Managerial Economics - handouts

Managerial Economics

Unit – I

Nature and Scope of Managerial Economics – Definition of Economics –

Important concept so Economics – Basic Economic Problem –
Relationship between Micro and Macro economics – Objectives of the
Firm

Definition of Economics:

Economics:
It is the study of the way in which mankind organises itself to tackle the basic problem of
scarcity. Economics is the science which studies economics problems. There are many definitions given
by many experts the important four definitions are the basic for the economics are

1. Science of wealth - Adam Smith

2. Science of Material welfare - Alfred Marshall
3. Science that Deals with Scarcity - Lionel Robbins
4. Science of Economic Growth - Paul A. Samuelson

Adam Smith:
Economic laws and practices have been in operation ever since human life came in existence. Adam
Smith is regarded as the “father of economics”, who first time organised and presented economic
thought in a systematic way in his book “ An Enquiry into the Nature and Causes of the Wealth of
Nations.”
This book was first published in the year 1776. This gave raise to whole new science known as
economics. This is how Adam Smith is known as the “father of economics”.

Adam Smith defined economics as “a science which studies the nature and causes of the wealth of
nations” for Adam Smith wealth was to be-all and end-all of economic activity. This definition came in
for sharp criticism for its narrow vision, and hence, since has largely been abandoned.

Alfred Marshall:
The great economist considered economics as a means or an instrument to better the conditions of
human life. He defines economics, “Political economy or economics is a study of mankind in the
ordinary business of life, and it examines that part of individual and social action which is most closely
connected with the attainment and with the use of the material requisites of well- being.”
It is on the one side a study of wealth and on the other and more important side a part of the study of
man. For Marshall wealth was only one of the ways to achieve economic welfare.

The important features of this definition is

• Economics is a study of the ordinary business of life
• Economics is a social science
• Economics studies only the material requirements of well-being.

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Lionel Robbins

Lionel Robbins is famous economist in 1932 out of his famous book, “The nature and significance of
Economic Science,” and introduced the, “Scarcity definition of economics.” The scarcity definition of
economics has been pounded by Lionel Robbins. His definition deals with scarcity.
He defines economics as, “Economics is the science which studies human behaviour as relationship
between ends and scarce means which have alternative uses.”

Features of Robbins definitions:

• Economics is a positive science, it states the facts as they are

• Economics studies human behaviour relating to decision making regarding the use of resources
• Human wants are unlimited
• The available means are limited. But these are capable of alternative uses.

Prof. Paul. A. Samuelson:

He further added to the utility of Robbins definition. He defines economics as follows, “Economics is
the study of how man and society choose, with or without the use of money, to employ scarce
productive resources which could have alternative uses, to produce various commodities over time and
distribute them for consumption now and in future among various people and groups of society.”

• The definition focus on both scarcity and growth.

• It is also known as the growth definition of economics.

Managerial Economics:

Managerial economics is a discipline which deals with the application of economic theory to business
management. It deals with the use of economic concepts and principles of business decision making.
Formerly it was known as “Business Economics” but the term has now been discarded in favour of
Managerial Economics.

Managerial Economics may be defined as the study of economic theories, logic and methodology which
are generally applied to seek solution to the practical problems of business. Managerial Economics is
thus constituted of that part of economic knowledge or economic theories which is used as a tool of
analysing business problems for rational business decisions. Managerial Economics is often called as
Business Economics or Economic for Firms.

Definition of Managerial Economics:

“Managerial Economics is economics applied in decision making. It is a special branch of economics

bridging the gap between abstract theory and managerial practice.” – Haynes, Mote and Paul.
“Business Economics consists of the use of economic modes of thought to analyse business situations.”
McNair and Meriam

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“Business Economics (Managerial Economics) is the integration of economic theory with business
practice for the purpose of facilitating decision making and forward planning by management.” –
Spencer and Seegelman.
“Managerial economics is concerned with application of economic concepts and economic analysis to
the problems of formulating rational managerial decision.” – Mansfield

Nature and Scope of Managerial Economics:

• The primary function of management executive in a business organisation is decision making

and forward planning.
• Decision making and forward planning go hand in hand with each other. Decision making means
the process of selecting one action from two or more alternative courses of action.
• Forward planning means establishing plans for the future to carry out the decision so taken.
• The problem of choice arises because resources at the disposal of a business unit (land, labour,
capital, and managerial capacity) are limited and the firm has to make the most profitable use of
these resources.
• The decision making function is that of the business executive, he takes the decision which will
ensure the most efficient means of attaining a desired objective, say profit maximisation. After
taking the decision about the particular output, pricing, capital, raw-materials and power etc., are
prepared. Forward planning and decision-making thus go on at the same time.
• A business manager’s task is made difficult by the uncertainty which surrounds business
decision-making. Nobody can predict the future course of business conditions.
• He prepares the best possible plans for the future depending on past experience and future
outlook and yet he has to go on revising his plans in the light of new experience to minimise the
failure.
• Managers are thus engaged in a continuous process of decision-making through an uncertain
future and the overall problem confronting them is one of adjusting to uncertainty.
• In fulfilling the function of decision-making in an uncertainty framework, economic theory can
be, pressed into service with considerable advantage as it deals with a number of concepts and
principles which can be used to solve or at least throw some light upon the problems of business
management.
• E.g to profit, demand, cost, pricing, production, competition, business cycles, national income
etc. The way economic analysis can be used towards solving business problems, constitutes the
subject-matter of Managerial Economics.
• Thus in brief we can say that Managerial Economics is both a science and an art.

Scope of Managerial Economics:

The scope of managerial economics is not yet clearly laid out because it is a developing science. Even
then the following fields may be said to generally fall under Managerial Economics:

1. Demand Analysis and Forecasting

2. Cost and Production Analysis
3. Pricing Decisions, Policies and Practices
4. Profit Management
5. Capital Management

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These divisions of business economics constitute its subject matter.

Recently, managerial economists have started making increased use of Operation Research methods
like Linear programming, inventory models, Games theory, queuing up theory etc., have also come
to be regarded as part of Managerial Economics.

1. Demand Analysis and Forecasting: A business firm is an economic organisation which is

engaged in transforming productive resources into goods that are to be sold in the market. A
major part of managerial decision making depends on accurate estimates of demand. A forecast
of future sales serves as a guide to management for preparing production schedules and
employing resources. It will help management to maintain or strengthen its market position and
profit base. Demand analysis also identifies a number of other factors influencing the demand for
a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics.

2. Cost and production analysis: A firm’s profitability depends much on its cost of production. A
wise manager would prepare cost estimates of a range of output, identify the factors causing are
cause variations in cost estimates and choose the cost-minimising output level, taking also into
consideration the degree of uncertainty in production and cost calculations. Production
processes are under the charge of engineers but the business manager is supposed to carry out the
production function analysis in order to avoid wastages of materials and time. Sound pricing
practices depend much on cost control. The main topics discussed under cost and production
analysis are: Cost concepts, cost-output relationships, Economics and Diseconomies of scale and
cost control.

3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial
Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a
business firm largely depends on the correctness of the price decisions taken by it. The important
aspects dealt with this area are: Price determination in various market forms, pricing methods,
differential pricing, product-line pricing and price forecasting.

4. Profit management: Business firms are generally organized for earning profit and in the long
period, it is profit which provides the chief measure of success of a firm. Economics tells us that
profits are the reward for uncertainty bearing and risk taking. A successful business manager is
one who can form more or less correct estimates of costs and revenues likely to accrue to the
firm at different levels of output. The more successful a manager is in reducing uncertainty, the
higher are the profits earned by him. In fact, profit-planning and profit measurement constitute
the most challenging area of Managerial Economics.

5. Capital management: The problems relating to firm’s capital investments are perhaps the most
complex and troublesome. Capital management implies planning and control of capital
expenditure because it involves a large sum and moreover the problems in disposing the capital
assets off are so complex that they require considerable time and labour. The main topics dealt
with under capital management are cost of capital, rate of return and selection of projects.

Conclusion: The various aspects outlined above represent the major uncertainties which a business
firm has to reckon with, viz., demand uncertainty, cost uncertainty, price uncertainty, profit

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uncertainty, and capital uncertainty. We can, therefore, conclude that the subject-matter of
Managerial Economics consists of applying economic principles and concepts towards adjusting
with various uncertainties faced by a business firm.

Important Concepts of Economics:

Some Important concepts of Economics are:
1. Goods
2. Wealth, Capital and Income
3. Money
4. Value and Price
5. Equilibrium
6. Consumption and Wants
7. Slope or Rate of Change

1. Goods: The human wants are the starting point of all economic activity. There are two things with
which he can satisfy these wants – goods and services. Goods mean the commodities that we use, and
services refer to the work that a person may do. Services are not something tangible or concrete.
Generally “goods” refer to those material and non-material objects which satisfy human wants. But in
economics, the term is used in a narrow sense. For our purpose the “goods” includes only those material
objects which possess the following characteristics.
(i) These can be transferred from one person to another and
(ii) These can be exchanged for one another.
The most important classification of goods is as Free goods and Economic goods.
Free goods are those that exist in plenty that you can with out any payment. E.g. Air, Water, sunshine,
etc
Economic goods are those goods which are scare and exist in limit quantity, man can have it by paying
for the goods. E.g. T.V., Washing machine, mobile phone etc., It can be further classified into: (i)
Consumer goods and (ii) Producer goods (also known as Capital goods).

(i) Consumer goods: are those goods which directly satisfy human wants, e.g. food, cloths, house etc. It
can be classified into (a) Durable goods (b) Single-use goods
(a) Durable goods: The goods that can be consumed a number of times without any damages to
its utility and its life time is more e.g. furniture, shoes, t.v, etc
(b) Single-use goods: The goods have limited life and it gets destroyed as soon as they are
consumed e.g. food, cold drinks, vegetables, fruits etc.,
(ii) Producer goods (Capital goods): these goods that help in further production and may durable
goods like machines, tools, etc and single use goods like raw materials, coal, fuel, etc.

