers to any corporation desiring to enter or exit the
market. Because the end output from all sellers is so similar, consumers
are unable to discern between one company's product or service and that
of its competitors.
Features of Perfect Competition:
a) Large Number of buyers and Sellers
b) Homogeneous Product
c) Free Entry and Exit
d) Perfect Knowledge
e) Perfect Mobility of Factors of Production
f) Transport Cost
g) No Government Intervention
a) Large Number of Buyers and Sellers – There will always be a large
number of buyers and sellers in this type of marketplace. The
advantage of having a large number of small -scale producers is that munotes.in

Page 130

Managerial Economics

130 their resources cannot be pooled to affect market prices. If the quantity
given by an individual seller is insignificant in p roportion to the
overall market produce, they will be unable to influence the market
price on their own.
b) Homogenous Product - In an ideal market, the purchasers' product or
service should be homogeneous in every manner. There should be no
distinction betwe en them in terms of quantity, size, flavour, or other
criteria, so that they can be utilised interchangeably. If a retailer
attempts to charge a higher price for nearly comparable products, they
will quickly lose customers.
c) Free Entry and Exit - In a truly competitive market, no artificial
barriers prevent a firm from entering or compel an established firm to
remain when it wishes to leave. Their decision to enter, remain in, or
depart the market is purely driven by economic concerns.
d) Perfect Knowledge - Both buyers and sellers are well informed about
the current market conditions. Buyers are aware of the product's
specifications as well as its price. At the same time, the sellers are
aware of the potential sales of their products at different price points.
Because the customers are already aware of the product, there is no
need for advertising or sales promotion. As a result, firms are not
required to invest in these operations. It also enables businesses to save
money on advertising and other marketing acti vities, allowing them to
keep product costs low.
e) Perfect Mobility of factors of Production - Under ideal competition,
factors of production such as labour, raw materials, and capital should
have complete mobility. Workers should be able to move from one
location (industry, market, or manufacturing unit) to another based on
their pay. There should be no restrictions on the movement of raw
materials or capital.
f) Transport Costs - All sellers' costs for transferring goods, services, or
production inputs from one location to another in a fully competitive
market are either zero or constant. All vendors are presumed to be
equally near or far from the market. As a result, the cost of
transportation for all of them is the same. As a result, overall
production costs a nd selling prices remain consistent across the board.
g) No Government Interference - The government or any other regulating
agency is not interfering with the smooth operation of the ideal
competition. There are no restrictions or limitations on supply or
pricing, and prices can change entirely based on demand and supply.
In a completely competitive market, all commodities and services have
a single consistent price. It is determined by the supply and demand
dynamics.
munotes.in

Page 131

Types of Market

131 8.3 PRICE DETERMINATION UNDER PERFECT
COMPETITION MARKET
8.3.1 Price Determination in Short Run:
The term short period refers to a period of time in which current plants
cannot be expanded and new plants cannot be built to fulfil rising demand.
However, there is enough time for producers to adju st their output to the
increased demand by overworking their fixed capacity factories to some
level.The fact that a company is in equilibrium does not mean it is making
abnormal profits. Firms may generate supernormal profits, normal profits,
or losses in the short -run equilibrium.
a) Supernormal profit:

Fig 8.2
The level of the average cost in the short run equilibrium determines
whether the firm produces supernormal profits, normal profits, or losses.
The firm obtains supernormal profits if the average cost is less than the
average revenue. The average cost QC is less than the average revenue QB
in above figure and the firm makes profits equivalent to the area ABCD.
b) Loss:

Fig 8.3 munotes.in

Page 132

Managerial Economics

132 If the average cost exceeds the average revenue, the company will los e
money. The above figure demonstrates that the firm's average cost QF
exceeds its average revenue QG, resulting in a loss equal to the shaded
region EFGH. In this instance, the company will only keep producing if it
can cover its variable costs.
Otherwise , it will shut down since ceasing operations is preferable for the
company; it reduces losses.
c) Shutdown:

Fig 8.4
The 'closing -down point' is the moment at which a company's variable
costs are covered. If the price falls below the cost of goods sold o r average
costs grow, the company will not be able to cover its variable costs and
will be better off closing down. The shut -down point is depicted in the
above figure.
8.3.2 Price Determination in Long Run:
The long run is defined as a span of time long e nough to allow for changes
in both the variable and the fixed factors. As a result, all factors are
variable and non -fixed in the long run. Firms can change their output in
the long run by upgrading their fixed equipment. They can increase the
existing pla nts, replace them with new ones, or add new ones.
Furthermore, new businesses can enter the industry in the long run. On the
other hand, if the situation requires it, firms can reduce their fixed
equipment by allowing them to wear out without being replace d over time,
and the present firm can exit the industry.As a result, the long run
equilibrium will relate to a condition in which economic forces have been
given complete freedom to adjust. The long run average and marginal cost
curves are important for de termining output decisions in the long run.
Furthermore, in the long run, average variable cost has no bearing.
Because all costs are variable and none are fixed in the long run, the
average total cost is critical. munotes.in

Page 133

Types of Market

133 As a result, the conditions for a perfect ly competitive firm's long -run
equilibrium can be expressed as;
Price = Marginal Cost = Minimum Average Cost

Fig 8.5
The firm under perfect competition is in long -run equilibrium at price OP
when:
Price = Marginal Cost = Minimum Average Cost
At price OP, not only will all firms be in equilibrium at output OQ, but the
industry will be in equilibrium as well, because there will be no incentive
for new firms to enter or current firms to leave because everyone will be
receiving normal profits. Thus, under per fect competition, entire
equilibrium, i.e. equilibrium of all individual enterprises as well as the
industry as a whole, is attained in the long term at OP price.
8.4 FEATURES OF MONOPOLY MARKET
The word monopoly is a mixture of two words: 'Mono' and 'Poly .'
Monopoly is defined as a market condition in which there is only one
seller of a commodity. Monopoly is defined as a market scenario in which
there is only one seller of a commodity. There are no close substitutes for
the product it provides, and admiss ion is difficult. Individual owners,
single partnerships, and joint stock companies are all examples of single
producers. In other words, there is no distinction between firm and
industry when there is a monopoly.
The monopolist has complete control over t he commodity supply. He has
the market power to establish the price since he controls the supply of the
commodity. As a single seller, a monopolist can effectively rule without a
throne. If monopoly is to exist, the cross elasticity of demand between the
monopolist's product and the product of any other seller must be extremely
low.
munotes.in

Page 134

Managerial Economics

134 Definition:
“A pure monopoly exists when there is only one producer in the market.
There are no dire competitions.” –Ferguson
“Pure or absolute monopoly exists when a single fi rm is the sole producer
for a product for which there are no close substitutes.” –McConnel
Features of Monopoly Market:
a) One Seller and Large Number of Buyers:
b) No Close Substitutes:
c) Difficulty of Entry of New Firms:
d) Monopoly is also an Industry:
e) Price Maker
a) One Seller and Large Number of Buyers: The monopolist's business is
the sole business; it is an industry. However, it is expected that there
would be a considerable number of buyers.
b) No Close Substitutes: There must be no close substitutes for the
monopol ist's product. The cross elasticity of demand between the
monopolist's product and those of others must be minimal or non -
existent.
c) Difficulty of Entry of New firms: Even when a firm is producing
abnormal profits, there are natural or artificial barriers t o new firms
entering the industry.
d) Monopoly is also an Industry: Under monopoly there is only one firm
which constitutes the industry. Difference between firm and industry
comes to an end.
e) Price Maker: When a monopoly exists, the monopolist has complete
control over the commodity's supply. However, due to the vast number
of purchasers, each buyer's desire represents an endlessly small portion
of the total demand. As a result, customers must pay the monopolist's
set price.
8.5 PRICE DETERMINATION UNDER MONOP OLY
MARKET
8.5.1 Price Determination in Short Run:
Understanding the nature of the demand curve confronting a monopolist
becomes critical when there is a monopoly. There is no distinction
between firm and industry under a monopoly situation. As a result, w hen a
monopoly exists, the firm's demand curve becomes the industry's demand
curve. The monopolist faces a downward sloping demand curve because
the consumer's demand curve slopes downward from left to right. It munotes.in

Page 135

Types of Market

135 simply means that if a monopolist lowers the price of a commodity,
demand for that product rises, and vice versa.

Fig 8.6
As shown in figure, the monopolist's average revenue curve slopes down
from left to right. Also sloping downward from left to right is marginal
revenue (MR) curve. The MR curv e is below the AR curve, indicating that
average revenue (= Price) is PQ at OQ output, but marginal revenue is
MQ. As a result, AR> MR or PQ > MQ.
a) Supernormal profit:

Fig 8.7
When MC = MR, the company is in equilibrium at point E, and the MC
curve beg ins to rise. OP is the price, and OQ is the 'total production' of the
commodity as determined by the condition. We must measure the
difference between AR and AC in order to compute profits or losses. If
AR > AC, the difference between the two is profit per unit, which we can
calculate by multiplying it by the total number of units created. munotes.in

Page 136

Managerial Economics

136 b) Normal Profit:

Fig 8.8
The price is RQ = OP in the first figure, and the cost of production per unit
is TO in the second. As a result, RS =PT is the profit unit. Tot al profit is
the PTSR dark region on the OQ quantity of production, which is
abnormal profit. The established price is RQ = OP in the second figure,
and the average cost is RQ. There will be no profit at all in this situation.
c) Loss:

Fig 8.9
Price per unit is RQ = OP in figure three, whereas cost per unit is SQ. As a
result, SR (TP) stands for loss per unit. As a result, the shaded area of the
TPRS will be completely lost. However, this loss is only a temporary
occurrence. This loss will vanish with tim e, and under certain conditions
and circumstances, only profit will be earned.
8.5.2 Price Determination in Long Run:
Over time, the monopolist makes adjustments to his equipment and
manufacturing procedures. During this time, he will adjust the efficiency munotes.in

Page 137

Types of Market

137 and capacity of his resources to meet his needs in order to maximise profit.
However, the quantity of production is determined in the same way as it
was in the short period.The following diagram demonstrates this:

Fig 8.1 0
The LMC and LMR intersect at p oint E in this diagram, and then the LMC
continues to rise. As a result, OQ production is established, and OP is the
price. However, the average cost is SQ. So the profit per unit is RS, and
the overall profit at OQ production is PTSR.
8.6 FEATURES OF MONO POLISTIC MARKET
Monopolistic competition is a market condition in which a large number
of companies sell closely related but distinct products. Monopolistic
competition can be seen in markets for soap, toothpaste, air conditioning,
and other items.When we go into a department store to buy toothpaste,
we'll see a variety of brands such as Pepsodent, Colgate, Neem, Babool,
and so on.
Monopolistic Competition = Monopoly + Perfect Competition
Features of Monopolistic Competition:
a) Large Number of Buyers and Sell ers
b) Product Differentiation
c) Selling Costs
d) Freedom of Entry and Exit
e) Lack of Perfect Knowledge
f) Pricing Decision
g) Non-Price Competition
a) Large Number of Buyers and Sellers - There are a lot of companies
selling things that are similar but not identical. Each f irm is self -
contained and has a small market share. As a result, a single munotes.in

Page 138

Managerial Economics

138 company's market price control is limited. The presence of a large
number of businesses creates market competition.
b) Product Differentiation - Despite the enormous number of sellers, each
firm can wield some degree of monopoly through product
diversification. Differentiating items based on brand, size, colour,
shape, and other factors is known as product differentiation. A firm's
product is a close but not perfect equivalent for anothe r firm's product.
c) Selling Costs - Products are differentiated under monopolistic
competition, and these distinctions are communicated to purchasers
through selling costs. The expenses incurred on product marketing,
sales promotion, and advertising are refe rred to as selling costs. Such
expenses are expended to encourage customers to purchase a specific
brand of a product over a competitor's brand. As a result, under
monopolistic competition, selling costs account for a significant
portion of total costs.
d) Freedom of Entry and Exit - Firms under monopolistic competition
have complete freedom to enter or depart the industry at any moment.
It assures that a company does not experience abnormal earnings or
losses in the long run. However, in monopolistic competit ion,
admission is not as easy or as free as it is under perfect competition.
e) Lack of Perfect Knowledge - Both buyers and sellers are unaware of
the current market conditions. Selling expenses instil fake superiority
in the minds of consumers, making it dif ficult for them to compare and
contrast different products on the market. As a result, even if other
lower -cost products are of same quality, consumers prefer a particular
product (despite its high price).
f) Pricing Decision - Under monopolistic competition, a company cannot
be both a price taker and a price maker. Each firm, on the other hand,
has partial control over the pricing by manufacturing a unique product
or establishing a specific reputation. The amount to which he can
control price is determined by how loyal his customers are to his
brand.
g) Non-Price Competition - Non-price competition exists alongside price
competition in monopolistic competition. Non -Price Competition is
when a company competes with another company by giving away free
gifts, offeri ng favourable credit conditions, and so on, without
increasing the price of its own items.
8.7 PRICE DETERMINATION UNDER MONOPOLISTIC
MARKET
8.7.1 Price Determination in Short Run:
In the short run, a monopolistically competitive corporation can make a
supernormal profit, a normal profit, or a loss. All three instances are
explained in the diagrams below. munotes.in

Page 139

Types of Market

139 a) Super Normal Profit:
Given a firm's demand and cost curves, the firm would create the profit -
maximizing level of output when MR=MC. This is the firm's output level
of equilibrium.