2. Wealth, Capital and Income:

Wealth is the stock of all those objects-material or immaterial– which possess the following
characteristics,
(i) it must have utility
(ii) it must be scarce
(iii) it must be transferable
(iv) it must be external to human being

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All the economic goods possess the above characteristics; a stock of such goods will be called wealth.
Some immaterial objects like goodwill also form part of wealth. These are known as immaterial wealth.
Wealth can be classified into four as follows:
(i) Personal Wealth- like buildings, ornaments, cloths etc
(ii) Social wealth- like roads, bridges, public hospitals, etc
(iii) National wealth- mines, forests, rivers, etc
(iv) International wealth- like international sea- routes, air-routes etc.

Capital: It is the part of wealth which is used in the process of production like tools, machinery, raw
materials, etc., it would be seen that all capital is wealth but all wealth is not capital.

Income: The earnings received by various factors of production- land, labour, capital and organisation-
according to a time schedule are called income. It is obtained by producing goods, performing services
or by services or by investing.

3. Money: Money is anything that is generally acceptable as a medium of exchange and acts as a
measure of value. It is accepted in payment of goods and services. It is given and received without
reference to the standing of the person who offers it as payment. It is classified as
(i) Cash money- it includes currency notes and coins
(ii) Bank money- it consists of cheques, drafts, bills of exchange, etc.

4. Value and Price: The term ‘value’ is used to express the utility or usefulness of a commodity or
services; the term ‘price’ is used to explain the units of money required to purchase the commodity.

5. Equilibrium: The word Equilibrium has been borrowed from Physics. It is very frequently used in
modern economic analysis. Equilibrium means a state of balance. When forces acting in opposite
direction are exactly equal, the object on which they are acting is said to be in a state of equilibrium. It
also refers to a state when a situation is ideal or optimum or when complete adjustment has been made
to changes in an economic situation, there is no incentive for any more change, so that no advantage can
be obtained by making a change. For e.g. A consumer is said to be in an equilibrium position when he is
deriving maximum satisfaction.

A producer or a firm is said to be in equilibrium when it is making a maximum profit or incurring a

minimum loss, here there will be no inducement to change.

6. Consumption and Wants:

Consumption means the using up of goods and services in such a manner that the wants of
members of the community are satisfied, thus it may be defined as any economic activity directed to
satisfy human and his wants. If any goods are destroyed by unforeseen accidents like earthquake, flood,
wars etc it is not consumption as there is no economic purpose is served. It is divided as Consumption of
goods- there is always a time gap between production and consumption and Consumption of services-
services are consumed the moment they are produced.
Wants means a wish or a desire. Which plays a vital role in the economic life are those which
have an urge to effort and which find their satisfaction through that effort. Wants differ in their intensity,
it can be conveniently classified into three categories as (a) Necessaries (b) Comfort (c) Luxuries.

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7. Slope or Rate of Change: The concept of slope or rate of change is essential to gain an understanding
of many economic principles. The slope, of a line or curve is defined as the rise / run or ∆Y / ∆X, where
delta (∆) refers to a ‘change in’

From the fig the concept of slope is illustrated. The value of the slope for any segment of the straight
line AB is 1.0. The slope of the line AB in the figure indicates that for every 1unit change in X there is a
unit change in Y.

Basic Economic Problem:

From the study of the essential processes of an economy, it would appear that some fundamental
problems arise whatever the type of economy. An economy exists because of two basic facts,
1. Human wants for goods and services are unlimited
2. Productive resources with which to produce goods and services are scare.

Wants are unlimited and resources are limited, the economy has to decide how to use its scarce
resources to give the maximum possible satisfaction to the members of the society. In doing so, an
economy has to solve some basic problems called central problems of an economy, which are:
1. WHAT to Produce
2. HOW to Produce
3. FOR WHOM to Produce

What ever the type of economy or economic system, these problems has to be solved some how. These
are the basic and fundamental for all economies.

1. WHAT to Produce:
The problem ‘what to produce’ can be dived into two related questions.
a. Which goods are to be produced and which not?
b. What quantities those goods, which the economy has decided to produce, are to be
produced?
If productive resources were unlimited we could produce as many numbers of goods as we like.
If the resources are in fact scarce relative to human wants, an economy must choose among
different alternative collections of goods and services that it should produce.
E.g. If it is desired to produce more wheat and less cotton, land use will have to get diverted for
cultivation of cotton to wheat.

2. HOW to Produce:
• The problem ‘how to produce’ means which combination of resources is to be used for
the production of goods and which technology is to be made use of in production.
• Once the society has decide what goods and services are to be produced and in what
quantities, it must then decide how these goods shall be produced. There are various alternative
methods of producing a good and the economy has to choose among them. It is always possible

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to employ alternative techniques of production to produce a commodity, e.g. labour can more
generally, be substituted by machines, and vice- versa.
• A choice would have to be made say between labour- intensive techniques and capital-
intensive techniques of production.
• E.g. Bricks and cement can be carried by labour to the upper floors of a building under
construction. Alternatively elevators and lifts can do the job; we have to make the choice.

3. FOR WHOM to Produce:

• ‘For whom to produce’ it means how the national product is to be distributed
among the members of the society, who should get how much of the total amount of goods and
services produced in the economy.
• The third problem of sharing of the national product, Distribution of the national
product depends on the distribution of national income. Those people who have larger incomes
would have larger capacity to buy goods and hence will get greater share of goods and
services. Those, who have low incomes would have less purchasing power to buy things. The
more equal is the distribution of income, the more equal will be the distribution of the national
product.
The question arises how is the national income to be distributed, that is, how is it to be determined as to
who should get how much of the national income? Should the people get equal incomes and hence equal
shares from the national product, or whether the distribution f national income should be done on the
basis of the Marxian principle ‘from each according to his ability, to each according to his needs’ or
should the distribution of national income be in accordance with the contribution made to the total
production, that is, should everybody get income exactly equal to what he produces?
The main difficulty in the question of distribution of national product or income is how to reconcile the
equity and justice aspect of distribution with the incentive aspect. From the point of view of equity
distribution of national product or income n the basis f equality seems to be the best that the problem is
that equality in the distribution of national product or income may adversely affect the incentive to
produce more. If this incentive is destroyed or greatly diminished as a result of promoting equality, the
total national output available for sharing may be so much smaller that the living standards of all may go
down.

The Micro Economics and Macro Economics:

Economic analysis is of two types (a) Micro economic analysis and (b) Macro economic analysis
1. Micro economics:

Definition:
According to E. Boulding, “Micro economics is the study of particular fir, particular household,
individual price, wage, income, industry, and particular commodity.”
In the words of Leftwitch, “Micro economics is concerned with the economic activities of such
economic units as consumers, resource owners and business firms.”
o ‘Micro’ is a Greek word means ‘small’
o Micro economic theory studies the behaviour of individual decision-making units such as
consumers’ resource owners, business firms, individual households, wages of workers, etc
o It studies the flow of economic resources or factors of production from the resource owners
to business firms and the flow of goods and services from the business firms to households. It

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studies the composition of such flows and how the prices of goods and services in the flow
are determined.
o In this analysis economists pick up a small unit and observe the details of its operation.
o It provides analytical tools for the study of the behaviour of market mechanism.
o It is also called as Price theory and
o It is also called as Partial Equilibrium analysis.

Importance of Micro economics:

o Micro economics occupies a very important place in the study of economic theory.
o It has both theoretical and practical importance.
o It explains the functioning of a free enterprise economy
o It tells how millions of consumers and producers in an economy take decisions about the
allocation of productive resources among millions of goods and services.
o It explains how through market mechanism goods and services produced in the community
are distributed
o It explains the determination of the relative prices of the various products and productive
services.
o It helps in the formulation of economic policies calculated to promote efficiency in
production and the welfare of the masses.

Limitations:
 It cannot give an idea of the functioning of the economy as a whole. An individual industry
may be flourishing, where as the economy as a whole may be languishing
 It assumes full employment which is a rare phenomenon, at any rate in the capitalist world.
Therefore it is an unrealistic assumption

2. Macro economics:
Definition:

According to E. Boulding “Macro economics deals not with individual quantities as such but
with aggregates of these quantities, not with individual income but with national income not with
individual prices but with price levels, not with individual outputs but with national output.”
According to Gardner Ackely, “Macro economics concerns with such variables as the aggregate
volume of the output of an economy, with the extent to which its resources are employed, with the size
of national income and with the general price level.”

• Macro economics is the obverse of microeconomics.

• It is the study of economic system as a whole.
• It studies not one economic unit like a firm or an industry but the whole economic system
• Therefore it deals with totals or aggregates national income output and employment, total
consumption, saving and investment and the genera level of prices.
• It is also called as Income theory and
• It is also called as aggregative economics.

Importance:

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 It helps in understanding the functioning of a complicated economic system

 It gives a bird’s eye view of the economic world
 For the formulation of useful economic policies for the nation macro economics is of the utmost
significance.
 It is far more fruitful to regulate aggregate employment and national income and to work out a
national wage policy
 It occupies most important place in economic theory in its pursuit of the solution of urgent
economic problems.

Limitations:
o Individual is ignored altogether. It is individual welfare which is the main aim of economics.
o It overlooks individual differences. Say the general price level may be stable, but the price of
food grains may have gone spelling ruin to the poor.

Difference between Micro economics and Macro economics:

The main differences between micro economics and macro economics are the following:
S.n Micro economics Macro economics
o
1. Difference in the degree of It studies the individual units of It deals with aggregates like
aggregation: the economy like a firm, a national income and aggregate
particular commodity. savings. It studies the problem
of the economy as a whole
2. Difference in objectives It is to study of principles, It studies the problems,
problems and policies concerning policies and principles relating
the optimum allocation of full employment of resources
resources and growth of resources.
3. Difference of subject It deals with the determination of It is full employment, national
matter price, consumer’s equilibrium, income, general price-level,
distribution and welfare, etc. trade cycles, economic
growth, etc.
4. Method of study Micro economics laws establish Macro economics elements
relationship between the causes are categorized into aggregate
and effects of economics units like aggregate demand,
phenomena and it is formulated aggregate supply, total
by taking some assumptions. consumption, total investment,
etc.
5. Different assumptions It analysis how production and It analysis how full
factors of production are employment can be achieved.
allocated among different uses.
6. Difference of the forces of It studies the equilibrium It deals with equilibrium
equilibrium between the forces of individual between the forces demand
demand and supply or market and supply of whole economy.
demand and supply.

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Unit – II
Demand Analysis – Theory of consumers behaviour – Marginal Utility
Analysis – Indifference curve analysis -Meaning of Demand – Law of
Demand – Types of Demand – Determinants of demand – Elasticity of
Demand – Demand Forecasting.

Demand Analysis: Theory of Consumer behaviour:

Introduction:

o For taking appropriate decisions, the decision-makers require an adequate knowledge about the
Market conditions, specially of the relevant segment of the Market.
o The Market has two sides, viz Demand and Supply. Demand and Supply also called as Market
forces and “invisible hands”.
o Demand may be classified as Individual Demand and Market Demand
o We have to analyse the basic principles underlying the consumer demand.
o The factors which govern consumer behaviour, i.e how does a consumer decide ‘what to buy’
and ‘how much to buy’. These questions take us to the Theory of Demand.
o Utility of the consumer goods is the basis of consumer demand. It is therefore useful to examine
first the concept and the law of utility.

Meaning of Utility:

“Utility is the power or property of a commodity to satisfy human desires.” People pay for a
commodity for its want-satisfying quality. The want-satisfying property of a commodity is ‘subjective’,
not ‘objective’. That is whether a commodity is useful for a person or not, it depends on her/his need for
that commodity or not. Utility is often user-specific. A commodity need not be useful for all. The Utility
of commodity varies from person to person and from time to time depending on the urgency or intensity
of their respective needs.

“Utility” and “Satisfaction” are different. The former stand for ‘expected satisfaction’ where as
the latter ‘satisfaction realized’. Consumer wants to buy a commodity he thinks about the utility of the
commodity or how much of satisfaction the commodity is capable of giving. Only after purchasing he/
she realize the ‘satisfaction’. When ‘expected satisfaction’ is not realized after consumption, it would
decide the consumer to choose or not the commodity in future.

Consumer Theory:

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There are two basic approaches to discuss the consumer demand theory. This theory is taken
from the mathematics:

1. Cardinal utility approach or Classical approach or Neo-classical approach: - which utility

(satisfaction) has been made measurable. That is the utilities contained in commodities are
made quantifiable.

2. Ordinal utility approach or Indifference Curve Analysis- It dispenses with measurement of

utility or comparing utility in quantities as this is not a realistic one and takes up the analysis
of the preference of the consumer. On the basis of the preferences, the commodities are
ordered or ranked as first, second, third, etc.

Concepts of Total and Marginal Utility:

Total Utility is the amount of satisfaction derived from the consumption of or possession of a
commodity. That is total utility is the total satisfaction derived in consuming all the quantities of
commodity purchased.
Marginal Utility is the Utility or satisfaction derived from one unit of that commodity.
Definition- Prof. Bouldiing, “Marginal Utility of any quantity of commodity is the increase in the
total utility which results from a unit increase in consumption.”
“Marginal Utility is the rate of change of total utility caused by a small given change in
the quantity of the commodity.”
E.g. A consumer purchases a packet of biscuits. Total utilities or satisfaction derived refers to the
utilities of all biscuits in the packets.
Marginal utility refers to a single biscuit in the packet. If all biscuits in the packet is alike, then marginal
utility is

Total Utility
Total Utility = ____________
Total quantity

This may be stated in a different way; suppose the consumer consumes ‘m’ units of a commodity then
the aggregate of the utilities derived from ‘m’ units may be referred to as the total utility of ‘m’ units.
The marginal utility of ‘m’ units of a commodity is the difference between the total utilities of (m+1)
and ‘m’ units, (or) (m-1) units.
Marginal utility is the utility of the “Marginal unit”
Marginal unit may be an additional unit or one extra unit or the last unit.
Since Managerial utility is the change in total utility due to an additional unit. It can be expressed
mathematically by;

Dux
Mux = --------
Dqx

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Where,

Mux = Marginal utility of a commodity X

Dux = Change in the total Utility of X
Dqx = Change in the total quantity of X
The Marginal Utility occupied an important place in economic theory.

There are two laws developed on the basis of Marginal utility which have several applications,
1. Law of Diminishing Marginal Utility
2. Law of Equi- Marginal Utility.

1. Law of Diminishing Marginal Utility:

The law of diminishing marginal utility was formulated by Alfred Marshall. The law of
diminishing marginal utility states that as a consumer increases his consumption of a commodity,
marginal utility keeps on falling.
In other words, every additional unit of a commodity yields less and lesser satisfaction.
E.g. A man feeling hungry wants to take Apple. He take out a Apple it gives some utility, say 20 utilities
you consume the second Apple, the second apple yields you lesser utility, the third Apple yields still less
utility and so on.
Every successive increase in the consumption of Apple yields less and less of Utility.
This is what the law of diminishing marginal utility states.

No. of Apple Marginal utility Total utility

1 20 20
2 16 36
3 12 48
4 8 56
5 4 60
6 0 60
7 -4 56

The following curve represents the graphical representation of the marginal utility schedule.

Total and Marginal utility

80
60
Utility in units

40 MU
20 TU

-20
Number of Apples

Assumptions of the Law:

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The law applies only when these assumptions satisfied;

1. Uniform quality and size of the commodity
2. suitable quantity of consumption
3. consumption with in the same time
4. no change in the mental condition of the consumer during consumption
5. no change in fashion or taste
6. no change in the price or its substitutes
2. Law of Equi -Marginal Utility (or) The Law of Maximum Satisfaction:
The law explains the behaviour of the consumer who has to make a choice out of many given
commodities and services on which he can spend his limited amount of money. The maximum
satisfaction can be derived out of the expenditure of a given sum, if the utility derived from the last unit
of money spent on each object of expenditure is more or less equal. Based as it is on the law of
diminishing marginal utility, this law makes the assumption that a consumer’s income and tastes are
constant and the various units of every commodity which is purchased are equal in quality and kind.

Definition or Statement:
The principle states that to get maximum utility from the expenditure of his limited income
(budget), the consumer purchases such amount of each commodity that consumer purchases such
amount of each commodity that the last unit of money spent on each of them affords him the same
marginal utility.
The consumer is faced with a choice among many commodities that he can and would like to buy, and
his income is always in sufficient to buy all the commodities for him and as much as he likes. Therefore,
he would get maximum satisfaction (utility) only if he allocates his limited income on the purchase of
different commodities in such a way as yields him the same marginal utility in all.
The principle of equi-marginal utility can be stated better if we visualize each commodity as
having several uses and also that each consumer ranks the uses in his mind. The consumer tries to put
each unit of the commodity to its most important use. He will, in this way, spend his income in such a
way that way that the last rupee spent on each of the commodities gives him the same marginal utility.
Marshall stated it thus, “If a person has a thing which he can put to several uses, he will distribute it
among these uses in such a way that it has same marginal utility, for if it had a greater marginal utility in
one use than in another, he would gain by taking away some of it from the second use and applying it to
the first.”
The following table shows the marginal utility of spending successive rupees of income on Apples and
Bananas.
Equating marginal utilities of expenditure on apples and bananas for a consumer with limited
income:
Units of Money Marginal Utility of Apples Marginal Utility of Bananas
(K in ‘000) (Units) (Units)
1 20 16
2 18 14
3 16 12
4 14 10
5 12 8
6 10 6
7 8 4
8 6 2

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We can easily see that the consumer will start spending his first thousand Kwacha on apples because the
highest marginal utility is twenty in apples. The second thousand Kwacha is also spend on because the
next highest utility is eighteen here. The third thousand kwacha is spent on bananas, the fourth on apples
again. In this way the consumer goes on spending kwacha by kwacha till he spends all the eight
thousand kwacha with him.
We find that the last (marginal) kwacha spent on apples gives the same marginal utility as the last
kwacha spent on bananas. Both give twelve utils of marginal utility to the consumer. The total utility for
the consumer is 122 utils which is the highest obtainable with the expenditure of eight thousand kwacha.
Any other allocation of the eight thousand kwacha shall gives less total utility to the consumer.

Limitations of the law:

There are some cases where the law of Equi-marginal utility is not applicable. They are:
1. Effect of fashion and customs
2. Consumers also use indivisible goods
3. Utility cannot be measured
4. Non- availability of goods.
5. Constant income and prices
6. Durable goods.

Indifference Curve Analysis (Ordinal):

The Ordinal system has been evolved to explain the behaviour of the consumer. The indifference curve
approach was first outlined by Pareto, an Italian economist. Later on it was developed by the Russian
Economist Slutsky in 1915. It was presented in detail and popularized by J.R. Hicks and R.G.D. Allen in
“A Reconsideration of Theory of Value” in 1934. Later in 1939, J.R Hicks in his famous work “Values
and Capital” offered a detailed treatment of this new analysis.

What the economist wants to know is whether a particular combination of goods has the same
significance to the consumer as another combination of goods. That is, we have to find out the
preference of the consumer between two goods or between two combinations of goods. The human mind
may not be capable of precisely measuring utility derived from a commodity.