Fig 8.1 1
We measure output on the X axis and cost and revenue on the Y axis. AR
and MR are the more elastic or flatter average and marginal revenue
curves. The short run average and marginal cost curves are abbreviated as
SAC and SMC. The equilibrium point of the firm is E, and the output level
of the firm is OQ. As a result, the pricing is either OP or QM. TR=
OQMP, TC=OQER in the following diagram with price OP and output
OQ. As TR>TC, excess profit = REMP (OQMP -OQER)
b) Nor mal Profit: A typical profit condition is quite uncommon. Due to
changes in demand and cost conditions, the firm may be able to just meet
its production costs, i.e. the scenario of normal profit.

Fig 8.1 2 munotes.in

Page 140

Managerial Economics

140 The firm is in equilibrium at point E 1, the inter section of the MR and MC
curves, with provided revenue and cost curves. TR= OQ 1R1P1, TC=
OQ 1R1P1, Output= OQ 1, Price= OP 1. The corporation will generate a
regular profit because TR=TC.
c) Loss: Due to demand and cost factors, the corporation may have to ru n
at a loss. We can demonstrate the loss scenario using the figure below.

Fig 8.1 3
The firm is in equilibrium at point E 2, where the MR and MC curves
overlap, with the specified revenue and cost curves. OQ 2 is the
equilibrium output, and OP 2 is the equil ibrium price. OQ 2L2P2 is the TR,
while OQ 2N2M2 is the TC. The firm will lose money if TC>TR. When a
company experiences a short -term loss, it must decide whether or not to
continue operating. The company will continue to operate as long as it can
cover its entire variable costs, and when TR comes into play.
8.7.2 Price Determination in Long Run:
The firm will be able to make all required modifications in its fixed factors
of production in the long run. Because all costs are variable, the company
cannot cont inue to lose money. Because there is no barrier to entry or exit,
more firms will enter the market, and enterprises that cannot afford their
costs of production will exit. More firms joining the market diminish the
market share of existing firms, resulting in all firms making a normal
profit in the long term. The following diagram can be used to demonstrate
the scenario of normal profit. munotes.in

Page 141

Types of Market

141

Fig 8.1 4
The equilibrium point is E, where the MR and MC curves intersect, given
the revenue and cost curves. Because T R=TC, there is a normal profit.
Equilibrium output= OQ, price= OP, TR= OQRP and TC= OQRP.
8.8 FEATURES OF OLIGOPOLY MARKET
The term oligopoly comes from two Greek words: 'oligo' which means
few and 'poly' which implies seller. Oligopoly is a market structu re in
which there are just a few vendors of homogeneous or differentiated
products (but more than two). So, oligopoly is a type of monopolistic
competition that exists between monopolistic competition and monopoly.
A market scenario in which a few enterpri ses sell homogeneous or
differentiated items is known as an oligopoly. The number of firms in an
oligopolist market is difficult to estimate. There could be three, four, or
five companies.Competition among the few is another name for it. With
only a few fi rms in the market, one firm's actions are likely to have an
impact on the others. In an oligopoly industry, products are either
homogenous or heterogeneous.
Pure or perfect oligopoly is one type, whereas imperfect or differentiated
oligopoly is another. Pu re oligopoly is most common among
manufacturers of industrial items such as aluminium, cement, copper,
steel, zinc, and so on. Automobiles, cigarettes, soaps and detergents,
televisions, rubber tyres, refrigerators, typewriters, and other consumer
items ar e examples of imperfect oligopoly.
Features of Oligopoly:
a) Few Firms
b) Interdependence
c) Non-Price Competition
d) Barriers to Entry of firms
e) Role of Selling Costs
f) Group Behaviour
g) Nature of the Product
h) Indeterminate Demand Curve munotes.in

Page 142

Managerial Economics

142 a) Few Firms - There are just a few lar ge enterprises in an oligopoly. The
actual number of businesses is unknown. Each company contributes a
considerable amount to the entire output. Different enterprises
compete fiercely, and each one tries to outsmart the other by
manipulating both prices an d output volume. In India, for example, the
vehicle market is oligopolist because there are only a few car
manufacturers.Because the number of firms is so small, any action
taken by one of them is likely to have an impact on the other firms. As
a result, e ach firm maintains a watchful eye on the activities of
competitors.
b) Interdependence - Oligopolistic firms are interdependent. The term
"interdependence" refers to how the acts of one firm influence the
actions of others. When deciding its price and output levels, a
company evaluates the actions and reactions of its competitors. A
change in output or pricing by one firm elicits a response from other
market participants.
In India, for example, a few companies dominate the automobile
market (Maruti, Tata, Hyun dai, Ford, Honda, etc.). Any alteration
made by one company (say, Tata) to one of its vehicles (say, Indica)
will cause other companies (such as Maruti, Hyundai, and others) to
make changes to their own vehicles.
c) Non-Price Competition - Firms in an oligopo ly have the ability to
affect prices. They do, however, aim to avoid price competition
because they are afraid of a price war. They adhere to a price -fixing
policy. Price rigidity is a scenario in which prices tend to remain
constant despite changes in dem and and supply. Firms compete with
each other through different means such as advertising, superior
customer service, and so on.
When a company seeks to lower its pricing, its competitors will
respond by lowering their prices as well. If it tries to raise the price,
though, other companies may not follow suit. It will result in the firm's
proposed price increase losing clients. As a result, businesses prefer
non-price competition to price rivalry.
d) Barriers to Entry of firms - The fundamental reason for the oligopoly's
small number of firms is the hurdles that prohibit new firms from
entering the field. Patents, the need for a considerable amount of
capital, control over critical raw materials, and other factors all restrict
new businesses from entering the m arket. Only those companies who
can overcome these obstacles are allowed to enter the business. As a
result, companies can make anomalous profits over time.
e) Role of Selling Costs - Because of the fierce competition and
interdependence of the firms, numerou s sales promotion strategies are
employed to boost product sales. Under an oligopoly, advertising is in
full flow, and it may often become a life -or-death situation. When a
company is in an oligopoly, it relies more on non -price competition. munotes.in

Page 143

Types of Market

143 When there is an oligopoly, selling expenses are more essential than
when there is monopolistic competition.
f) Group Behaviour - There is total interconnectedness among different
enterprises in an oligopoly. As a result, a firm's price and output
decisions have a direct i mpact on its competitors. Oligopoly
enterprises prefer collective decisions that safeguard the interests of all
the firms over separate price and production strategies. Firms that
operate as if they were a single entity, despite their individual
independen ce, are said to be engaging in group behaviour.
g) Nature of the Product - Oligopolistic enterprises can produce uniform
or differentiated goods.
a. The industry is known as a pure or perfect oligopoly if the firms
create a homogeneous product, such as cement or steel.
b. The industry is called differentiated or imperfect oligopoly if the
firms create a differentiated product, such as autos.
h) Indeterminate Demand Curve - In an oligopoly, it is impossible to
predict a producer's exact behaviour pattern. As a result, an
oligopolist's demand curve is indefinite (uncertain). Because
businesses are so intertwined, they can't afford to ignore the reactions
of their competitors. Any pricing adjustment by one entity may result
in price changes by competitors. As a result, the d emand curve is
always moving and is neither defined nor indeterminate.
8.9 PRICE DETERMINATION UNDER OLIGOPOLY
MARKET
Oligopoly market can be understood throughSweezy's non -collusive
oligopoly model as well as collusive oligopoly models involving cartels
and pricing leadership.
8.9.1 Sweezy's Kinked Demand Curve (Rigid Prices) Model:
Prof.Sweezy proposed the kinked demand curve analysis in a 1939 work
to explain price rigidities commonly encountered in oligopolistic settings.
Sweezy assumes that if an oligo polistic firm cuts its pricing, its
competitors will follow suit in order to avoid losing consumers. As a
result, lowering the price will not significantly increase demand. Its
demand curve is relatively inelastic at this point.If the oligopolistic firm
raises its pricing, however, its competitors will not follow suit and modify
their prices. As a result, the quantity requested of this organisation will be
significantly reduced. This part of the demand curve has a lot of wiggle
room. In both of these cases, the oligopolistic firm's demand curve has a
kink at the current market price, which explains pricing rigidity.
The following figuredepicts the price -output connection in the oligopolist
market, where KPD is the kinked demand curve and OP 0 is the prevailin g
price in the oligopoly market for one seller's OR product. Starting at point munotes.in

Page 144

Managerial Economics

144 P, which corresponds to the present price OP 1, any price rise above it will
significantly lower his sales, as his competitors are unlikely to match his
price increase. This is b ecause the kinked demand curve's KP section is
elastic, while the corresponding KA portion of the MR curve is positive.
As a result, any increase in price will reduce not only his total sales, but
also his total revenue and profit.

Fig 8.1 5
If the seller lowers the price of the goods below OPQ (or P), his
competitors will also lower their pricing. He will increase sales, but his
profit will be lower than before. The reason for this is that below P, the PD
component of the kinked demand curve is less elast ic, and the
corresponding part of the marginal revenue curve is negative. As a result,
the seller will lose in both price -raising and price -lowering situations. He
would keep to the current market price, OP 0, which is still fixed.
Effects of Cost Variation s on Kinked demand curve:
Changes in costs within a certain range have no effect on the prevailing
price in oligopoly under the kinked demand curve approach. Assume that
the cost of production reduces, and the new MC curve is MC 1. It cuts the
MR curve in t he gap AB, resulting in OR as the profit -maximizing output
that can be sold at OP 0.It's worth noting that any cost decrease will result
in the new MC curve cutting the MR curve in the gap, since as costs fall,
the gap AB continues to grow for two reasons:
(1) As costs decline, the upper section KP of the demand curve becomes
more elastic due to the increased certainty that a price increase by one
seller will not be followed by competitors, reducing his sales significantly.
(2) As costs decrease, the lower h alf PD of the kinked curve becomes
more inelastic, as there is a larger likelihood that a price cut by one seller
will be followed by other competitors. munotes.in

Page 145

Types of Market

145

Fig 8.1 6
As a result, at P, the angle KPD tends to be a right angle, and the gap AB
grows, cutting th e marginal revenue curve inside the gap with any MC
curve below point A. The overall consequence is the same production OR
at the same price OP 0, with the oligopolistic sellers reaping higher
profits.If the cost of production rises, the marginal cost curve , now known
as MC 2, will shift to the left of the old curve, MC. The price situation will
be rigid as long as the higher MC curve crosses the MR curve within the
gap up to point A. However, as costs rise, the price is unlikely to stay
constant indefinitely , and if the MC curve rises above point A, it will
intersect the MC curve in the portion KA, resulting in a lower quantity
sold at a higher price. We can conclude that even when costs fluctuate,
price stability may exist under oligopoly if the MC curve cut s the MR
curve in its discontinuous half. However, where costs are falling rather
than rising, the odds of pricing rigidity are higher.
8.9.2 Collusive Oligopoly:
Collusive oligopoly is a situation in which companies in a given industry
decide to band toge ther as a single entity in order to maximise their
combined earnings and negotiate market share. The former is referred to
as a joint profit maximisation cartel, while the latter is referred to as a
market -sharing cartel. Another sort of cooperation is cal led leadership, and
it is built on unspoken agreements.
A) Cartels:
A cartel is a group of independent businesses operating in the same
industry. Prices, outputs, sales and profit maximisation, and product
distribution are all governed by cartel policies. Cartels can be voluntary or
compulsory, open or secret, depending on the government's policy on the
formation of cartels. As a result, cartels come in a variety of shapes and
sizes, and they employ a variety of strategies to adhere to a variety of
common p olicies, depending on the sort of cartel. The two most common
types of cartels are discussed below: (1) joint profit maximisation or
perfect cartel; and (2) market -sharing cartel. munotes.in

Page 146

Managerial Economics

146 a) Cartel for Joint Profit Maximization:
In an oligopolistic market, the unc ertainty creates an incentive for rival
enterprises to form a perfect cartel. A perfect cartel is a type of perfect
collusion that is at its most extreme. In this case, companies that produce a
uniform product form a centralised cartel board in the industr y. This
central board receives the price -output decisions made by the individual
enterprises.
The board sets output quotas for its members, as well as the price to be
charged and how industry profits are distributed. Because the central
board manipulates p rices, outputs, sales, and profit distribution, it acts as a
single monopoly whose primary goal is to maximise the oligopolistic
industry's combined profits.
Joint profits will be maximised when the industry MR matches the
industry MC, given the market dem and curve and its corresponding MR
curve, D denoting the market (or cartel) demand curve and MR denoting
the marginal revenue curve. The lateral summation of the MC curves of
firms A and, resulting in M = MC a + MC b, is used to draw the aggregate
marginal c ost curve of the industry M. At point E, where the curve
intersects the industry MR curve, the cartel solution that maximises joint
profit is determined.

Fig 8.1 7
As a result, the total output is OQ, which will be sold at a price of OP =
(QF). The cartel board will allocate industry output by equating the
industry MR to each firm's marginal cost, just as it would in a monopoly.
Drawing a straight line from E to the vertical axis and passing through the
curves MC b and MC a of firms and A at points E b and E a, respectively,
yields the share of each firm in the industry output.
As a result, firm A's part is OQ a, and firm B's share is OO b, both of which
equal the total output OQ which is OQ a + OQ b. The monopoly solution is
the price OP and output OQ distributed between A with lower costs sells
larger output than firm B with higher costs, so OQ a>OQ b; however, this
does not mean that A will make more profit than B. munotes.in

Page 147

Types of Market

147 The joint maximum profit is the sum of RSTP and ABCP earned by A and
which will be pooled into a fund and distributed by the cartel board in
accordance with the agreement reached by the two firms at the time of the
cartel's formation. A pooling agreement of this type will allow both firms
to maximise their joint profit as long as their individual profits do not
exceed the former.
b) Cartel of Market -Sharing:
In practise, another type of perfect collusion in an oligopolistic market
occurs when member firms of a cartel enter into a market -sharing
agreement to form a cartel "while maintaining a significant de gree of
freedom concerning the style of their output, their selling activities, and
other decisions."
Market -sharing can be done in two ways:
(i) N on-price competition - A loose form of cartel is a non -price
competition agreement among oligopolistic enterp rises. Under this sort of
cartel, the low -cost enterprises urge for a low price and the high -cost firms
for a high price. However, they eventually come to an agreement on a
common price below which they will not sell.
They must be able to make some money a t such a low price. Firms can
compete on a non -price basis by varying the colour, design, shape,
packaging, and other features of their products, as well as having their
own advertising and other sales activities. As a result, each firm shares the
market w ithout regard to price while selling the product at the agreed -
upon common price.
(ii) Quota Agreement - The quota agreement among firms is the second
method of market sharing. In an oligopolistic industry, all firms form
collusion in order to charge a uni form price. The fundamental agreement,
however, is that the market will be shared evenly among member firms,
allowing each firm to profit from its sales.
B) Price Leadership:
When all oligopolistic firms in an industry follow the lead of one large
firm, it is referred to as price leadership.The firms have an unspoken
agreement to sell the product at a price set by the industry leader (i.e. the
big firm). There is sometimes a formal meeting with the leader firm, and a
clear agreement is reached. A uniform pr ice is established if the products
are homogeneous. Prices can be uniform even if the product is
differentiated. The leader announces any price changes that occur from
time to time, and the other firms follow suit.
There are several sorts of price leadersh ip. However, we'll look at three of
the most common pricing leadership models right now:
a) Low -Cost Price Leadership:
In the low -cost price leadership model, an oligopolistic firm with lower
costs sets a lower price that all other firms must follow. As a result, the
low-cost company becomes the price leader. munotes.in

Page 148

Managerial Economics

148 b) Dominant Firm Price Leadership:
This is a typical case of price leadership in which the industry is
dominated by one large dominant firm and a number of small firms. The
dominant firm sets the price for the entire industry, while small businesses
sell as much as they want and the dominant firm fills the remaining
market. As a result, it will choose the price that maximises its profits.
c) Barometric Price Leadership:
The barometer price leadership mo del is one in where there is no single
leader firm, but rather one oligopolistic firm with the wisest management
that announces a price change first, followed by the rest of the industry.
The dominant firm with the lowest cost, or even the largest firm in the
industry, may not be the barometric price leader.It's a company that
functions as a barometer for predicting changes in industry cost and
demand situations, as well as overall economic conditions. Other firms in
the sector consider such a firm as the l eader and follow it in making price
changes for the product based on a formal or informal implicit agreement.
8.10 SUMMARY
A market is a place where people can come together to exchange products
and services.A perfect competition marketplace is one in whic h several
enterprises compete to sell the same product or service.The term short
period refers to a period of time in which current plants cannot be
expanded and new plants cannot be built to fulfil rising demand.The long
run is defined as a span of time l ong enough to allow for changes in both
the variable and the fixed factors.Monopoly is defined as a market
condition in which there is only one seller of a commodity.Monopolistic
competition is a market condition in which a large number of companies
sell c losely related but distinct products.Oligopoly is a market structure in
which there are just a few vendors of homogeneous or differentiated
products (but more than two).
8.11 QUESTIONS
1. Explain the features of perfect competition market. How price is
determ ined under perfect competition market?
2. What are the features of monopoly market? Elaborate the price
determination in monopoly market.
3. What is monopolistic market? Explain its features and price
determination.
4. Explain the features of oligopoly market along with collusive and non -
collusive models.

munotes.in

Page 149

149 9

PRICING PRACTICES

Unit Structure
9.1 Introduction
9.2 Factors Affecting Pricing Decision
9.3 Marginal Cost Pricing
9.4 Mark -up Pricing
9.5 Transfer Pricing
9.6 Product Line Pricing
9.7 Price Skimming
9.8 Penetration Pricing
9.9 Summary
9.10 Questio ns
9.0 OBJECTIVES
 To study the factors which affect pricing decision
 To understand the concept of marginal cost pricing
 To study the meaning of Mark -up pricing
 To understand the concept of Transfer pricing
 To study what is the meaning of Product line prici ng
 To understand the concept of Price Skimming
 To understand the meaning of Penetration pricing
9.1 INTRODUCTION
Pricing strategy refers to the technique by which businesses price their
products or services. Almost all businesses, large and small, base the
pricing of their goods and services on production, labour, and advertising
costs, then add a set percentage to make a profit. Pricing techniques munotes.in

Page 150

Managerial Economics

150 include penetration pricing, price skimming, discount pricing, product life
cycle pricing, and even competitiv e pricing.
9.2 FAC TORS AFFECTING PRICING DECISION
9.2.1 Internal Factors: Organizational Factors, Marketing Mix,
Product Differentiation, Product Cost, and Firm Objectives.
1. Organisational Factors
Pricing choices are made at two levels inside the organis ation. Top
executives are in charge of overall pricing strategy. They identify the basic
market segment ranges into which the product falls. The real mechanics of
pricing are handled at lower levels of the organisation, with a focus on
individual product p lans. Typically, a team of production and marketing
experts collaborate to determine the pricing.

2. Marketing Mix
Price is merely one of several crucial factors in the marketing mix,
according to marketing professionals. Any change in any of the four
factors has an immediate impact on the others: production, promotion, and
distribution. In some industries, a company may utilise price reduction as
a marketing strategy.
Other businesses may raise prices as part of a deliberate effort to create a
high-end p roduct line. In any situation, the endeavour will fail unless the
price change is accompanied by a comprehensive marketing campaign.
When a company raises its prices, it may include a more impressive -
looking bundle and launch a new advertising campaign.

munotes.in

Page 151

Pricing Practices

151 3. Product Differentiation
The price of the product is also determined by its qualities. To entice
customers, many features are added to the goods, such as quality, size,
colour, appealing packaging, alternate usage, and so on. Customers
generally pay a hi gher price for a product that has a new style, fashion, a
nicer box, and so on.
4. The product's cost
The cost and price of a thing are inextricably linked. The cost of
production is the most crucial aspect. When selecting whether or not to
promote a produ ct, a company may try to determine what prices are
reasonable in light of existing market demand and competition. The
product is eventually sold to the general public, and their ability to pay
will determine the price; otherwise, the product would flounder in the
market.
5. The Firm's Objectives:
A company may have a variety of aims, and pricing plays a role in
accomplishing those goals. Firms may pursue a number of value -oriented
goals, such as increasing sales revenue, increasing market share,
increasing client volume, decreasing customer volume, preserving an
image, maintaining a constant price, and so on. Pricing policy should be
created only after careful evaluation of the firm's objectives.
9.2.2 External Factors: Demand, Competition, Suppliers, Econom ic
Conditions, Buyers, and Government.
1.Demand
Pricing is plainly affected by market demand for a product or service.
Because demand is influenced by factors such as the number and size of
rivals, prospective purchasers, their capacity and readiness to pa y, their
preferences, and so on, these considerations are taken into account when
determining the price.
A firm can calculate the expected price in a few test markets by
experimenting with different prices in different marketplaces and
comparing the outcom es to a controlled market where the price is not
changed. If the product's demand is inelastic, excessive prices may be set.
If, on the other side, demand is elastic, the firm should not set high
pricing, but rather lower prices than competitors.
2. Compet ition
Pricing decisions are influenced by competitive conditions. Price
determination is heavily influenced by competition. A firm may set a price
that is equal to or lower than that of its competitors, provided that the
product's quality is never lower th an that of its competitors.
munotes.in

Page 152

Managerial Economics

152 3. Suppliers
Suppliers of raw materials and other commodities can have a considerable
impact on product pricing. If the price of cotton rises, the increase is
passed on to manufacturers through suppliers. It is then passed on t o
customers by manufacturers.
However, when a manufacturer looks to be generating significant profits
on a specific product, suppliers may try to gain money by charging more
for their supplies. In other words, the price of finished goods is
inextricably re lated to the price of raw resources. Pricing is also
determined by the scarcity or abundance of raw materials.
4. Economic Conditions
Pricing is affected by inflationary or deflationary tendencies. During a
recession, prices are dropped significantly in or der to maintain the level of
turnover. Prices, on the other hand, rise during the boom phase to
compensate rising production and distribution costs. To adapt to changes
in demand, price, and so forth.
There are several pricing options available:
(a) Prices can be increased to safeguard profits from growing costs.
(b) Price protection mechanisms that link delivery prices to current costs
can be devised.
5. Buyers
The numerous individuals and businesses who purchase a company's
products or services may have a n impact on price decisions. When a large
number of them purchase a specific product, brand, or service, their nature
and behaviour effect pricing.
6. Government
Price discretion is also influenced by price controls enacted by the
government when it is dee med necessary to halt the inflationary tendency
in the prices of specific products. Prices cannot be raised because the
government closely monitors pricing in the private sector. Marketers
clearly have significant control over internal elements, whereas th ey have
little, if any, control over external factors.
9.3 MARGINAL COST PRICIN G
Prices are set by marginal cost rather than fixed cost in marginal cost
pricing. Fixed costs are disregarded. For determining equilibrium
production, economic analysis relies on Marginal Cost and Marginal
Revenue analysis. Profit maximisation is a key goal for businesses. To
achieve this goal, the firm strives to set its prices in such a way that the
total contribution to fixed expenses is maximised. munotes.in

Page 153

Pricing Practices

153 Under perfect competition, the marginal cost curve cuts the marginal
revenue curve from below, and at the point of equilibrium, MR= MC and
MR= AR. Thus MC= AR.
Benefits of Marginal Cost Pricing:
1) Under marginal cost pricing, prices are made competitive simply by
having a greater f ixed overhead structure. If a company's variable
expenses are significant, its prices become uncompetitive. In the near
run, variable costs can be controlled, while fixed costs are
uncontrollable.
2) Marginal costs more closely reflect future cost levels a nd cost
relationships than present costs since one is more interested in
modifying the cost when making a pricing decision. These fluctuations
are represented by marginal cost, whereas fixed cost does not indicate
such changes as a result of price decision s.
3) Marginal cost pricing enables firms to devise more aggressive price
strategies. This pricing strategy increases sales while decreasing
marginal expenses.
4) Marginal cost pricing is more useful for pricing a product over its life
cycle.
Disadvantages of Marginal Cost Pricing:
1) Because some accountants are unfamiliar with marginal cost
approaches, they are unable to explain their application to
management.
2) Marginal cost pricing is unappealing.
3) During a recession, a corporation utilising the mar ginal cost pricing
approach may drop its prices in order to stay in business; this may
prompt other firms to lower their prices as well, resulting in cutthroat
competition.
9.4 MARKUP PRICING
Markup pricing is a pricing method in which the price of a produ ct or
service is set by adding the sum of the items and a percentage of the total
as a markup. In other terms, it is the process of determining a product's
selling price by adding a percentage to its cost. A markup is the price
difference between the selli ng price and the cost of a good or service.
Profit for a corporation is essentially the price added to the total cost of a
good or service. Consider the following equation to better understand this
concept:
Cost of Good or Service + Markup = Selling Price
This means that firms can determine their retail or selling pricing by
adding a specific markup to the cost of making the goods or providing the
service. If you want to know the markup %, apply the following formula:
Markup Percentage = ((Sales Price – Unit Cost)/(Unit Cost )) × 100 munotes.in

Page 154

Managerial Economics

154 The amount of markup used by a business is determined by its demands,
the type of firm, and the industry in which it operates. While some
industries can afford to mark up the price of their goods and services by a
modest proport ion, others can afford to mark up the price of their goods
and services by a significant amount.
Advantages of Markup Pricing:
Markup Pricing has various advantages that can help your business
succeed. Here are some of the advantages of Markup Pricing.
1) Increases Profits: Considering markup pricing will help you set
strategic prices for your goods and services that will make a profit for your
firm. If you mark up your goods and services sufficiently, you can assist
offset any production costs.
2) Recover Costs: Because you have the ability to create a profit when you
mark up the pricing of your products and services, you can apply this
profit to the labour and materials you used. This will keep you from falling
into debt solely to produce your goods and se rvices.
3) Simple Calculations: While developing a pricing strategy necessitates
various key figures, finding the appropriate markup price is very simple
due to its simple equation.
How to Make Use of Markup Pricing:
You can utilise markup pricing for a va riety of purposes to help your
business get to the top of its industry. Here are a few examples of how you
can use markup pricing to your advantage.
1) Determining unit selling or retail prices: Before deciding on a retail
pricing for a product or service, evaluate how much profit you want to
generate and the highest price it will go for on the market. For example, if
you want to make a 10% profit on every item you sell, the retail price of
each item must be the sum of its wholesale price and a 10% markup o n its
wholesale cost.
2) To satisfy profit objectives: To create a profit, a product or service
mark -up must cover all business expenses. When you make a deliberate
mark -up, you can assist offset any losses you made while developing the
product or service and keep out of debt.
3) Create an effective pricing plan: You may use markup pricing to your
advantage by developing an effective price strategy for your company.
When you can create enough profits with the proper markup %, you can
surpass your competitor s and help your firm find better success in its
specific market.
9.5 TRANSFER PRICING
The value of products transferred between two parties who are linked to
one another is referred to as transfer pricing. The sum thus attached can be munotes.in