But it is definitely capable of finding out at any given time whether one commodity is preferable
to the other, or one combination of goods is as desirable as another combination.

The consumer can rank his preference very easily and say which is better than the other.
E.g. A man, who plans his consumption over a period of a day, has ten thousand Kwacha which he can
spend in units of two thousand Kwacha each. In deciding how to spend the money, the man will have to
decide as to what he should do first and what he would do afterwards. Suppose he spends the first two
thousand Kwacha in seeing movie, the second two thousand in taking meal, the third two thousand
Kwacha in buying book, the fourth in cigar, the fifth in drink, then it is evident that the consumer derives
greater satisfaction in seeing a picture, less satisfaction in food, still less in book and still less in cigars
and drink. This order of preference is his ‘Scale of Preference’. The first commodity in the scale gives
the consumer greater utility and the utility descend in the order of importance.

Scale of Preference:
1 Movie A
2 Meal B
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4 Cigar D
5 Drink E
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The concept of scale of preference does not attempt to measure utility at all. It is a device by which the
utilities of commodities are compared and chosen. This preference and ranking is easier, and there is no
magnitude for the preference. The concept of scale of preference has been given practical shape through
indifference curve technique.

Indifference Curve Analysis:

An indifference curve shows different combinations of two commodities which give the consumer an
equal satisfaction. It is not necessary that in actual practice a consumer may consider only a combination
of two commodities. He may even take a combination of larger number of commodities and may
compare it with another combination of the same commodities in order to make his choice. For
simplicity, we usually take only the combination of two commodities, with one commodity on the X-
axis and the other on the Y-axis.

Indifference schedule:
The indifference schedule is a statement of various combinations of two goods that will be equally
acceptable to the consumer. The various combinations give the consumer equal satisfaction and as such,
he is indifferent to various combinations.

Combinations Bananas Biscuits

First 1 20
Second 2 15
Third 3 12
Fourth 4 10
Fifth 5 9

From the schedule, we can find that while the number of bananas is increasing, the number of biscuits is
decreasing, so that the consumer remains in the same level of satisfaction. The consumer is indifferent to
these combinations as both give him equal satisfaction. Similarly, all combinations in the schedule give
the consumer equal satisfaction, so much so, the consumer gives equal preference to the various
combinations in choosing. The consumer is indifferent to various combinations and he is prepared to
take up any combination, as they give him equal satisfaction. The consumer cannot measure the
magnitude of satisfaction in each combination, but he can compare and say that they are equal.

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Indifference Curve:
The data in the indifference schedule can be represented in the graph with one commodity in the
X axis and another commodity in the Y axis. The various combinations of the two commodities are
plotted and joined to form a curve called indifference curve.

20 –

15 –

10 –

5 –

Biscuits
0 1 2 3 4 5
Bananas

Demand:
Meaning:
o In Economics, use of the word ‘demand’ is made to show the relationship between the prices
of a commodity and the amounts of the commodity which consumers want to purchase at
those price.
o Demand is one of the forces determining price.
o The theory of demand is related to the economic activity of a consumer, that is consumption,
the process through which a consumer obtains the goods and services he wants to consume is
known as demand.

Definition of Demand:
Hibdon defines, “Demand means the various quantities of goods that would be purchased per
time period at different prices in a given market.”
Bober defines, “By demand we mean the various quantities of given commodity or service which
consumers would buy in one market in a given period of time at various prices, or at various incomes, or
at various prices of related goods.”
Demand can be understand by the following characteristics,
1. Demand is not mere desire, but desire with the capacity to purchase.

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2. Demand is always related to price. That is the quantity demanded should be expressed only in
terms of the price of that commodity
3. Demand should be referred to per unit of time.
4. Demand varies for a commodity with variations in income.
5. Demand for a commodity varies with variations of prices of related goods.

Law of Demand:
The Law of demands states that the demand for a commodity increases when its price decreases
and falls when its price increases or raises, other things remains constant or same.
‘the other things’ includes income, price of the substitutes and complements, taste and
preferences of the consumer etc.
The law of demand can be illustrated more conveniently with the help of a demand schedule and
a demand curve.

Demand Schedule:

Demand schedule is a numeric tabulation showing the quantity that is demanded at selected prices. It is
the way of expressing the relationship between the price of a commodity and quantity demanded.
E.g. A hypothetical demand schedule for tea is given below;

Price per cup of tea (k) No. of cups of tea demanded per Symbols representing price-
consumer per day quantity combination
700 1 I
600 2 J
500 3 K
400 4 L
300 5 M
200 6 N
100 7 O
o The table shows even alternative prices and the corresponding quantities (number of cups of
tea) demanded per day.
o Each price has a unique quantity demanded associated with it.
o As price per cup of tea decreases, daily demand for tea increases
o This relationship between quantity demanded of a product and its price is the law of demand

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Demand Curve:
A demand curve is a graphical representation of the relationship quantity demanded and price. A
normal demand curve slops downwards form left to right. It is known as the negative slope of the
demand curve. Downward slope of a demand curve indicates an inverse relationship between the price
and quantity demanded. It implies that the quantity demanded rises as the price falls.
Y D
7 i

6 j

5 k

4 l
Price per cup (k)

3 m

2 n
0
1 D’

1 2 3 4 5 6 7 8
O X
Why does a demand curve slope downwards?
The negative slope of a demand curve, illustrating the inverse relationship between the price of a
commodity and the quantity demanded. There are two different alternative approaches to this problems,
they are known as;
(i) traditional approach
(ii) Modern approach

(1) Traditional approach:

It is based on the law of diminishing marginal utility. It was propagated by Alfred Marshall. It
states that as a consumer consumes more units of a commodity, it yields him lesser and lesser marginal
utility. That a consumer will continue consuming a commodity until the marginal utility of the
commodity becomes equal to its price that is

MUx = Px
i.e
Marginal Utility Price of
of commodity X = Commodity X

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Y D
M
P

M1
Marginal utility and price

P1

M2
P2
D’

Price Quantity demanded

OP OQ
O OP1 Q OQ1 Q1 Q3 X
OP2 Quantity
OQ2 of Commodity

 As at the price OP, the consumer will demand OQ quantity of the commodity
 At the price OP1 ,he will demand OQ1quantity
 At the price OP2, he will demand OQ2 quantity
 Thus at lower price, the consumer demands more of the commodity. This is what the law of
demand states.
 The marginal utility curve itself becomes the demand curve of consumer.

The approach incorporates the following factors:

(i) Change in the number of consumers:

At a lower price, more consumers can afford to buy the commodity and vice-versa

(ii) Diverse use of a commodity:

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At a lower price, a commodity can be put to different uses, at a higher price, use of the commodity is
restricted to a few important uses.
(e.g) The electricity can be used for lighting, cooking, heating, cooling, etc. suppose the price of
electricity rises, its consumption will be restricted only for lighting purpose, or cooking as result, the
total consumption of electricity or total demand for electricity will be decreased.

(2) Modern Approach:

It explains the law of demand in terms of two effects viz
(i) income effect
(ii) substitution effect

(i) Income effect:

This is based on the concept of real income (purchasing power). A fall in the price of a
commodity also implies an increase in real income of the consumer. i.e ability to purchase more quantity
of the same commodity with the same income. Similarly at a higher price consumer’s ability to purchase
commodity falls.
E.g. At a price of K5000 per cassette, you may afford to buy 2 cassettes. But if the price falls to K3000
per cassette, you can buy 3 cassettes, and price of K2500 you can buy 5 cassettes so on.

(ii) Substitution effect:

It is based on the concept of relative prices. A fall in the price of X means, all the other prices
and income levels remaining unchanged, that the prices of all other commodities would have increased
in terms of X. Therefore the consumer is induced to purchase more of X and cut down on the demand
for other commodities.

Determinants of Demand:

1. Non- durable goods:

There are 3 basic factors influencing the demand for Non durable goods.

(a) Disposable income:

This is determined by disposable personal income.
Disposable Income (DI) = Personal income – direct taxes –
other deductions

Disposable income is published by the central statistical organization. It is expressed by

DN = f (Y) , Y means income, other things being equal, the demand for commodity N depends upon the
disposable income of the house hold. DI gives an idea about the purchasing power of house hold.

(b) Price:

It is expressed as DN = f (P) P is price, other things being equal. The demand for commodity N
depends upon its own prices of the related goods i.e complements and substitutes. The demand for a
commodity is inversely related to its own price and the price of its complements. It is positively related

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to its substitutes. Price elasticities and cross elasticities of non- durable goods help in their demand
forecasting.

(c) Population:

It is expressed by DN = f (S), S means size of the population, other thing being equal, the
demand for commodity N depends upon the size of the population and its composition. Population can
be classified on rural and urban ratio, sex ratio, income groups, social status, and literacy. Demand for
non- durable goods influence by all these factors.

2. Durable consumer goods:

In forecasting the demand for Durable consumer goods, we have to study the following factors
about the demand for the goods.

(i) In case of durable consumer goods the consumer can post pone its replacement. He can use
the existing commodity longer buy getting repair to purchase latest model bike it depends upon factors
like social status, prestige of the commodity, income, taste, availability of spares etc. The rate of
replacement depends upon the wear, and tear rate.

(ii) use of consumer durable goods depends upon some other special facilities like electricity
supply for household goods, good roads for cars and bikes.

(iii) The purchase is durable consumer goods is a decision influenced by the family rather than
individual consumer durables are consumed in common by the member of a family.

E.g Television, refrigerator, washing machine, etc. are used common by the household.
The demand forecast of goods commonly used should take into account the number of households rather
than size of population while estimating the number of households, the income of house holds, and
composition of family should be taken into consideration.

(iv) Demand for durable consumer goods is very much influenced by their prices and the credit
facilities available by them. Some times availability of credit facilities, installment payments etc., can
offset the effect of a price increase on the demand.