Page 155

Pricing Practices

155 used to both products and services. When items are transferred from one
unit to another, especially when the two units are located in separate
nations, the notion of transfer pricing comes into play.
The exchange of products and services should take place between two
units of a multinational or multi -state corporation. Larger organisations are
divided into many divisions in order to provide effective management
control over the institution as a whole. The transfer price is the amount
charged by one unit of the organisation to t he other unit for goods or
services delivered.
Because this transfer occurs between two units of the same organisation, it
is classified as an internal transfer rather than a sale. It might be one of the
most essential aspects in assessing the flow of good s and services among a
company's many divisions.This might assist you in measuring the
performance of various divisions and units. When there are a large number
of internal transfers, it becomes critical and must be handled carefully.
Pricing must be deter mined with careful consideration for the eventual
market price. If the transfer price is set too high, the selling centre will be
preferred, whereas if it is set too low, the buying centre will be favoured.
Objectives of Transfer Pricing:
Now that we under stand what a transfer pricing mechanism is and why it
is significant, we can analyse the goals that the notion seeks to achieve.
Here are a few aims that you might find interesting -
1) Profitability:
Transfer price should take into account the profitabili ty of both the
organization's divisions. Because both divisions are owned by the same
company. As a result, the objects, goods, and services can be set at any
price.
However, if you want to keep the profit margins of both divisions
unaltered, it would be a good idea to keep the prices as close to market
prices as possible.
2) Taxation:
Taxation will also be affected by the transfer price. A proper transfer
pricing strategy will assist you in offsetting the tax liability of one division
with an equivalent li ability on the other. One of the primary goals of
transfer pricing is to maximise your company's overall tax profits. Open
market considerations do not influence the transactions. This allows you to
increase your taxation options.
3) Goal Alignment:
The tr ansfer pricing should be set up in such a way that the divisional
earnings of each division are completely aligned with the parent
company's goals. The emphasis should be on increasing the profit margins munotes.in

Page 156

Managerial Economics

156 of the subdivisions while not affecting the overall profitability of the
parent organisation. Transfer pricing must be set up in such a way that
overall company earnings improve.
4) Individual unit performance review:
Transfer pricing might be one of the greatest ways to arrive at the most
accurate valuatio n of the individual divisions. This can aid in making more
informed decisions.
Appraising the managerial performance of the divisions, evaluating the
contributions of the individual entities to the overall profits of the
company, and assessing the worth of each division as an individual unit
are some of the areas where transfer pricing can help with performance
appraisal and performance management.
5) Examining international trade in depth:
Another primary goal of transfer pricing is to quantify the interna tional
commerce scenario. Pricing should be consistent with import and export
norms and precisely measured.
A price that is too low can distort international trade data to a larger
extent. Transfer pricing prices should be set in such a way that they do no t
skew international trade data.
6) Profit shifting
Profit shifting is a method of lowering one's tax liability in a specific
jurisdiction. This can be accomplished by artificially lowering
profitability. It also aims to decentralise production so that pro fits are
concentrated sufficiently in the region where the commodities are
manufactured.
Some other objectives of transfer pricing:
While transfer pricing must address the key purposes stated in the
preceding section, it must also address a few other criti cal objectives.
Among the other goals outlined in plain terms are the following:
Why Lower customs duty payments because the transfer is between two
divisions of the same parent company. This will assist in lowering your
pricing so that your products remai n competitive in the market.
• Transfer pricing supports you in avoiding import quota limitations. This
allows you to import the items without restriction.
• Allowing you to transfer funds to other places to help with company
funding rules.
The primary goa l of the transfer pricing idea is to allocate earnings
between the parent company and its subsidiaries. However, if the two
units or divisions are located in different countries, the taxes patterns will munotes.in

Page 157

Pricing Practices

157 be different, making the accurate computation and fix ing of the transfer
price a problematic issue.
In any event, the main reason for choosing an appropriate transfer price is
to minimise or decrease taxation and so enhance profit. Transfer pricing's
worldwide goals will include lower foreign exchange risks, increased
competitive advantage, and improved governmental relations.
9.6 PRODUCT LINE PRICING
Product line pricing, also known as product lining, is a retail marketing
method that involves categorising and pricing products and services in the
same catego ry based on their characteristics and quality. The division of
goods and services into pricing categories is intended to generate different
levels of perceived quality in the minds of buyers. Retailers frequently use
this pricing approach in -store to displ ay products from the same category.
Products are displayed in order of quality and features.
Purpose of Product Line Pricing:
The goal of product line pricing is to maximise profits by presenting new
items with the highest quality and number of features al ongside other
products and services with lower quantity and features, with the highest
quality products having the highest price tags.
Another goal of product line price strategy is for a company to be able to
offer something to customers of various socioe conomic backgrounds when
they visit a business store.
Effectiveness of Products Line Pricing:
People of various classes have options when it comes to product line
pricing. Buyers typically examine price tags before determining which
goods to purchase. If y ou own a retail store, you've probably seen
customers look at the price tags before deciding which things to buy.
Customers are not all equal in terms of purchasing power or preference.
Some customers desire premium quality products at any price, whereas
others want decent quality products that meet their needs at a reasonable
price.
As a result, product line pricing enables a firm to provide something to
consumers of all socioeconomic backgrounds when they visit a business
store. Pricing lines, on the othe r hand, without justifying the increased
price, may leave an unfavourable impression in the minds of clients. As a
result, in order to maximise profit, the pricing lining strategy must be
thoroughly planned before implementation.
Benefits of Product Line P ricing:
The price line strategy offers numerous benefits for both businesses and
customers. munotes.in

Page 158

Managerial Economics

158 1) It is beneficial to clients with varying purchasing power and
requirements.
2) Customers may easily select the things they can afford without the
seller's assistance.
3) The price lining technique provides buyers with multiple options for a
single product.
4) Buyers can select from a variety of products based on their budget and
the desired qualities of the product.
5) Changing the price is also advantageous for businesses since it allows
them to create huge profits without making large investments, which is
standard practise.
6) Using this strategy, businesses can increase sales because most
customers buy things at greater prices because they believe that the
higher the price, the higher the quality of the product.
7) Even if a company sells a variety of products, marketers should
concentrate on a single brand. As a result, the pricing line lowers
marketing and advertising costs.
8) A product line pricing strategy helps manufacturers redu ce inventory
since they know which products need to be produced more in order to
fulfil demand.
9) Labor and overhead expenses are reduced since multiple items can be
created with the same machines and the same work can produce
products with varying qualities .
Product Line Pricing Drawbacks:
1) The price line marketing method is intended to focus solely on the
price of products.
2) If the manufacturers make greater income using the strategy, it will
have a negative impact on sales of the pricey product during inflat ion,
as individuals may begin purchasing a cheaper product at a low price
to save expenditures.
3) A shift in market trend or inflation may result in surplus inventory.
4) It can also have a negative influence on the brand's devoted customers
if they are unable to find products that are worth the price.
5) The product line pricing approach suggests that the company does not
treat all customers equally because not all customers can enjoy the
premium features, and even if they stick with your branded product,
they wil l be dissatisfied.
munotes.in

Page 159

Pricing Practices

159 9.7 PRICE SKIMMING
Price skimming is a pricing strategy in which the price of goods or
services is initially set high and then gradually reduced as consumers
become more familiar with it. This strategy is aimed at early adopters
rather than the general public.
A variation on this method is termed penetration pricing, and it involves
setting cheap prices at the time of debut in order to penetrate markets.
Benefits of Price Skimming:
1. Increased Return on Investment
Charging the highest i nitial price at the introduction of an innovative
product, particularly in high -tech industries, might assist your company in
recouping R&D and advertising costs. Companies such as Apple gain
from large short -term earnings at the debut of a product, and th e initial
higher prices are justified by the technological achievements they produce.
The bottom line is that if you put all of your cash flow and resources into
developing a gadget or service that no competitor can match, you should
be able to charge high er prices during the launch to recoup the majority of
your investment and, hopefully, fund future developments.
2. It aids in the creation and maintenance of your brand's image
Price skimming can also give the impression that a product is a high -
quality "m ust have" for early adopters who can't live without the latest
technology. Higher costs at the start of a product's life cycle allow you to
establish a prestigious brand image that really attracts status aware
consumers, and you'll also have the breathing room you need to drop
prices as competitors enter the market. In some circumstances, a lower
starting price at the outset can create customer price sensitivity, making
subsequent rate increases unfeasible without losing sales.
3. It divides the market into segments
Price skimming, as previously noted, is an excellent strategy to segment
your consumer base, potentially allowing you to collect the most possible
profits from different categories of customers as you lower the price.
Starting with a higher price will not deter early adopters, and as you lower
the price over time, you will attract more price sensitive customers. You
may capture some of that consumer surplus and increase your revenue by
changing your prices depending on the product demand curve and the
maximum price your consumers are prepared to pay.
4. Early Adopters Aid in the Testing of New Products
One advantage of early adopter customers is that they serve as test
subjects for new items. Those status conscious customers who buy your
new produc t first can provide vital feedback and assist you in ironing out
the wrinkles before the next update and, hopefully, a larger user base. munotes.in

Page 160

Managerial Economics

160 Early adopters who enjoy your product can act as brand ambassadors,
creating a sense of quality through word of mouth i n addition to being
valuable testers. This free offer will entice new clients to purchase the
goods when the price reduces.
Price Skimming's Drawbacks:
1. It is only effective if your demand curve is inelastic
Price skimming may be a realistic strategy for Apple, but only when the
amount requested does not fluctuate drastically when prices change. If
your product's demand curve is generally elastic, which means that price
adjustments have a stronger effect on product demand, then starting with
high prices c ould substantially hinder your sales. Any company's goal is to
make a product as inelastic as possible, but not everyone sells tech
products or services that are innovative enough to appear vital to
consumers.
2. In a crowded market, this is a poor strateg y.
Prior to determining prices in any business, it is critical to measure client
valuations and analyse the competition (and their market share). If you
already have a lot of competitors, chances are your demand curve is fairly
elastic, and excessive price s during your product launch will drive buyers
away. Price skimming is not a realistic approach in an already crowded
industry, so unless your product has incredible new features that no one
can match, it may be best to avoid skimming if you want to preser ve a
competitive advantage.
3. Competitors are drawn to skimming.
Perhaps your product is innovative enough to create a new market, but as
demonstrated by the introductions of the iPhone and iPad, competitors
such as Samsung and Microsoft are lurking aroun d the corner. High prices
at the start of a new product's life cycle will entice competitors to enter the
market, and the inelasticity of a demand curve is almost always reduced
over time due to the introduction of viable substitutes. Skimming pricing
migh t also limit the rate of adoption by your potential customers, allowing
your competitors more time to duplicate and improve on your product
before you've profited on the desire for innovation.
4. It may enrage your early adopters.
Remember those brand evan gelists who were the first to buy your
product? They might just as well be the source of your worst PR
catastrophe. If costs drop too drastically or too soon after the first product
introduction, your early users will feel cheated. This type of backlash wa s
experienced by Apple in 2007, when the company reduced the price of the
iPhone by $200 dollars just two months after its introduction. The fast
price drop from $599 to $399 may have helped raise demand, but some of
the phone's early adopters were underst andably disappointed. munotes.in

Page 161

Pricing Practices

161 To prevent making clients at the top of your demand curve feel duped,
utilise price skimming consistently and avoid rushed or blatantly evident
price drops. Price skimming is also known as price discrimination, which
is the practise o f selling the same product at different prices to different
groups of customers. This tactic is prohibited in some situations, but the
precise requirements that define illegal price discrimination are dubious to
say the least. Check out our post on pricing strategy ethics for more
information on the ethical issues surrounding price discrimination.
9.8 PENETRATION PRICING
Penetration pricing is a pricing strategy used to quickly gain market share
by initially charging a low price to entice customers to buy. This pricing
strategy is typically used by new market entrants. Predatory pricing is an
extreme form of penetration pricing.
Rationale Behind Penetration Pricing:
A new entrant is likely to utilise a penetration pricing approach to swiftly
gain a significa nt amount of market share. One of the simplest ways to
distinguish new entrants from existing market players is through price.
This pricing strategy's overarching goal is to:
 Obtain a market share
 Foster brand loyalty
 Convert consumers from competitors
 Create large demand while attempting to capitalise on economies of
scale.
 Expel competitors from the market
Situations in which penetration pricing is effective:
 When product difference is minimal
 Price -elasticity of demand
 Where the product is appropriate fo r a mass market (and, therefore,
for utilising economies of scale)
Penetration Pricing Illustration and Example:
A contemporary small -sized player in the laundry detergent business,
where laundry detergent sells for roughly $15. Company A is a
multinationa l corporation with a huge amount of extra manufacturing
capacity, allowing it to create laundry detergents at a significantly cheaper
cost.
Company A decides to enter the market, use a penetration pricing strategy,
and sell laundry detergent for $6.05. The cost of producing laundry
detergent for the company is $6. munotes.in

Page 162

Managerial Economics

162

Fig 9.1
Company A makes a nominal profit per sale with a marginal cost of $6
and a sale price of $6.05 However, the corporation is content with this
decision because its overarching goal is to c onvert clients, acquire as much
market share as possible, and take advantage of economies of scale due to
their large production capacity.
Company A feels that its competitor will be unable to sustain itself in the
long run and will be forced to abandon th e market. When the competition
departs the market, Company A will become the exclusive seller of
laundry detergent, allowing it to establish a monopoly and raise prices to a
level that provides a substantial profit margin.
Benefits of Penetration Pricing:
1) Widespread adoption and diffusion: Penetration pricing allows a
company's product or service to be swiftly embraced and adopted by
clients.
2) Market dominance: Competitors are frequently caught off guard by a
penetration pricing strategy and have little oppo rtunity to respond. The
company can take advantage of the opportunity to convert as many
clients as possible.
3) Economies of scale: The price strategy generates a large number of
sales, allowing a company to gain economies of scale and lower its
marginal cos t.
4) Increased goodwill: Customers who find a good deal on a product or
service are more likely to return to the company in the future.
Furthermore, increased goodwill generates positive word of mouth.
5) High inventory turnover: Penetration pricing increases i nventory
turnover, which pleases vertical supply chain partners such as retailers
and distributors.
munotes.in

Page 163

Pricing Practices

163 Drawbacks of Penetration Pricing:
1) Pricing expectation: When a company employs a penetration pricing
approach, customers frequently expect constant low pric es. Customers
may get unsatisfied and cease purchasing the goods or service if prices
progressively rise.
2) Little customer loyalty: Bargain hunters or those with low customer
loyalty are frequently drawn to penetration pricing. If they locate a
better barga in, said clients are likely to migrate to competitors. Price
cuts, while successful for short -term sales, rarely result in client
loyalty.
3) Harm brand image: Low prices may harm brand image by leading
customers to perceive the brand as cheap or of poor qual ity.
4) Price war: A price war may be triggered by a price penetration
strategy. This reduces overall market profitability, and the only
companies strong enough to survive a protracted price war are usually
not the new entrant that started it.
5) Inefficient lon g-term pricing approach: Price penetration is not a long -
term pricing strategy. It is usually a better idea to enter the market with
a pricing strategy that your company can live with in the long run.
While it may take longer to gain a significant market s hare, such a
patient, long -term strategy is more likely to benefit your firm in the
long run and expose you to less financial dangers.
9.9 SUMMARY
Price is the value that is put to a product or service and is the result of a
complex set of calculations, re search and understanding and risk taking
ability. A pricing strategy takes into account segments, ability to pay,
market conditions, competitor actions, trade margins and input costs,
amongst others. It is targeted at the defined customers and against
comp etitors. Under marginal cost pricing prices are determined on the
basis of marginal cost and not fixed cost. Markup pricing refers to a
pricing strategy wherein the price of a product or service is determined by
calculating the sum of the products and a pe rcentage of it as a markup.
Transfer pricing refers to the value of the goods transferred between the
two parties related to one another. Product line Pricing, also known as
product lining, is a retail marketing technique that involves grouping
products an d services in the same category into different price ranges
based on their features and quality. Price skimming is a pricing strategy
where the price of goods or services is set high at the time of launch and
then lowered as consumers become more familiar with it.


munotes.in

Page 164

Managerial Economics

164 9.10 QUESTIONS
1. Explain the factors affecting pricing decision.
2. Explain in detail marginal cost pricing.
3. Elaborate markup pricing.
4. What is transfer pricing? Explain in detail.
5. Write in brief about product line pricing.
6. Explain price skimming str ategy in detail.
7. Illustrate penetration pricing in detail.





munotes.in

Page 165

165
10
PROFIT MANAGEMENT

Unit Structure
10.0 Objectives
10.1 Concept of Profit
10.2 Profit Management
10.3 Role of Profits in a Market Economy
10.4 Significance of Profits in a Market Economy
10.5 Nature and Measurement of Profit
10.6 Profit Policies
10.7 Th e Hypothesis of Profit Maximization and its Alternative
10.8 Summary
10.9 Questions
10.0 OBJECTIVES
 To study the concept of profit
 To understand the concept of profit management
 To understand the role of profit in a market economy
 To study the significance / importance of profits in a market economy
 To study the nature and measurement of profit
 To understand various profit policies
 To study the hypothesis of profit maximization and its alternative
10.1 CONCEPT OF PROFIT
Profit is a financial concept which can be described when the income of
the firm exceeds the expenses of the firm. After all the expenses and taxes,
whatever is left with the firm is termed profit. In economies, it can be
described as the amount gained by selling a product.
munotes.in

Page 166

Managerial Economics

166 The amount earned shou ld be more than the amount incurred on
manufacturing the product. In sustaining business activities when the
amount spent on the product is less than the amount earned on the product,
the firm is said to be in a profitable position.
It can be better explai ned with the help of cost price and selling price.
When the selling price exceeds the cost price, the difference between them
is profit.
Therefore,
Profit = Selling price - Cost priceProf. Schumpeter defines, “profit is the
reward for the work of entrepren eur or it is a payment for risks,
uncertainties and innovations”
In economics, the excess of total revenue over the total cost during a
specific period of time is profit.
10.2 PROFIT MANAGEMENT
The main objective of every business is to earn profit. Profit in a ny firm
reflects the success and chances of survival. A business firm is designed
with an objective to make profits. In managerial economics, profit
management is a crucial and difficult concept.
To earn profit a firm needs to manage certain things. A firm has to take
care of cost of the product, price of the product, allocation of the resources
and decisions related to the investment.
From the beginning, it is expected that the firm should evaluate their
business decisions properly. It is important for bus inesses to critically
evaluate their investment decisions. Framing capital budgeting policies is
another difficult area.
A firm has to consider the various aspects while dealing with this concept
like amount of profit, profit margin, nature of profit, meas urement of
profit, pricing and profit policies, profit planning and management. Profit
planning and management includes break even analysis, cost -volume
profit analysis etc.
A firm takes risk to earn profit. Risk bearing is a reward for firms to earn
profi t. A successful businessman or manager is one who can evaluate the
nature of costs and revenues at different levels of output.
It is a famous generalization in the field of management that “Whatever a
manager does, he/she does through decision making. As, decision making
is the heart of management. Decision making related to profit in business
is a spinal cord.
If the decisions related to profit and investment are made and framed
wrong, the business will not stand long. The more successful manager
estimatio n to reduce uncertainty brings more profits to the firm.
munotes.in

Page 167

Profit Management

167 Profit planning and profit measurement are the major constituents of
managerial economics in understanding how it involves difficult areas of
business to be studied. Profit management helps firms to achieve the goal
of their sustenance.
We can say it is premium to cover costs of staying in the market. It also
ensures supply of future capital. In economics, an entrepreneur/manager is
expected to take into consideration two types of costs - explicit co sts and
implicit costs to ascertain profit.
10.3 ROLE OF PROFITS IN A MARKET ECONOMY
In a market system a firm earns a profit, when its revenue is greater than
its costs. To an opposite, in a market system a firm suffers loss, when its
costs are greater than it s revenue. Profit is the remaining item when the
company pays all his expenses and still left with a certain amount.
Thus, profit can be described as a monetary benefit which a firm earns
after paying all expenses and taxes.
In a capitalist economy, profit creates incentives and opportunities for the
firms. An incumbent company with higher profit incentive can decide to
lower costs and produce new products. With an expansion of an economy,
new businesses may join the market. Benefits play an important role when
it comes to considering the concept of profit. The subject of profit in
business is a lucrative concept.
Firm earning profit can increase productivity and production, and can
expand customer choice. They can also go for allocating resources based
on their customers choice and preferences.
Sometimes, to increase profit, firms may make some wrong decisions.
Those wrong decisions can trigger market failures. In order to increase
profit, a firm may pursue short term profit management policy and ignore
its negative impact which will fall on long term policy. We have seen
examples of many firms.
They start their journey of making wrong decisions by buying or investing
in some failing businesses. It continues to make the decisions of selling off
its properties . Last, the firms make the decision of laying off the
employees, ultimately contributing in demeaning the goodwill of the firm.
In a market economy, profit plays an important role but the decisions
related to this field play a more significant role. A firm on the basis of
these decisions can stay, survive or leave the market. Capitalist economy
demands profit but sometimes it triggers market failure which leads to
losses generated by the firms.
10.4 SIGNIFICANCE OF PROFIT IN A MARKET
ECONOMY
In the market, profi t acts as a catalyst. The concept of profit in a market
economy encourages firms to innovate new products and also increases munotes.in

Page 168

Managerial Economics

168 the efficiency of the firms. It helps firms to make important decisions
related to fund investment and its management. It attracts new firms to
enter the market. With the help of the diagram given below, can we
understand how significant the concept of profit is?

Fig.10.1: Significance of profit in a market economy
01. Investment of Funds
Firms earning high profit can contribute signifi cantly in research and
development of products. Because of the capacity of huge investment,
firms can see the perspective of encouraging their research and
development area to earn more and more profit.
02. Helps in Generating Revenue
Money attracts more money . Adequate amount of profit helps firms to
expand their business operations. Expansion and development of their
businesses results in generating more revenue for the firms. Higher the
revenue, higher is the profit.
03. Rise in Wages
Workers are an integral par t of any organization. If a firm earns higher
profit, it can pay higher wages to workers. Profit increases the efficiency
of firm in terms of payment of wages and salaries to workers and
employees respectively.
munotes.in

Page 169

Profit Management

169 04. Encourages Innovation
In a market economy, th e profit management role is significantly visible.
Due to more and more profit, an entrepreneur is encouraged to innovate
new products, new markets, new methods of production and new
techniques to cut costs. Profit management encourages innovation as a
reward for the hard work put by the entrepreneur.
05. Increases Efficiency
Profit management encourages firms to cut costs. The planning and
implementation is done in such a way that the firm innovates and works to
cut production costs to earn more profit. This increases the efficiency of
the firm.
06. Encourages Resource Allocation
Profit plays a vital role in resource allocation. Higher profit ensures
smooth conduction of business firms. On the basis of decisions related to
allocation of resources, a firm may contin ue to expand and explore more
and more opportunities to work in this or in other areas. Higher profits act
as an incentive for entrepreneurs.
10.5 NATURE AND MEASUREMENT OF PROFIT
10.5.1 Nature of Profit
The nature of profit can be defined as a factor reward. The conc ept of
profit entails different meanings. Profit mabe looked upon as a reward for
entrepreneurial skills. It is termed as a reward earned by the entrepreneur
for bearing risk and uncertainty in business. The following points explain
the nature of profit in a more elaborate way.
10.5.1.1 The nature of profit can be defined as it is not predetermined.
Like a contract where the amount to be received is certain, the nature
of profit is not predetermined and certain. It is not a predetermined
contractual payment.
10.5.1.2 The remuneration is not fixed in the form of profit for an
entrepreneur.
10.5.1.3 To understand the nature of profit, one has to know the
difference between ‘Economic profit’ and ‘Business profit’.
Economic profit represents the sales revenue of the firm. It takes into
consideration both explicit costs and implicit costs. While, business
profits are an accounting term which represent the excess of income
over payments.
10.5.1.4 Profit is the reward of an entrepreneur for bearing risk and
uncertainties.
10.5.1.5 Profit does not arise in stat ic conditions. It arises only in
dynamic conditions. Many economists have favored this concept of
profit in managerial economics. munotes.in

Page 170

Managerial Economics

170 10.5.1.6 Profit cannot arise under a perfect competition market. It arises
when there is an imperfect competition market.
10.5.1.7 Profit is con sidered as reward for innovation.
10.5.1.8 It is also considered that the profit may arise due to the
nature of windfall. Maybe an inflationary boom can provide
opportunities for firms to earn supernormal profit.
10.5.1.9 In ordinary sense, profit is a residual surplus earn ed by the firm.
10. The term profit can be negative.
10.5.2 Measurement of Profit
As mentioned earlier, the term profit has different meanings for different
people. For a businessman, profit means a surplus income generated from
business activities after paying all the expenses and taxes.
For Economists, profit can be described as a reward received by the
entrepreneur for bearing risk and uncertainty in business. An entrepreneur
earns profit when he/she combines all the factors of production to serve the
needs of society. It can be termed as economic profit or pure profit.
For an enthusiast, profit is an income that comes from deducting outflow
from inflow. The same concept in opposite he/she will understand when
the concept of loss will come. For an accountant, p rofit means excess of
income over expenses.
The problem of measuring profit has always been a difficult affair due to
the different concepts given by different people to the concept of profit.
Accountants follow conventions and principles and define their terms of
profit by enumeration. Their approach is completely different from
economists. There is a difference between the concepts of historical profit
and anticipated profit. Conventional accounting is concerned with
historical profit. In Accounting, prof it is an ex -post concept.
Economists define profit in their terms and it is functional in nature. They
associate profit with the reward for an entrepreneur for bearing risks and
uncertainties. In economics, profit is an ex-ante concept. Economists are
basically interested in studying the theoretical aspects of economics, while
accountants deal with the practical aspects. In general, it is true that profits
are a better reflection of business as far as the growth and survival is
considered.
There are several ways to understand the concept of how to measure
profit. Here are some ways to understand this concept more clearly –


munotes.in

Page 171

Profit Management

171




Fig.11.2: Ways to measure Profit
01. Gross Profit


Gross profit is also referred to as gross income. It is the income from gains
before tax. It is calculated by deducting the cost of goods sold (COGS)
from sales revenue. Gross profit includes the following items in addition to
net profit -
● Remuneration for factors of production of entrepreneur
● Maintenance charges
● Depreciation charges
● Extra personal profit
● Net profit It is calculated as,
Gross profit = Sales revenue - Cost of Goods Sold (COGS)
02. Earning before Interest, Tax and Depreciation (EBIT)
Earning before interest, tax and depreciation provides an accurate picture
of a firm’s cash flow. It also shows how easily a firm can repay its debt.
Rather than simply looking at profit, this profit gives lenders an idea about
the kind of risk associated with the firm.
After deducting the cost of goods sold and all expenses except interest,
depreciation and taxes, this profit helps to measure the firm’s cash flow.
It is calculated as,
EBIT = Sales revenue - Cost of goods sold and other expenses except
interest, depreciation and taxes
03. Earning before Interest and Tax
Earning before interest and tax helps to identify the operating profit of the
firm without deducting tax. It is an important measure of a firm's
operating efficiency. It shows how much the business makes from its core.
munotes.in