Elasticity of Demand:
Elasticity of demand is the measure of the degree of change in the amount demanded of the commodity
in response to a given change in price of the commodity, price of some related goods or change in
consumer income.

Elasticity of Demand is 3 types:

1. Price elasticity of demand

2. Income elasticity of demand
3. Cross elasticity of demand

(1) Price elasticity of demand:

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“The elasticity of demand in a market is great or small according as the amount demanded
increases much or little for a given fall in price and diminishes much or little for a given rise in price.” –
Alfred Marshal.

That the price elasticity of demand measures the responsiveness of the quantity demanded of a
commodity to a change in its price. The price elasticity of demand is commonly called the elasticity of
demand. This is because price is the most changeable factor influencing demand.

Ep = Proportion ate change in demand

Proportion ate change in Price
(or)
Symbolically:

∆Q P
Ep = ×
∆P Q

Where, Q = Original quantity demanded, P= Original Price, ∆Q = Change in quantity demanded,

∆P = change in price, EP = Price elasticity coefficient.
E.g. Suppose 10 units of a commodity are demanded at a price of K4 each. If 12 units of the commodity
are demanded at a price of K3 each elasticity of demand for this commodity can be calculated as

∆Q P
EP = ∆P ×Q ∆ Q = 12 – 10 = 2, ∆ P = 4-3 = 1
2 4
= × = 0.8
1 10

Value of Elasticity Co-efficient and their description:

(a) Perfectly elastic demand ( EP = ∞):
Where no reduction in price is needed to cause an increase in quantity demanded. In this case in
demand curve is horizontal and parallel to the quantity axis.

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(b) Absolutely inelastic demand: ( EP = 0)

Where a change in price however large, causes no change in quantity demanded. In this case
demand curve is vertical and parallel to price axis.

(c) Unit elasticity of demand: ( EP = 1)

Where a given proportionate change in price causes an equal proportionate change in quantity
demanded. Here the demand curve takes the form of, whose form is given by PQ= K, a constant.

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(d) Relatively elastic demand: ( EP › 1)

Where a change in price causes a more than proportionate change in quantity demanded. In this
case demand curve is more flatter.

(e) Relatively inelastic demand: ( EP ‹ 1 )

Where a change in price causes a less than proportionate change in quantity demanded. In
this case demand curve is steeper.

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Factors that influence the price elasticity of demand:

a) Number of close substitutes:

The more substitutes that are available, the greater the price elasticity of demand.

b) Luxury or necessity:
Necessities generally will tend to have inelastic demand while luxuries will tend to have an
elastic demand.

c) Durable or non- durable goods:

In the case of durable goods, replacements takes place before the commodity reaches the
end of its life. People exchange their cars just because of new model is preferred. So consumers can
actually decide just when they want to enter the replacement market. If price rises they can postpone
purchase. Or if price falls, they might purchase earlier than intended.

d) Number of uses which the product has:

The more uses a product has, the more elastic the demand.

e) Percentage of consumer’s budget:

The more expensive a product and the bigger part it plays in the total consumer’s budget,
the more strongly the price changes are going to be felt by the consumer and there will not necessarily
be inelastic because the frequency of purchase is also to be considered to find the overall part played that
commodity in the total budget.

f) Habit:
Once people form a habit of using a particular commodity, they do not care of price changes
over a certain range. Therefore demand for such commodities becomes inelastic.
g) Time:
Longer the period of time, more elastic is the demand. Shorter the time, less elastic is the demand.

(2) Income Elasticity of Demand:

Income elasticity of demand means the ratio of the percentage change in the quantity
demanded to the percentage change in income. Income elasticity measures the responsiveness of

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demand to change in income. It gives us an idea of the sensitivity of demand for a commodity as
consumer’s income changes.

EY = Proportion ate change in demand

Proportion ate change in income
(or)
Symbolically:
∆Q Y
EY = ∆Y × Q

E.g A household demands 30 liters of milk, when his monthly income is K300, 000. If the house hold’s
income increases to K500, 000 his demand for milk increases to 40 liters, the income elasticity of
demand will be,

∆Q Y
EY = ∆Y × Q

∆Q = 40 – 30 = 10

∆Y = 500, 000 – 300, 000 = 200, 000

10 300 ,000
EY = × = 0.5
200, 000 30

Hence the house hold’s demand for milk is income elastic.

Types of Income Elasticity of Demand:

(a) Positive income elasticity of demand:

When the amount demanded of commodity increases with increases in income and vice-versa,
the income demand curve will be shown as positively sloping from left upwards to the right. In this case
commodity in X axis and income Y axis the commodity is normal.

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(b) Zero income elasticity:

When the demand for a commodity for a commodity does not respond to changes in income. It is
said to be completely income inelastic. E.g Salt, post cards etc.
In these case, the income demand curve is shown as a straight line parallel to the vertical axis Y.

(c) Negative income elasticity:

When the amount demanded of a commodity diminishes with an increase in income of the
consumer, the commodity is said to be an inferior one. (e.g) low quality food grains, soaps, etc.
The income demand curve will be shown as sloping from left downwards to right.

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(3) Cross Elasticity of Demand:

The cross elasticity of demand is a measure of the responsiveness of purchases of Y to change in

the price of X. That is a change in the price of one good cause a change in the demand for another good.
Ec = Proportion ate change in the quantity of commodity of X
Proportion ate change in the price of commodity of Y
(or)
Symbolically:
∆Qx Py
EC = ∆Py × Qx

For e.g. Suppose the price of coffee rises from K1000 of 250 grams to K1200 per tin. As a result,
consumers’ demand for tea, an immediate substitute, rises from 70 kilos to 100 kilos. The cross
elasticity of demand of tea for coffee is
∆Qx Py
EC = ∆ Py × Qx

∆Qx = 100 – 70 =30 kilos

∆Py = 1200 – 1000 = k 200

Qx = 70 kg

Py = 1000

30 1000
EC = × = 2.14
200 70

Classification of commodities through Cross elasticity:

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The Cross elasticity of demand can be used to classify goods into three types;

(1) Substitute goods:

The Cross elasticity of demand for tea and coffee goods is positive, because a rise in the price of
tea will raise the demand of Coffee. The raise in demand for coffee as a result of the rise in the price of
tea will give a positive co-efficient of Cross elasticity.

(2) Independent goods:

Goods as eggs and diesel engines have no price relationships with one another. If eggs price go
cheaper, the demand for diesel engine remains unaffected. The value of Cross elasticity is Zero therefore
called as ‘Independent goods’.

(3) Complementary goods:

Milk and sugar are examples of complementary goods, when price of milk rises; its demand falls
since sugar is used along with milk, so demand for sugar will also fall. The value of cross elasticity in
this case will be negative because the price of milk and the demand for sugar move in opposite
directions.

Types of Demand:

The demand types are as follows;

a) Individual demand and Market demand
b) Autonomous and Derived demand
c) Demand for durable and non durable goods demand
d) Short term and long term demand

a) Individual demand:
The quantity of a commodity which an individual is willing to buy at a particular price at specific
time, his given income, his taste and prices of the other commodities is known as ‘Individual’ demand
for a commodity.
Market demand: The total quantity which all the consumers of a commodity are willing to buy at a
given price, income, other prices and taste is known as market demand.

b) Autonomous and Derived demand:

Autonomous demand: The demand for a commodity is one that arises independent of the demand
for any other commodity. E.g. demand for a commodity which arises from needs of human, like food,
cloths, shelter,etc.
Derived demand: It is one that is tied to the demand for some ‘parent product’. The demand for a
commodity that arises because of the demand for some other commodity is called derived demand.
E.g. Agricultural tools and implements, cotton, bricks, cement etc.

c) Demand for Durable and Non-durable goods:

Durable goods are those whose total utility is not exhausted by a single use, it can be used
repeatedly or continuously over a period. Durable goods can be consumer goods and producer goods e.g.
furniture, scooter, car, building etc.
The demand for durable goods changes over a relatively longer period. The demand will be
exponentially.

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Non-durable goods: the goods which can be used or consumed only once and their total utility is
exhausted in a single use. Eg. Food items, drinks, soaps, fuel etc. The demand for nondurable goods
depends largely on their current prices, consumers income and fashion and is subject to frequent change
where as the demand for the durable is influenced also by their. The demand will be lineally.

d) Short term and long term demand:

Short term demand: It refers to the demand for such goods are demanded over a short period.
The goods like fashion consumer goods, seasonal goods, inferior substitutes during the scarcity of
superior goods, fashion wears etc.
Long term demand: It refers to the demand which exists over long period. The change is
perceptible only after a long period. E.g the change is perceptible only after a long period like producer
goods, consumer goods, durables and non- durable goods. Though their brands or varieties demand will
be short term demand.

Demand Forecasting:
A forecast is merely a prediction concerning the future. Thus a demand forecast is a prediction of future
sales. Demand forecasting is essential for a firm because it must plan its output to meet the forecasted
demand according to the quantities demanded and the time at which these are demanded. The
forecasting demand helps a firm to arrange for the supplies of the necessary inputs without any wastage
of materials and time and also helps a firm to diversify its output to stabilize its income overtime.
Demand forecasting is given great importance in countries like USA and UK because in these countries
firms produce on mass scale and overproduction may land the firms in big losses.
The purpose of demand forecasting differs according to the type of forecasting.
(1) The purpose of the Short term forecasting:
It is difficult to define short run for a firm because its duration may differ according to the nature
of the commodity. For a highly sophisticated automatic plant 3 months time may be considered as short
run, while for another plant duration may extend to 6 months or one year. Time duration may be set for
demand forecasting depending upon how frequent the fluctuations in demand are, short- term
forecasting can be undertaken by affirm for the following purpose;
(i) Appropriate scheduling of production to avoid problems of over production and under-
production.
(ii) Proper management of inventories
(iii) Evolving suitable price strategy to maintain consistent sales
(iv) Formulating a suitable sales strategy in accordance with the changing pattern of demand and
extent of competition among the firms.
(v) Forecasting financial requirements for the short period.