Page 172

Managerial Economics

172 Except interest and taxes, cost of goods sold and all expenses are deducted
from sales revenue to get this profit.
It is calculated as,
EBIT = Sale revenue - Cost of goods sold and other expenses except
interest and taxes
04. Earning before Tax
Earning before tax helps firms to know how much tax firms owe to pay
from their bus iness operations. It is also known as profit before tax or Pre
Tax earning. It is calculated by deducting all expenses except tax. This
profit metric can be used to measure the performance of firms in terms of
paying taxes from their business operations.
It provides an insight to the firm’s financial standing and performance. For
various stakeholders, this profit metric plays an important role. It helps
them to measure how a company is able to generate enough income in
order to operate and pay its obligatio ns.
It is calculated as,
EBT = Sales revenue - Cost of goods sold and other expenses except tax
05. Earning after Tax
Earning after tax is also known as profit after tax or net profit. It is an
important measure of the firm. It shows the actual amount the firm is
making in an operating year after paying all expenses including tax.with
the help of net profit, a firm’s operation efficiency and performance can be
identified. It shows the cost and cash earnings of the firm.
It is the measure of a firm's net profita bility. Earning after tax is often
referred to as the bottom line because it is calculated after subtracting all
expenses and taxes from the business revenue.
It is calculated as,
Earning after Tax or Net profit = Sales revenue - Cost of goods sold and
all other expenses and taxes





munotes.in

Page 173

Profit Management

173 Table 10.1 Difference between Gross Profit and Net Profit
Point of
Difference Gross Profit Net Profit
Meaning Difference between total
cost and total revenue is
gross profit. When all the expenses are
deducted from gross profit,
the balance is called net
profit.
Inclusion Remuneration for factors of
production of entrepreneur,
maintenance charges,
depreciation charges, extra
personal profit and net profit Reward for coordination,
risk bearing, bearing
uncertainties and innovation

Profit denotes the difference between total revenue and total cost. While
calculating total cost, a firm includes all the expenses like raw material
cost, labour cost, direct and indirect expenses, factory expenses,
administrative expenses, sellin g and distribution cost. The implicit cost
incurred by the entrepreneur is excluded. But, in economic cost explicit
and implicit both cost are included to ascertain actual profit from total
revenue.
The difference between total cost and total revenue is ca lled gross profit.
When all the expenses are deducted from gross profit, the balance is called
net profit.
10.6 PROFIT POLICIES
The main motive of a firm is to make profits. The success of any firm is
determined by the volume of profit generated by a firm in a particular
period. But, in this modern world many firms do not agree with this
objective of running businesses.
They give due importance to other objectives of the firm as well.
Economic theory emphasizes profit earning and maximization as the chief
policy of a firm while the modern businesses do not accept this view and
advocate that they do focus on earning profit but the other goals are
important as well.
In practice, firms seldom seek to maximize profits. Other than profit, firms
focus on many other goals. Instead of putting pressure on profit
maximization, many firms put limits on their profits. All these constitute
the profit policy.
10.6.1 Aims of Profit Policy
The main aim of profit policy is to give due importance to other primary
goals of the firm which helps the organization to earn profit. It's true that munotes.in

Page 174

Managerial Economics

174 profit maximization is an important objective but it is not the only
objective of the firm.
Adequate profit ensures the regularity and efficiency of a firm paying
dividends, salaries and wages to the shareholders, employees and labour
respectively. The profit policy focuses on -
● Inventory goals
● Production goals
● Sales goals
● Administration goals
● Marketing goals
● Profit goals - profit planning, administration and management
The following points advocates the necessity and importance of profit
policy in a firm -

Fig.10.3: Importance of Profit Policy
01. Restricting the Entry
Reasonable profits ensure survival and growth of the firm. If a firm is
focusing on only profit, chances are there that they will compromise with
the other primary goals of the firm. If a firm is following a policy which
restricts its profit but ensures a sufficient amount to run business and other
activities, no competitors are likely to enter the market. A firm to some
extent can enjoy monop oly in this case.
02. Business and Consumer Goodwill
In order to win the confidence and appreciation of consumers, a firm’s
profit policy advocating low margin can help businesses in earning
reputation and building goodwill. Consumer is the most important elem ent
of any business.
munotes.in

Page 175

Profit Management

175 Firms have to restrict their profit limit to maintain goodwill in the eyes of
their consumers. During inflation, a firm follows a stable pricing policy
that can attract the attention of consumers. On the other hand, if a firm
follows h igh profit margin may face consumer resentment
03. Consideration of Wages
Higher the profit, higher the wages. Higher profit may be considered as a
reason for the firms to pay higher wages to the labour. With the help of
their association, they can demand high er wages if the firm declares higher
dividends to the shareholders. If a firm keeps the reasonable profit margin,
with consumers it ensures the harmonious relation of the firm with
laborers also. Profit control is imperative if a firm wants to maintain
cordial relations with the labour.
04. Preference to Liquidity
Liquidity preference means the priority to hold cash to meet the daily
transactions. The first thing any investor will observe is the Balance sheet
of the firm before investment. In order to maintain the ratio of current
assets to current liabilities, the firm keeps less profit and maintains high
cash.
For a comfortable position, it is important for a firm to maintain cash. In
banking business, the more preference is given to liquidity rather than
profitability.
05. Avoiding Government Interference and High Taxation
High profits may be considered as an index of monopoly power. It may
attract the government's attention and further can lead to investigation. To
avoid government interference and control, a firm adopts a reasonable
profit policy.
High profits are also considered to generate high tax amounts for the firm.
To avoid government regulation, intervention and high taxation, it is wise
to adopt a low profit or reasonable profit margin policy.
06. Market Lea dership
A firm can achieve market leadership either in the area of maximum sales
volume or in the area of product lines by keeping profit margin
satisfactory. The consistency of the profit should be in accordance with the
capital invested in the business, workforce employed and the volume of
output produced. To dominate the market, a firm may seek to maximize its
sales volume.
07. Service Motive
Many firms adopt a service approach to serve the nation. A firm rather
than to earn profit can work towards the motiv e of providing more
employment and job opportunities with reasonable wages to the youth of
the nation. munotes.in

Page 176

Managerial Economics

176 Rather than focus on profit maximization, a firm can look into the matter
of welfare and goodness of employees and workers.
10.7 THE HYPOTHESIS OF PROFIT MAXI MIZATION
AND ITS ALTERNATIVES
According to traditional economic theory, maximization of profit is the
sole objective of the firms. With the help of the analysis of demand and
supply conditions, a firm generates a large amount of money to run a
business. Th e conventional price theory is based upon the profit
maximization hypothesis.
Conditions of profit maximizing
When the difference between total revenue and total cost is maximum at
that level of output, a firm maximizes its profit. The traditional price
theory determines the study of price -output in maximizing profit in terms
of marginal cost (Mc) and marginal revenue (MR).
The two conditions where a firm maximizes its profit are -
i) Marginal cost = Marginal revenue
ii) Marginal cost curve cut the marginal revenu e curve from below.
The two conditions mentioned above are applicable to a firm under
perfect competition and monopoly market.
It can be expressed as, Maximize π (Q)
Where π (Q) = R (Q) - C (Q)
Where π (Q) is profit R (Q) is revenue,
C (Q) are costs,
Q are the units of output sold.
Assumptions of Profit Maximization
The approach of profit maximization theory is based on following
assumptions -
01. The firm w ants to maximize its profit. The goal is to achieve this in the
long run.
02. The firm has knowledge about the price at which it can sell different
levels of output.
03. The firm has certainty regarding price or costs.
04. The entrepreneur himself is the owner and man ager of the firm.
05. The firm is assumed to achieve this goal by applying the marginalist
principle. munotes.in

Page 177

Profit Management

177 06. It is assumed that the tastes and fashion of the consumer is constant.
07. The technology of production is given.
08. The firm produces products which are divisible a nd standardized in
nature.
09. New firms can enter the market only in the long run.
The hypothesis of profit maximization helps firms in two ways -
01. It helps in predicting the behavior of business firms.
02. It helps in predicting the price -output behavior. The price-output
behavior can be predicted under various market conditions.
Under perfect competition at the price determined by the industry,
business firms have to maximize their profits. In an imperfect market, the
firms are price makers. They search for the price output conditions where
they can maximize their profits. This hypothesis is better than any other
hypothesis in explaining and predicting the behavior of firms under
different market conditions.
10.7.1 ALTERNATIVE TO PROFIT MAXIMIZATION THEORY
W.J. Baumol has suggested one alternative to profit maximization. His
model is known as Boumol’s Single Period sales (Revenue). He advocated
that firms operating in oligopoly will seek to maximize sales revenue. It is
subject to a profit constraint. His argument of this theory is based on
public statements by businessmen. His model clearly states the difference
between sales maximization and profit maximization.
Based on his management consulting experience, Baumol has suggested
that firms attempt to maximize sales. Maxi mizing sales is subject to profit
constraint.
As an alternative to profit maximization, different economists have
suggested a variety of profit policies.
01. According to K. Rothschild, the primary objective of an enterprise
is long-run survival. He also empha sized maximizing the security of
the organization.
02. W.W. Cooper has emphasized on the liquidity parameter as the most
important factor for the business firms.
03. An entrepreneur may have two objectives, according to N. Reder -
to maximize profits and to mainta in financial control of the firm.
04. H.A. Simon advocated that an entrepreneur focuses on earning
satisfactory return rather than maximizing profit.
munotes.in

Page 178

Managerial Economics

178 10.8 SUMMARY
● When the selling price exceeds the cost price, the difference between
them is profit. In economics, t he excess of total revenue over the total
cost during a specific period of time is profit.
● In managerial economics, profit management is a crucial and difficult
concept. The main objective of every business is to earn profit. Profit
in any firm reflects th e success and chances of survival. A business
firm is designed with an objective to make profits.
● In a capitalist economy, profit creates incentives and opportunities for
the firms. An incumbent company with higher profit incentive can
decide to lower cost s and produce new products. With an expansion of
an economy, new businesses may join the market.
● Economic theory emphasizes profit earning and maximization as the
chief policy of a firm while the modern businesses do not accept this
view and advocate that they do focus on earning profit but the other
goals are important as well.
● Adequate profit ensures the regularity and efficiency of a firm paying
dividends, salaries and wages to the shareholders, employees and
labour respectively. The profit policy focus es on other goals as well.
10.9 QUESTIONS
01. Define profit. Explain the concept of profit in economic sense and
general sense.
02. What is profit management? Explain its significance in market
economy.
03. Write a note on nature and measurement of profit.
04. Explain the vari ous aspects of profit policy. Why is it important for a
firm to have a profit policy?
05. Explain the hypothesis of profit maximization.
06. Highlight the various alternatives to the hypothesis of profit
maximization.



munotes.in

Page 179

179 11
DEMAND FOR CAPITAL AND SUPPLY OF
CAPITAL
Unit Structure
11.0 Objectives
11.1 Demand for Capital
11.2 Supply of Capital
11.3 Equilibrium between Demand and Supply
11.4 Criticisms of the theory
11.5 Capital Rationing
11.6 Capital Budgeting
● Net Present Value
● Internal Rate of Return
11.7 Appraisals
11.8 Summary
11.9 Questions
11.0 OBJECTIVES
 To understand the meaning of demand for and supply of capital
 To study the process of equilibrium between demand and supply
 To understand the concept of capital rationin g
 To study the concept of capital budgeting
11.1 INTRODUCTION
Demand and supply analysis comes under the domain of
microeconomics. Microeconomics is the study of individual units, firms
etc. from the microscopic point of view. The concept of demand and
supply analysis studies the interaction of buyers and sellers. How do they
interact to fix transaction prices and quantities?
Price is something which determines the value of the product for the both -
buyer and seller. Demand and supply analysis is an importa nt concept to munotes.in

Page 180

Managerial Economics

180 study in macroeconomics. How the demand for capital and supply of
capital affects the operations and activities of the firms is a major area to
study.
For investment analysis, this concept significantly describes the need of the
study.
11.1 DEMAN D FOR CAPITAL
The demand for capital represents the amount of capital an entrepreneur
wants to invest in his/her business. The amount of capital is required to
purchase capital goods like equipment, plants, machines and tools. These
capital goods are requi red for the production of goods and services. The
demand for capital is inversely related to rate of interest.
If the interest rate is high, entrepreneur’s demand for capital will be less. If
the interest rate is low, entrepreneurs want to have high invest ment. This
concept is because of marginal physical productivity of capital. Marginal
physical productivity of capital is a change in the production output of the
firm when an additional unit of capital is employed. The other inputs
remain the same.
Symboli cally it can be represented as, Symbolically,
A firm employs additional units of a factor until marginal
revenue productivity equals marginal factor costing. Capital is an
important factor of production and it is no different from other factors
of produ ction. The first step is to assess the firm’s demand for capital.
After this step, the firm determines the present value of marginal revenue
products and marginal factor costs.
11.2 SUPPLY OF CAPITAL
Supply of capital is the amount available for investment. Th e amount
which is available for investment is called savings. The amount which is
left after consumption is savings. The monetary value left after the
consumption is called savings. The relation between savings and rate of
interest is direct. The rate and interests and savings are directly related. If
the interest rate is high, people save more to earn interest. If the interest
rate is low, the people will show less interest in savings or investment.


munotes.in

Page 181

Demand For Capital And Supply of Capital

181 Symbolically it can be represented as,

11.3 EQUILIBRIUM BET WEEN DEMAND AND SUPPLY
The point of equilibrium between demand and supply comes to a point
when the demand for capital is equal to supply of capital. The equilibrium
interest rate can be determined by the point of intersection of investment
and savings cur ves. The actual interest rate may differ in real life. If it is to
be brought on the graph, above the level of equilibrium saving exceeds
investment.
The excess supply of capital brings down the rate of interest. It can go
down to equilibrium level. If it is below the equilibrium, investment
exceeds savings. The excess demand for capital brings the rate of interest
up. The actual rate of interest sooner or later comes to the equilibrium
level.
11.4 CRITICISM OF THE THEORY
The theory of demand for capital and supply of capital suffers from many
criticisms –
1. Money is not only demanded for investment but also for speculation
and precautionary motives.
2. This theory is based on diminishing marginal productivity of capital.
Due to some other factors, there may be incr easing marginal
productivity of capital.
3. The demand and supply factors can also be determined by the level of
income
4. Supply of capital also comes from other sources like dishoarding,
depreciation fund etc.
5. Saving and investment are affected by each other. This theory ignored
this dimesion.
11.5 CAPITAL RATIONING
Capital rationing is an approach of management. In this approach,
management allocates the available funds by going through the various
opportunities. The approach of capital rationing enhances the bott om line
of the company. Firms always go for the project which has a higher net
present value on the side.
munotes.in

Page 182

Managerial Economics

182 There are many motives behind this approach of management. In many
scenarios where the past revenues generated through investments were not
up to the mark, the firm might take this approach. The primary goal is to
make sure that a firm is going to take rational decisions while investing
heavily in assets. This approach helps management to make decisions
related to capital funds.
11.5.1 MEANING
A firm decides to undertake many projects. Projects are analyzed on the
basis of their performance in terms of their past performance. How much
they have generated from the project is a matter of analysis in terms of
return? Firms by putting the concept of capital rationi ng can bring the
concept of ceiling on a project where the past revenues generated on the
same were not up to the mark.
Capital rationing is a process through which a firm places a limit on the
extent of projects that it decides to undertake. It is a strat egy used by
companies to limit the number of investment projects they undertake. It is
a process of choosing the most profitable projects among the alternatives.
Companies that employ capital rationing produce more return on
investment. As they choose wisely before investing into any project. It is
one of the methods of investing wisely in those projects which are expected
to yield good returns or one can say positive net present value or return on
investment.
11.5.2 DEFINITION
Capital rationing is defined as a pr ocess through which a firm puts a ceiling
on the number of projects for a particular period.
11.5.3 TYPES OF CAPITAL RATIONING
There are two ty pes of capital rationing -Fig.11.1 : Types of Capital
Rationing

munotes.in

Page 183

Demand For Capital And Supply of Capital

183 01. Hard Capital Rationing
The first type of capital rationi ng is also known as external rationing. This
rationing is being imposed on a company by circumstances beyond its
control. A firm suffers from a low credit rating as they may be restricted
from borrowing money to finance new projects. Thus, it may become
difficult for firms to secure financing.
In general, companies raise capital for additional funds. The funds are
raised through either equity or debt. This type of rationing arises from an
outside need to reduce the spending on the project. Further, it can lead to a
shortage of capital to finance future projects. In simple words, it involves
raising new capital in response to limited funds.
02. Soft Capital Rationing
Soft rationing is also known as internal rationing. This type of rationing
is internal to the firm and to some extent controllable in nature. Internal
rationing represents the rationing which arises due to the internal policies
of a company. A conservative policy adopted by the firm to achieve the
objectives of self -imposement can be termed as soft r ationing. For putting
control on internal spending or expenditure on resources, soft rationing
looks into the internal affairs of the company/firm.
Imposing some restrictions on its capital expenditure is a part of soft
rationing. A company simply puts the limit on the number of projects that
it will take at a time or in a particular period.
11.5.4 ADVANTAGES OF CAPITAL RATIONING
In the concept of capital rationing, return on investment analysis plays a
significant role. Companies that employ this strategy are ex pected to
produce higher return on investment. The reason is firms invest rationally.
Return on investment is a measure to evaluate the performance of the
investment. Companies invest their resources in highest profit potential
projects. The concept of cap ital rationing signifies the following important
points.
Fig. 11.2 : Advantage of Capital Rationing


munotes.in

Page 184

Managerial Economics

184 11.5.4.A Helpful in Budgeting
Capital rationing decisions are related to the allocation of funds to different
long term and short term assets. While evaluating the va rious proposals,
firms undergo careful and critical analysis of these proposals. The
decisions related to capital rationing are found to be helpful in budgeting.
11.5.4.B Project Management
Capital rationing helps in selecting those projects which ensures higher
returns. Due to limited availability of capital, managing projects in terms of
performance and returns has become an important task for the managers.
11.5.4.C Avoid Wastages
Capital rationing approach avoids wastages. It helps firms in preventing the
wastages of funds by not investing in each and every project available for
the investment. A firm can fully utilize the available funds by putting a
ceiling on certain investments expenditure.
11.5.4.D Higher Stability
The right approach of capital rationing ensures stability in t he working of
the firms. As the company avoids investing in every project, the finances
are utilized carefully and diligently. This approach helps in having
adequate finances for rough times. This also ensures more stability.
11.5.4.E Capital Budgeting
Capital budg eting decisions are known for their long term implications in
any business firm. Broadly speaking, capital budgeting decisions denote a
situation where decisions are to be taken related to the investment of lump
sum funds invested in the initial stages of a project. Capital rationing helps
in choosing best proposals in terms of returns.
11.5.4.F Fewer Projects
In the approach of capital rationing, a limited number of projects are
selected by imposing capital restrictions. Capital restrictions ensure the
selection of good proposals in terms of time, performance and returns. It
also helps in keeping the minimum/sufficient number of active projects and
thus manage well.





munotes.in

Page 185

Demand For Capital And Supply of Capital

185 DISADVANTAGES OF CAPITAL RATIONING
The following are the disadvantages of capital rationing -

Fig.1 1.3: Disadvantages of Capital Rationing
01. Small Projects
A firm is expected to invest some amount of funds in big projects to gain
long term benefits arising out of it. Due to limited funds, capital
rationing leads to opt for small projects. Small projects m ay not prove to
be profitable in the long run. Rationing puts restrictions on the amount of
funds a firm may invest.
02. Violation of Theory
The approach of capital rationing goes against the efficient capital market
theory. The theory suggests that projects w hich ensure hike in shareholders
funds and contribute in value addition should be encouraged and selected.
But, this approach puts a ceiling which may stop firms from choosing such
projects. This approach advocates the projects which have profitability
chances and are within the budget should be selected.
03. Confines the scope of NPV
Net present value represents the difference between the present value of
cash inflows and the present value of cash outflows over a period of time.
Projects with higher NPV are expected to be selected by the firms. Even if
all the projects show high profitability indices, capital rationing by putting
a ceiling limits their selection. It confines the scope of net present value of
projects.


munotes.in

Page 186

Managerial Economics

186 04. Cost of Capital
Determination of cost of ca pital is an important aspect for firms. If it is not
determined accurately, it may result in ineffective capital rationing. This
can also result in investment in inappropriate projects by the firm.
05. Avoided In-between Cash Flow
The pattern of cash flow in a project and its analysis is critically analyzed
by the experts in making decisions. The in-between cash flow helps to
assess the next move of investment in generating returns. In the approach
of capital rationing, only the final return on investment is co nsidered. In -
between cash flows are side lined.
06. Low Credit
The projects are selected only to estimate profit. Sometimes, a firm may
select a project which will generate lower return and reject the project
having the chances of generating higher returns. Th e approach also
requires a larger time frame to conclude. Putting a ceiling can affect the
financial performance of the firms and thus affect their credit in the market.
 Example of Capital Rationing
A firm XYZ Limited is in the process of preparing the cap ital budget for
the financial year. A finance manager has four proposals to evaluate. On
the basis of net present value, he is expected to choose some projects. Let
us understand this example with the help of the information given in the
table -
Table 11.1 showing the initial investment, net present value and
profitability index of the proposals.
Projects Initial Investment ()Net Present
Value (NPV) Profitability
Index (PI)
A 12,00,000 10,10,000 1.84
B 87,00,000 22,90,000 1.26
C 1,30,00,000 1,47,00,000 2.13
D 71,00,000 49,00,000 1.69

On the basis of initial investment, the company will evaluate the proposals
and arrange the proposals in terms of higher profitability index. If we will
arrange the projects on the basis of profitability index, it will b e seen like
this –
munotes.in

Page 187

Demand For Capital And Supply of Capital

187 Projects Initial
Investment () Net PresentValue
(NPV) Profitability Index
(PI)
C 1,30,00,000 1,47,00,0002.13
A 12,00,000 10,10,000 1.84
D 71,00,000 49,00,000 1.69
B 87,00,000 22,90,000 1.26

From the rearranged table, we can see that Project C is showing the highest
profitabi lity index. Out of the given projects, a firm as per the capital
rationing approach can choose the projects in a descending order.
11.6 CAPITAL BUDGETING
In capital budgeting, the role of a finance manager lies in the process of
critical and detailed analysis of various alternatives of various proposals.
The purpose is to select the best proposal out of it. The main objective of
evaluating the projects is to select the long term best investment projects
that are expected to make maximum contribution to the shareholder’s
wealth.
The main objective of financial management in the subject of managerial
economics is to maximize the shareholders wealth along with the other
objectives of the firm. The objective of capital budgeting justifies the same.
It helps managers in selecting the best alternative from the given one. The
decisions related to capital budgeting are related to the allocation of funds
to different long term assets.
It involves the entire process of decision making. The decisions are taken
to acquire th e long term assets whose returns are expected to arise over a
period of more than one year. That’s why these decisions are called capital
budgeting decisions.
11.6.1 MEANING
Capital budgeting decisions are known for their long term implications in
any business fi rm. Broadly speaking, capital budgeting decisions denote a
situation where decisions are to be taken related to the investment of lump
sum funds invested in the initial stages of a project. It is expected that the
returns will be generated over a period of more than a year. Capital
budgeting is a financial commitment as well as an investment for a long
period.
The decisions of capital budgeting are important because it creates
accountability and measurability. It is a process of evaluating investments
and h uge expenses. The purpose is to obtain the best returns on
investment. Organizations are expected to face many challenges when the munotes.in

Page 188

Managerial Economics

188 choice between two or more projects arise. Firms choose that project which
ensures higher return among the alternatives.
Selecting profitable projects and capital expenditure control are some of
the main objectives of capital budgeting. Finding the right sources for the
firm is also one of the important area of capital budgeting.
11.6.2 FEATURES OF CAPITAL BUDGETING
The features of ca pital budgeting may be stated as follows -
Fig.11 .4: Features of Capital Budgeting
11.6.2.A Long Term Effects
This is the most important feature of capital budgeting. The decisions have
long term effects on the risk and return composition of the firm. The
decisions can affect the future position of the firm. A finance makes a
commitment into the future by taking into consideration the future
needs of the firm. The implications and consequences are long term of the
capital budgeting decisions.
11.6.2.B Substantial Commitments
Capital budgeting decisions require substantial commitment. They
generally involve large commitment of funds and as a result a substantial
amount of funds are blocked in the capital budgeting decisions. More
attention is required while making these kinds of decisions. Generating
sufficient amounts of returns is always a challenge for managers as far as
the domain of capital budgeting decisions are concerned.
11.6.2.C Irreversible Commitments
Most of the decisions are irreversible in nature. Once taken, a firm canno t
revert back. Abandoning the project midway results in heavy losses. A firm
cannot afford to absorb heavy losses. Therefore, the capital budgeting
decisions should be taken only after considering and evaluating each and
every aspect of the project. The financial consequences can be far reaching
and a firm may find it difficult to cope up with it.
munotes.in