(2) The purpose of long- term forecasting:

The concept of demand forecasting is more relevant to the long-run that the short-run. It is
comparatively easy to forecast the immediate future than to forecast the distant future. Fluctuations of a
larger magnitude may take place in the distant future. In fast developing economy the duration may go
up to 5 or 10 years, while in stagnant economy it may go up to 20 years. More over the time duration
also depends upon the nature of the product for which demand forecasting is to be made. The purposes
are;
(i) Planning for a new project, expansion and modernization of an existing unit, diversification
and technological up gradation.
(ii) Assessing long term financial needs. It takes time to raise financial resources.
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(iii) Arranging suitable manpower. It can help a firm to arrange for specialized labour force and
personnel.
(iv) Evolving a suitable strategy for changing pattern of consumption. The emerging pattern of
industrialisation, urbanisation, education, degree of contact with the rest of the world could
be closely studied by a firm for forecasting demand.

Steps involved in Demand forecasting:

Various steps involved in demand forecasting they are;

(1) Setting the objective: Clarity of objective makes the process of demand forecasting easier. The
firm should be clear as to the purpose of demand forecasting. The firm may use demand
forecasting for determining the size of output, fixation of price, inventory control, change in
product- mix, up gradation of technology.

(2) Selection of goods: Categorisation of goods facilitates the selection of approach for demand
forecasting. Two fold classifications of goods may be resorted for forecasting.
(a) Consumer goods and capital goods
(b) Existing goods and new goods.
(3) Selection of method: There are different methods are there the success of particular method
depends upon the are of investigation, time available, resources, availability of data, availability
of trained personnel.
(4) Interpreting the results: This is most important step in demand forecasting. The results of
demand forecasting should be very carefully analysed before any inferences in drawn out of
them. Forecasting is based on a number of assumptions. If these assumption change, as they may
due to changes in political, economic, social and international factors, the revision of forecast
may become inevitable.

The requirements for demand forecasting:

Demand forecasting can be made merely by guess. It requires through understanding of the current and
future conditions. Such understanding is obtained through market research the requirements are;
(a) Elements relating to consumers:
 total number of consumers
 distribution of consumers / products
 total purchasing power and per capita income / household
 income elasticities
 consumer tastes, social customs etc
 consumer marketing details like when, where, how, how many do they buy
 effects of design, colours, etc on consumers preferences.

(b) Elements concerning the suppliers:

o Current levels of sales
o Current stocks of goods
o Trends in sales and stocks
o Market shares
o Pattern of seasonal fluctuations
o Research and development trends
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o Company strength and weakness

o Product life cycle
o New product possibilities

(c) Elements concerning the market:

 The effect of price change i.e price elasticity
 Product characteristics
 Identification of competitive and complementary products.
 Number and nature of competitors
 Forms of market competitions
 General price levels

(d) Other exogenous elements:

National income, population, education etc
Government policies
Taxation levels
International economic climate etc.

Demand forecasting methods:

Methods of Demand Forecasting

Survey Methods Statistical Methods

Experts opinion Consumers survey Trend projection Regression Barometric Simultaneous

Survey method method method method method methods

Demand Forecasting
Estimation of demand for a product in a forecast year/ period is termed as Demand forecast. Demand
forecast is a must for a firm operating its business as today's market is competitive, dynamic and
volatile.

Methods of Forecasting
Surveys Technique
• Survey of business executives, plant and equipment, expenditure plans. Basically compilation of
expenditure plans of related industries.

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• Survey of plans for inventory changes and sales expectations.

• Survey of consumer expenditure plans.

Opinion Polls
• Consumer survey: In this method the consumers are contacted personally to disclose their future
purchase plans. This could be of two types-Complete enumeration and sample survey.

• Sales force opinion method: In this method people who are closest to the market( sales peoples)
are asked for their opinion on future demand. Then opinion of different people is compiled to get
overall demand forecast.

• Expert Opinion (Delphi Technique): Opinions of different experts are taken and compiled. If
there are discrepancies between the different viewpoints, successive rounds of iterations are
undertaken taking into account the opinions of other experts, until near consensus emerges

Statistical Methods

Time Series Analysis

Forecasts on the basis of an analysis of historical time series data
Trend Projection Method
Based on the assumption that there is an identifiable trend in the variable to be forecast which
will continue in the future
Time Series data is used to fit a trend line on the variable under forecast either graphically or by
statistical techniques
Y = a + bt; t → time
Forecasting is done by extrapolating the trend line into the future.
Barometric Methods
Leading Indicator Method : correlated with the variable to be forecast. These indicators tend
normally to anticipate turning points in a business cycle.
• Coincident indicators: These are indicators which move in step or coincide with movements in
general economic activity or business cycle.

• Lagging indicator: These are indicators which lag the movements in economic activity or
business cycle.

Regression Method
• Identification of variables which influence the demand for the good whose function is under
estimation.

• Collection of historical data on all relevant variables.

• Choosing an appropriate form of the function.

• Estimation of the function

• Simultaneous Equation Method

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• (Econometric Models)

• Econometric forecasting models range from single equation models of the demand that the firm
faces for its product to large multiple equation models describing hundreds of sectors and
industries of the economy. Use estimating equations based on Economic Theory

• Input – Output Forecasting

• Input output analysis was introduced by Prof. Leontief. With this technique the firm can also
forecast using Input output tables. It shows the use of the output of each industry as input by
other industries and for final consumption. Input and output analysis allow us to trace through all
these inter industry input and outputs flow though out the economy and to determine the total
increase of all the inputs required to meet the increased demand.

UNIT – III

Production and Cost Analysis – Production – Factors of Production –

Production function – concept – Law of variable proportions – Laws of
return to scale and economics of scale – cost analysis different cost
concepts – cost output relationship – short run and long run – Revenue
curves of firms – Supply Analysis

Factors of Production:

Human beings need various goods and services to satisfy their wants. Act of production is essential for
the satisfaction of wants. Production is important economic activity. It is an activity directed to satisfy
the peoples wants through exchange. Production is not merely transformation of material things or
creation of utility but it also involves the process of exchange through which goods and services reach
the ultimate consumers to satisfy their wants.
Production requires the use of certain resources. It is the co-operative effort of the various ‘factor of
production.’ Modern economist prefer to call them as ‘inputs’ what ever goes into the production
process to produce goods and services it is called inputs. Inputs or factors of production are divided into
two categories.
(1) Factor inputs – Land, Labour, Capital and Enterprise these are called primary inputs.

(2) Non- factor inputs- Raw materials and other semi-finished products form other producing units,
they are called secondary inputs.
(1) Land:
Land includes all those natural resources, whose total supply in the economy is fixed or inelastic.
It does not mean only surface of soil but also free gifts of nature such as forest, mines, rivers, rainfall
etc.

Characteristics of Land:

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 It is a free gift of nature- the man has not to pay any price for it so long as it is owned and
controlled by some one.
 In elastic supply- supply of land is fixed; man can change the uses of it.
 Immobility of land- It cannot be shifted from one place to another
 Passivity- Land itself cannot produce any thing assistance of labour and capital is needed to
make land productive.

(2) Labour:
Labour may be defined as human exertion of the body or the mind undertaken with a view to
produce material things and services. Labour is any type of manual or mental activity done with a view
to earning a reward.

Characteristics of Labour:
o Labour is an active factor of production
o Labour is perishable- it cannot be stored
o Labour is inseparable from the labourer – Labourer has to present himself physically.
o Productivity of labour can improve – it can be improved through education, training etc
o Supply of labour is inelastic during the short run – labour supply is related to the population
o Labour differs in productivity - the efficiency and productivity between labourers differs from
one to another.

(3) Capital:
Capital consists of those kind of wealth, other than the free gifts of nature, which yield income.
The capital is any thing produced by man which can be used for further productions. It is different from
other factors, as it is man made. Capital consists of producer’s goods and stocks of consumer goods not
yet in the hand of consumers. It consists of the following.

(a) Structures: such as private resident, factory buildings, government buildings etc.
(b) Equipments: it includes three types of goods viz,
(i) Durable consumer goods- its like furniture, t.v, Air con, cars, etc. which are yet
to reach consumer.
(ii) Durable capital goods: they are like machinery, plants, tools, roads, bridges,
buses, dams, etc.
(iii) Inventories: they are such as stocks of raw materials, intermediate goods and
finished goods lying unsold.
(c) Money: it is used for production purpose.

Characteristics of Capital:
A man made factor
A secondary factor of production
Depreciation – it depreciates when it is used for production and depends on durability, so provision must
be made for replacing it.

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A mobile factor – it is easily transferable from one place to another.

A passive factor – it is unable to produce without land and labour therefore it is passive factor.
Elastic supply - The supply of capital assets can be increased through higher savings, supply is
diminished which there is no provision for depreciation.
Formation of capital involves a cost
Capital depends upon technology of production

Types of Capital:
Capital assists in production in different ways. The are classified in the following forms;

(a) Fixed and circulating capital:

Fixed capital is one which is durable and which is used in production for a considerable long
time. E.g. machines, plants, equipment, factory buildings, dams, etc.
Circulating capital refers to the capital which is used only once in production. It loses its utility
after single use. E.g. raw materials, seeds, coal, gas, petrol. etc.

(b) Material and personal capital:

Material capital consists of objects which exist in concrete and tangible form and are capable of
being transferred form one person to another. E.g. machine, tools, transformers, etc.
Personal capital comprises all those energies, faculties and habits which contribute to make
labour efficient. It includes all the personal qualities of an individual which are non- transferable. E.g.
art of dancing and singing, art of painting, etc.

(c) Sunk and floating capital:

Sunk or specialized capital is one which can be used in a specific occupation. Once invested in a
particular business, it cannot be withdrawn. E.g. railway bridges, factory buildings, dams, roads, etc.
Floating capital or free when it can be changed at will for employment in any branch of industry
and can at any time assume a different form. E.g. wood, raw materials, electricity, etc.

(d) Remuneratory and Auxiliary capital:

Remuneratory or wage capital is one which is applied to the payment of labour engaged in
production.
Auxiliary capital is that which assists the labour to carry out their duties smoothly. E.g.
machines, tools, equipment, etc.

(e) Production and consumption capital:

Production capital is all those articles which help the labour directly in production. E.g. raw
materials, machines, tools equipments, etc. it can be materials as well as personal.
Consumption capital it consists of those materials which indirectly assist in the process of
production. E.g. food, clothes, residential accommodation, vehicle, etc.

(f) Internal and external capital:

Internal capital is based upon the criterion of place. The capital which is the result of domestic
savings in the country is called internal capital.
External capital is which imported or invited form abroad and used in recipient country. E.g The
capital received in Zambia from the World Bank, International Finance Corporation, etc.

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(4) Enterprise:
Business is full of risks and uncertainties. The task of bearing risks is called enterprise. The man
who bears the risk of business is called an entrepreneur. Entrepreneurs are the owners of the business
who contribute the capital and bear the risk of uncertainties in business life. Several types of risks
involved in business like some times demand fall, short of supply, etc.

Functions of entrepreneur:
(a) Bearing of risks:
The entrepreneur hears a variety of risks which nobody else is prepared to undertake like
insurable risks and non-insurable risks. The entrepreneur needs to bear them. The entrepreneur claims
profit due to this specific function of uncertainty bearing.

(b) Decision- taking function:

This is an important function of an entrepreneur. He has to take decisions as regards the
following matters;
 Selection of the product
 Selection of the type of the firm
 Selection of the location of plant
 Selecting techniques of production
 Selection of the size of the firm.

(c) Distributive functions:

Peaceful and congenial atmosphere inside the factory premises is essential for smooth production
activity. The entrepreneur has to keep all factors of production contended. He has to decide about the
share that each factor of production should received form the total produce.

(d) Innovative function:

Innovation is considered as an important function of an entrepreneur. Innovation is defined as the
commercial use of invention. It is the commercial use of invention. The individuals and experts working
for corporation conduct basic research and invent new product, the new technology, new sources of
energy, and soon the entrepreneurs makes use of these inventions for commercial purposes. Innovation
helps a firm to earn large profits.

Product Concept:
Product or Out put refers to the volume of goods produced by a firm during a specific period of time.
The volume of goods produced can be looked at three different angles, they are
(a) Total product
(b) Marginal product
(c) Average product

(a) Total product:

The total product refers to the total volume of goods produced during specific period of time. It
can be raised only by increasing the quantity of the variable factors employed in production, but there is
limit tot which total product can increase with increase in the quantity of variable factors of production.
For e.g. A firm has capacity to keep 100 machines which 100 labours can work, if it keep 150 labours

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there will be over crowding. So the labour will not be able to work efficiently the total product when
changing units or labours are employed and all the other factors are kept constant.
Product schedule:
No. of men Total product
(units)
1 30
2 80
3 120
4 150
5 170
6 170
7 150
8 120

(b) Marginal product:

The rate at which total product increases is known as marginal product. Marginal product is the
addition to the total product resulting from a unit increase in the quantity of the variable factor. It would
be said the total product is maximum the marginal product is zero.
Product schedule:
No. of men Total product Marginal
(units) product
1 30 30 (30-0)
2 80 50 (80–30)
3 120 40 (120-80)
4 150 30 (150-20)
5 170 20 (170-150)
6 170 0 (170-170)
7 150 -20 (150-170)
8 120 -30 (120-150)

(c) Average product:

Average product can be known by dividing total product by the total number of units of the
variable factors. It is also known as the per unit product of a variable factor. It would be seen that the
Average product shows almost the same tendency as does the marginal product. Both the Marginal and
Average product rise but ultimately both of these falls. However, Marginal product may be Zero and
negative, but Average product can never be Zero. This is explained in the Laws of returns.

Product schedule:

No. of men Total product Average

(units) product

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1 30 30.0 (30/1)
2 80 40.0 (80/2)
3 120 40.0 (120/3)
4 150 37.5 (150/4)
5 170 34.0 (170/5)
6 170 28.0 (170/6)
7 150 21.4 (150/7)
8 120 15.0 (120/8)

Production Function:

The functional relationship between price of a commodity and its quantity demanded it is called demand
function. Similarly the production function explains the relationship between factor inputs and output
which means factors of production, their productivity and the final outcome of their efforts. The
production function illustrates technological relationship between inputs and output, that is with given
state of technological knowledge and during a particular period of time how much can be produced with
given amount of inputs. It can be written as

Q = f {f1, f2, ....., fn}

Q = the physical quantity produced per period of time

f1, f2, ..., fn = the physical quantities of ‘m’ different factor used.

Fixed factors and Variable factors of production:

Fixed factors of production: are those factors inputs whose quantity remains the same irrespective of
the level of input. i.e. land, building, machines, plant, equipment, etc.

Variable factors of production: are those inputs the supply of which has to be changed to obtain
different fixed and variable factors is relevant in short run only, in long run all the factors become
variable. i.e. the supply can be raised in long run.

Law of variable proportions:

The factors of production can be classified as fixed factors and variable factors. If we want to produce
more of goods / commodities, more quantity of factors of production have to be employed. The quantity
of fixed factors cannot be changed and quantity of the variable factors can be changed. If we increased
the quantity of the variable factors only the proportion between the fixed factors and variable factors will
change. How will this change in factor proportions affect the level of production? This is explained with
the help of the law of variable proportion. The classical or traditional explanation of the behaviour of
production illustrated by Prof. Alfred Marshall was in the form of the laws of returns. Marshall talked
about three laws of returns keeping the supply of fixed inputs as constant, if the supply of the variable
inputs is raised, then the total product in the beginning increases at an increasing rate, then at a constant
rate, and finally at a diminishing rate that is his three laws, viz,

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(a) The law of increasing returns

(b) The law of constant returns
(c) The law of diminishing returns.

(a) The law of increasing returns:

This law explains that with an increase in the quantity of variable factors, average and marginal
product show a tendency to rise. i.e. total product increase out an increasing rate, that is illustrated as
below,
Product Schedule:
No. of men Total product Average Marginal
product product
0 0 0 0
1 20 20 20
2 50 25 30
3 90 30 40
4 160 40 70
5 250 50 90

The diagram representation for the law of increasing returns;

Law of increasing returns

100
80
Product

60 MQ
40 AQ
20
0

No. of men employed

It shows that the average and marginal product of firms go on increasing with an increase in number of
men employed. Both the curves MQ, AQ are moving upwards.

The causes of the operation of law:

(i) Indivisibility of factors:

The marginal product of each of men would increase their total product at an increasing rate. The
certain factors of production are invisible. They can be put to their best use only when they can fully
employed.

(ii) Specialisation:
When large number of person employed on a job it makes possible to divide a hob in different
stage and each looks each stages, this in division of labour, it results to specialisation every person

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becomes perfect in their job, there for efficiency increases, it implies more production. So these are two
important factors that help bringing in increasing returns.

(b) The law of constant returns:

This law explains that if the quantity of a variable factor is changed, average and marginal
product will not change. i.e. total output will increase only at a constant rate.

Product Schedule:

No. of men Total product Average Marginal

product product
0 0 0 0
1 100 100 100
2 200 100 100
3 300 100 100
4 400 100 100
5 500 100 100

The diagram representation for the law of constant returns;

Law of Constant returns

200
Product

MQ
100
AQ

No. of men employed

That is with an increase in the number of men employed, total product increases at a constant rate. i.e.
MP and AP do not change. That is AQ = MQ they will form a single straight line.

(c) The law of Diminishing returns:

It is the ultimate stage of production. In initial stage, increase in the quantity of the variable
factor result in better organization better use of indivisible factors results in higher efficiency and more
production. But beyond a stage, “increase in the quantity of variable factor only disrupts the existing
organization. It spoils divisions of labour and breed inefficiency. At such stage, every increase in the
quantity of a factor only serves to bring down the marginal and the average product; this is illustrated as
below;
No. of men Total product Average Marginal Product Schedule:
product product
0 0 0 0
1 10 10 10
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3 25 8.3 7
4 30 7.5 5
5 32 5.4 2
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The diagram representation for the law of decreasing returns;

Law of increasing returns

12
10
8
Product

MQ
6
AQ
4
2
0

No. of men employed

That is with an increase in the number of men employed, total product increases but at a diminishing
rate, AQ and MQ product continuously fall. AQ and MQ curves will move downwards.

Modern approach:

The law of variable proportion explains the relations between proportions of fixed and variable inputs,
on the one hand, and output on the other hand. When the firms expand out put by employing more and
more units of variable factors, it alters the proportions between the fixed and the variable factors. There
is always an optimum combination of factors of production at which cost per unit is minimum. Too less
or too much of the variable factors leads to cost increase. The law speaks about three stages of
production.