Page 189

Demand For Capital And Supply of Capital

189 11.6.2.D Higher Degree of Risks
The decisions of capital budgeting involve a higher degree of risks. As the
other features demand more commitment from the manager. The decisions
have long term effects, require substantial and irreversible commitments.
The degree of risk attached to these decisions is high.
11.6.2.E Affect the capacity and strength to compete
To face the competition, the capital budgeting decisions affect the capacit y
and strength to compete in the market. A firm may gain competitive
advantage if the decisions related to capital budgeting are taken timely.
Similarly, a firm may lose competitiveness if the decision to modernize is
delayed or not rightly taken
11.6.3 KINDS OF CAPITAL BUDGETING DECISIONS
Fig.11 .5: Kinds of Capital Budgeting Decisions
11.6.3.A Accept -reject Decisions
The fundamental decision in capital budgeting is accepting or rejecting the
proposal on the basis of some criterias. If the project is accepted, the firm
would invest in it. If the project is rejected, it would not go in the
investment direction. The projects which yield a good return will be
considered for investment.
Firms in total consider few criterias while smoking capital budgeting
decisions -
11.6.3.A.1 Rate of return
11.6.3.A.2 Required rate of return
11.6.3.A.3 Cost of capital
The project which will satisfy all the conditions required will be
considered for investment and rest will be rejected.


munotes.in

Page 190

Managerial Economics

190 11.6.3.B Mutually Exclusive Projects
In this case of capital budgeting, acceptance of one project will exclude the
acceptance of other projects. It means if a firm is accepting one project, it
may rule out the necessity of accepting other projects as only one is to be
chosen. The alternatives in this case are mutually exclusive.
In the case of mutuall y exclusive projects, only one or some proposals can
be accepted and others have to be rejected. The most profitable
proposal will be accepted, letting other proposals be mutually exclusive.
The best alternative will be chosen by rejecting the other altern atives.
For example, if there is a need to buy a vehicle for transporting goods from
factory to warehouse, the firm will think of various options. After choosing
one proposal, the firm will eliminate other proposals.
11.6.3.C Capital Rationing
Capital rationing is a process through which a firm places a limit on the
extent of projects that it decides to undertake. It is a strategy used by
companies to limit the number of investment projects they undertake. It is
a process of choosing the most profitable projects am ong the alternatives.
Companies that employ capital rationing produce more return on
investment. As they choose wisely before investing into any project.
When firms have a fixed capital budget, they go for a capital rationing
approach. Large number of prop osals compete for this fixed investment.
The best among all alternatives is selected by the firms.
11.7.4. PROCESS OF CAPITAL BUDGETING
The process of capital budgeting involves the following important steps -
Fig.11 .6: Steps involved in Capital Budgetin g


munotes.in

Page 191

Demand For Capital And Supply of Capital

191 11.6.5 CAPITAL BUDGETING: TECHNIQUES OF EVALUATION
The attractiveness of any investment proposal depends on the following
aspects -
11.6.5.A Amount of expenditure required
11.6.5.B The potential benefits
11.6.5.C The time period
11.6.5.D Economic life of the project
There are different techniques available for evaluation and selection of a
proposal. The techniques of evaluation can be grouped into two categories -

Fig.11.7 : Techniques of Capital Budgeting
I. TRADITIONAL TECHNIQUES
The traditional techniques are also known as non -discounting techniq ues.
As the name itself suggests, these techniques do not discount the cash
flows to find out their net worth. The traditional or non -discounting are
further divided into two techniques -
01. Payback Period
Payback period is the length of time required to reco ver the initial cost of
the project. It is defined as the number of years required for the proposal’s
cumulative cash inflows to be equal to its cash outflow. But, this technique
does not give clear indication of the decision regarding investment.
The technique compares the payback period with some predetermined
target period. If the payback period is more than the target period, the
proposal should be rejected. If the payback period is less than the target
period, it can be accepted.
For example, if a prop osal requires an initial investment of Rs.1,00,000 and
is expected to generate a cash flow of Rs.20,000, Rs.30,000, Rs.40,000,
Rs.10,000 and Rs.8,000 over the next five years respectively. munotes.in

Page 192

Managerial Economics

192 Table 11.2 Calculation of payback period

A firm can expect to get the investment back in the fourth year because the
sum of cash inflows of the first 4 year is Rs.20,000, Rs.30,000, Rs.40,000
and Rs.10,000. The same is visible in the above table.
02. Accounting Rate of Return (ARR)
Accounting rate of return is a technique based on the accounting concept of
return on investment. The annual returns of a project expressed as a
percentage of the net investment in the project. It may be defined as
annualized net income earned on the funds invested in a project. It is a
measure based on the accounting profit.
Symbolically,
ARR = Average Annual Profit (after Tax) / Aver age Investment in the
project x 100
For example, the initial investment of the project is Rs.2,00,000 and the
salvage value is Rs.20,000. A project requires an additional working
capital of Rs.50,000 and is expected to generate the average annual profit
(after tax) of Rs.25,000, then the average investment and accounting rate
of return can be calculated as,
Average Investment = ½ (Initial Cost - Salvage Value) + Salvage value +
Additional working capital
= ½ ( 2,00,000 - 20,000) + 20,000 + 20,000
= Rs.1,30,000
ARR = Annual Profit (after tax) / Average investment in the project x 100
= 25,000/1,30,000 x 100
= 19.24 %
Year Annual C ash Flow (in Rs.)Cumulative Cash Flow (in Rs.)
1 20,000 `20,000
2 30,000 50,000
3 40,000 90,000
4 10,000 1,00,000
5 15,000 1,15,000
munotes.in

Page 193

Demand For Capital And Supply of Capital

193 II. DISCOUNTED CASH FLOWS OR TIME ADJUSTED
TECHNIQUES
The discounted cash flow techniques or time adjusted techniques are based
upon the fact tha t the cash flows occurring at different points of time are
not having the same economic worth. It is a valuation method used to
estimate the value of an investment based on its expected future cash
flows. There are various techniques of evaluating cash flo ws. All these
techniques have been discussed as follows -
01. Net Present Value (NPV) Method
The net present value of an investment proposal involves cash inflows and
outflow over a period of time. It is calculated by taking the difference
between present valu e of cash inflows and the present value of cash
outflows over a period of time. Net present value is considered as the
strongest element in making decisions for investment.
If a firm has multiple projects, the project with higher NPV is more likely
to be s elected. The investment with the positive and higher NPV will be
considered for investment. It is an important tool of capital budgeting.
NPV technique is used to analyze the profitability of a project. If the
project is found suitable, on the basis of NPV firms select the project for
investment.
It is calculated as,
NPV = Present value of Cash Inflows - Present value of Cash Outflows

The decision rule of the NPV deals with the concept of “ Accept the
proposal if the NPV is positive and reject the proposal if the NPV is
negative”. The positive NPV signifies that the value of cash inflow is more
than cash outflow. It implies that the project will generate positive returns.
In the case of mutually exclusive projects, the project with the highest NPV
will be s elected for investment. After that, the second highest NPV project
will be given priority. On the priority basis, the project with the highest
NPV will be given first priority and the project with the lowest NPV will be
assigned as the lowest one. The main objective is to find out the proposal
whose inflows have greater values than the outflows.
munotes.in

Page 194

Managerial Economics

194 Properties of the NPV Criteria
This technique has several important properties -
01. The net present values are additive. Other techniques do not have this
property.
02. The NPV calculations allow for the expected change in the discount
rate.
03. The intermediate cash flows are reinvested at a discount rate.
Merits of NPV
The merits of the NPV can be enumerated as follows -

Fig.1 1.9 : Merits of NPV Shortcomings of the NPV techniques
Apart from the merits, the NPV technique suffers from following
shortcomings -
01. There are multiple assumptions in this technique.
02. The technique involves different calculations.
03. It requires the predetermination of the required rate of return.
04. It does not provide a measure of the project's own rate of return.
05. The decisions are based on absolute measure.
02. Profitability Index
Profitability index is defined as the benefits per rupee invested in the
proposal. This technique is also known as benefit -cost rat io or present
value index. This technique is based on the basic concept of discounting
the future cash flows. The future cash flows can be ascertained by
comparing the present value of the future cash inflows with the present
value of the future cash outfl ows.
munotes.in

Page 195

Demand For Capital And Supply of Capital

195 The profitability index is calculated by dividing the total present value of
the cash inflows with the total present value of the cash outflows.
Profitability Index = Total present value of the cash inflows / total present
value of the cash outflows
The decision rule of PI is accept the proposal if PI is more than 1 and reject
if PI is less than 1. If the PI is equal to 1, then the firm may be indifferent.
03. Discounted Payback Period
The discounted payback period method is a combination of the payback
method and the discounted cash flow technique. The cash flows are
discounted to find their present values. The present value of cash inflows is
compared with the total present value of the cash outflows. The recovery
period of initial cost is also being mea sured. This method involves the
concept of time value of money.
04. Terminal Value (TV)
In this technique, the present value of the project is compared with the
initial outflow. The purpose is to find out the suitability of the proposal.
The techniques involve compounding the future cash flows first. The
future cash flows are first compounded at the expected rate of interest. The
compounded values are then discounted at an appropriate discount rate. It
results in finding out the present value. It is based on th e assumption of
investment of all future cash inflows.
05. Internal Rate of Return (IRR)
Internal rate of return is another important discounted cash flow technique
of evaluation of capital budgeting. It is defined as the discount rate which
produces a zero NP V. Unlike the NPV, the IRR is also based on
discounting techniques.
The internal rate of return is the discount rate which equates the total
present value of the cash inflows with the total present value of the cash
outflows. It is a measure used in finan cial analysis to find out the
potentiality of the proposals. The IRR indicates the annualized rate of
return for a given investment.
Symbolically it is calculated with the help of the formula given below -

munotes.in

Page 196

Managerial Economics

196 The decision rule of IRR advocates that higher IRR is considered as the
more desirable investment. And the lower IRR can be given lowest priority
in selecting proposals for investment. In the case of multiple projects, a
firm can prioritize the number of projects in terms of IRR. T he project with
the hig hest IRR will take the first position and lowest IRR will be placed at
last. It does not take into consideration the duration of the project.
Critical Evaluation
01. Besides the NPV, internal rate of return is another important
discounted cash flow technique o f evaluation of capital budgeting.
02. It takes into account the time value of money.
03. It helps firms in achieving the objective of maximization of
shareholders wealth.
04. The approach is based on the cash flows.
05. The proposal as per this technique is expressed as a percentage.
Illustration
The following mutually exclusive projects are considered :
Particular Project A Project B
PV of Cash Inflows Rs.40,000 Rs.16,000
Initial Cash outlay Rs.30,000 Rs.10,000
NPV Rs.10,000 Rs.6,000
PI 1.33 1.60

Which p roject should be preferred and why?
Analysis : The project with the higher NPV should be selected. As per the
NPV method, Project A should be selected. However, as per the PI
technique, project B should be selected as it is having higher PI.
11.7 APPRAISING THE PROFITABILITY OF THE
TECHNIQUES
The various techniques of capital budgeting deal with the various aspects
of the proposals. They are meant to appraise the performance of a project.
As per the decision rule, the technique evaluates proposals and suggests.
Let us understand the various techniques in brief.
01. Payback Period - If the payback period is more than the target time,
reject the proposal. If it is less than the target time, accept the proposal. munotes.in

Page 197

Demand For Capital And Supply of Capital

197 02. Accounting Rate of Return - IF the ARR is more than the pre-
specified rate of return, the proposal is likely to be accepted. If not, a
firm may reject the project.
03. Net Present Value - Accept the proposal if its NPV is positive and
reject the proposal if its NPV is negative.
04. Profitability Index - Accept the propo sal if PI is more than 1 and
reject if PI is less than 1. If the PI is equal to 1, then the firm may be
indifferent.
05. Discounted Payback Period - A project is acceptable if its
discounted payback is less than target payback period.
06. Terminal Value - Accept the proposal of the present value of the total
compounded value of all the cash inflows is greater than the present
value of the cash outflows.
07. Internal Rate of Return - A proposal may be accepted it its IRR, r, is
more than the minimum rate i.e. , k. If it is less than, it may be rejected.
If it is equal, the firm may be indifferent.
11.8 SUMMARY
● The demand for capital represents the amount of capital an entrepreneur
wants to invest in his/her business. The amount of capital is required to
purchase capital goods like equipment, plants, machines and tools.
Supply of capital is the amount available for investment. The amount
which is available for investment is called savings.
● The point of equilibrium between demand and supply comes to a point
when the demand for ca pital is equal to supply of capital. The
equilibrium interest rate can be determined by the point of intersection
of investment and savings curves.
● Capital rationing is a process through which a firm places a limit on the
extent of projects that it decides to undertake. It is a strategy used by
companies to limit the number of investment projects they undertake. It
is a process of choosing the most profitable projects among the
alternatives.
● Capital budgeting decisions denote a situation where decisions are to be
taken related to the investment of lump sum funds invested in the initial
stages of a project. It is expected that the returns will be generated over
a period of more than a year.
● The net present value of an investment proposal involves cash inflows
and outflow over a period of time. It is calculated by taking the
difference between present value of cash inflows and the present value
of cash outflows over a period of time.
● The internal rate of return is the discount rate which equates the
total prese nt value of the cash inflows with the total present value of the
cash outflows. It is a measure used in financial analysis to find out the
potentiality of the proposals. munotes.in

Page 198

Managerial Economics

198 11.9 QUESTIONS
01. Explain the concept of demand for Capital and supply of capital.
02. Write a note on the equilibrium point of demand for Capital and supply
of capital.
03. What is capital rationing? Explain its significance and shortcomings.
04. What is capital budgeting? Classify its various techniques.
05. Capital budgeting evaluation techniques should be capable of ranking
different proposals. Comment.
06. Do the NPV, IRR and PI always agree with respect to accept -reject
decisions? Support your explanation with the help of a few examples.



munotes.in