Total product (TQ) Marginal product (MQ) Average product (AQ)

Stage – 1
Increase at an increasing rate Increases, reaches its maximum Increases and reaches its
and then declines till MQ= AQ minimum.
Stage – 2
Increases at a diminishing rate It is diminishing and becomes It starts diminishing
till it reaches maximum equal to Zero.
Stage – 3
ItFixed
startsinput No. of
to declining TotalItOut put negative
becomes Average Marginal Stagesto decline.
It continues
Labour Out put Out put
0 0 0 0
1 3 3 3 Out put
2 8 4 5 I Schedule:
3 12 4 4
X 4
5
15
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3¾
3 2/5
3
2 II
Page 43
6 17 2 5/6 0
7 16 2 2/7 -1
8 13 1 5/8 -3 III
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Quantity of Variable input

15
12
9 MQ
out put

6 AQ
TQ
3
0
-3
Returns to Scale:
In put
In the short run a firm can change its level of production by changing the quality of variable factors. The
quantity of fixed factors remains unchanged. Hence the behaviour of production is explained by the law
of variable proportions. In the long run, the entire factor become variable, distinction between fixed and
variable factors disappears. A firm can manage to get additional plant, equipment or building or any
other resources that it could not manage in the short run. When a firm changes the quantity of both fixed
and variable factors in the long run it changes its scale of production.

Returns to Scale

3500
Level of production

3000
2500
2000
1500
1000
500
0
Scale 1 Scale 2 Scale 3

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The three different scale of production is shown, 0 – 2000 units with out changing the quantity of fixed
factors. It the firm decides to produce more than 2000 units it will have to change which can be attained,
if the firm changes both fixed and variable factors as in scale 2. Scale 3 can be attained if the firm
increases the quantity of both fixed and variable factors.

This is explained by the ‘returns to scale’. There are three types of returns to scale.
a. Increasing returns to Scale – When out put increases more than proportionately to the increase
in inputs, increasing returns to scale is exists. It occurs when the economies of scale operates.
b. Constant returns to Scale – When all inputs are increased by some proportion, the output also
increases in the same proportion it is said to be constant returns to scale.
c. Diminishing returns to Scale – When all inputs are increased by some proportion, the output
increases less than proportionately, we have decreasing returns to scale. It occurs when the
diseconomies of scale operates.

Increase in the quantity of Increase in Output Types of Returns to Scale

factors
10% 20% Increasing
10% 10% Constant
10% 7% Decreasing

Isoquants:
The modern economists explain the equilibrium of a producer with the help of Isoquants. Economists
make use of Isoquants or equal-product curves to explain the operation of the returns to scale. The
Isoquants joins all the combinations of factors inputs which yield the same level of outputs. That is all
combinations of two inputs providing the same level of output lie on the same equal product curve.
E.g. suppose a firm has two variable inputs, viz labour and capital. The firm can produce 1000units by
employing varying combinations of these inputs.

Equi- product curve schedule:

Combination Capital Labour Total product
st
1 10 + 5 1000
nd
2 6 + 10 1000
3rd 4 + 15 1000
th
4 3 + 20 1000
That all the combinations of labour and capital yield the same level of output. The Isoquant could be as;

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Returns to Scale could be explained by using Isoquants:

1. Increasing Returns to Scale:
In the case of increasing returns to scale, when all factors are increased in a given proportion, the
output increases by a greater proportion. E.g. If the amount of labour and capital is increased by
10%, out put increases by more than 10%. If the quantity of labour and capital doubles, output
increases more than double, and if the quantity of labour and capital three times, the output increases
more than three times. This is illustrated as below;

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Panel - B
INCREASING RETURNS TO SCALE

100

90
80

60
OUT PUT

40 40

20

10
0 0
K1L1 2K1L1 3K1L1
LABOUR / CAPITAL

Panel A:
Shows that a given proportionate increase in the use of labour and capital is attended by more than the
proportionate increase in output. When the labour and capital are double out put increases from 10 units
to 40 units. When the labour and capital are increases three times, out put increases from 40 units to 90
units. Reflecting increase returns to scale.

Panel B:
Shows that the out put is concave from above it shows increasing returns to scale.
The causes for increasing return to scale is:
(a) Specialisation
(b) Use of specialized machinery
(c) Economies of large scale
(d) Indivisibility

2. Constant returns to Scale:

In this case when all factors of production are increased in a given proportion, the output also
increases by same proportion. E.g. If the amount of labour and capital is increased by 10%, out put
also increases by 10%. If the quantity of labour and capital doubles, output increases to double, and
if the quantity of labour and capital three times, the output increases three times. This is illustrated as
below;

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CONSTANT RETURNS TO SCALE

100

80

60

40

30
20 20
10
0 0 K1L1 2K1L1 3K1L1
LABOUR / CAPITAL

Panel A:
Shows that equal increase in inputs is attended by equal increase in output. When the amount of labour
and capital are double out put increases from 10 units to 20 units. When the labour and capital are
increases three times, out put increases from 20 units to 40 units. Reflecting constant returns to scale.
Panel B:
Shows that the out put relation, the figure shows the out put is linear. It shows constant returns to scale.

3. Diminishing returns to Scale

In this case, output increases in a smaller proportion than the increase in all inputs, i.e in this case
as inputs are increased by a particular proportion, output increases less than proportionately. E.g. If
the amount of labour and capital is increased by 10%, out put increases by less than 10%. If the
quantity of labour and capital doubles, output increases less than double, and if the quantity of labour
and capital three times, the output increases less than three times. This is illustrated as below;

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DIMINISHING RETURNS TO SCALE

100

80

60
OUT PUT

40

20
14 17
10
0 0
K1L1 2K1L1 3K1L1
LABOUR / CAPITAL

Panel A:
Shows that a given proportionate increase in the use of labour and capital is attended by less than the
proportionate increase in output. When the labour and capital are double out put increases from 10 units
to 14 units. When the labour and capital are increases three times, out put increases from 14units to 17
units. Reflecting decreasing returns to scale.

Panel B:
Shows that the out put from the above shows decreasing returns to scale

Economies of Scale:
Economies of Scale imply the benefits derived by a producer by expanding its scale of production.
When a firm expands its scale or production, it finds itself using in a better way some of the resources
that were under utilized hitherto.
The benefits can accrue to a firm in two ways;
(1) Internal economies.
(2) External economies

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(1) Internal economies:

It accrues to a firm largely because of its own efforts. It begins to make better use of such
resources by expanding the scale of production which was not being utilized properly in the earlier
stage. That is when firm increases its scale of production, the reduced cost or economies, which this
firm gets as a result, these are the results of increased division of labour or use of improved production.

Causes of Internal Economies:

There are mainly two factors that give rise to internal economies,
(a) Indivisibilities:
Large scale of production makes it possible to make better use of the indivisible factors of
production the large scale of production brings in economics of scale. E.g. Salary given to employee or
contract made with employee will be same for manufacturing 500 units per/month or 1000 units
per/month.
(b) Specialisation:
Large scale of production makes it possible to introduce better division of labour. It is possible
for the firm to have more units of outputs at a lesser average cost. Division of labour makes it possible to
save on time involved in shifting from one process to another. To take advantage of the specialisation
and perfection reached by the individual at a particular process.

(2) External economies:

It accrues to a firm because of the reasons with which an individual firm has got nothing to do. It
is those benefits which are shared by a number of firms or industries when the scale of production in any
industry or groups of industries increases. Use of cost saving by research and development, development
in means of communication and transport, advantages of Localization, facilities for banking, advertising,
insurance, training common school, publication of industrial journal etc.

Causes of External Economies:

There are mainly two factors that give rise to external economies;
(a) Localisation of industries – It is concentration of number of firms to particular industry in particular
area. E.g. mining industries in Copper belt, Zambia
(b) Specialisation- the form of division of labour among the different firms belonging to the same area
and same industry.

Dis economies of Scale:

Dis economies of Scale arises through the decline in the efficiency in use of production factors as scale
increases. The following diseconomies of scale;
a. Managerial inefficiency
b. Labour relations
c. Marketing costs
d. Technical problems.

Cost - out put relationship:

The cost of production depends upon the output level, prices of factors of production, productivities of
factors, technology and efficiency. The economists have more importance to output as determinant of
cost of production, because output is subject to faster and frequent changes than others. Economists
study cost-out put relationship separately for the short-run and long-run.

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(1) Cost – out put relationship in the short-run:

In the short run the firm has a fixed plans and it can vary the out put by changing the other
variable inputs such as raw materials, labours etc. There fore in short-run, total cost of production
consists of a fixed cost portion and variable cost portion. For decision making manager has to
understand the following,
(a) Fixed Cost and Out put
(b) Variable cost and Out put
(c) Total cost and Output

(a) Fixed cost and Out put:

Fixed cost incurred on rent of factory and office building, interest payment on bonds and
depreciation of plant and equipment etc. Fixed cost remains same at a given capacity and do not vary
with out put. In graph TFC (Total Fixed Cost) is plotted in graph against output. TFC curve is a
horizontal straight line parallel to X axis. Average Fixed Cost (AFC) is obtained by as following;

TFC
AFC = LevelofOut put

The TFC does not vary with output. The larger the level of output the lower will be AFC and Marginal
Fixed Cost (MFC) will always be Zero. AFC slopes down wards from left to right because it falls
continuously as output expands. It is illustrated as below;

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(b) Variable Cost and Out put:

Variable is the cost incurred on variable factors such as raw materials, wages, and salaries to
employees etc. It has the direct relation with output. Total Variable Cost (TVC) increases as output
increases at beginning as out put increases TVC increases at a decreasing rate. Then at a constant rate
and eventually at an increasing rate.
The diagram shows the shape of TVC curve.

TVC
AVC = Output

(c) Total Cost and Out put:

The total cost (TFC + TVC) increases as out put increases because one of its components TVC is
an increasing function of out put and its other components TFC remains constant at all levels of output.
Total Cost (TC) curve is parallel to TVC curve. There is different between TVC and TC curves. The

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TVC curves starts from the origin. But the TC curves cuts the cost – axis at a point which shows the
TFC. The diagram illustrates;

Average Total Cost (ATC) also called as Average Cost is obtained by;

TC
ATC = Output

Corresponding to TC curve ATC curve first falls as out put increases then remains constant for some
output range and increases with every increase in output. Actually ATC curve is ‘U’ shaped for
following reasons
ATC = AFC + AVC

At very low quantities of output ATC is high because of high AFC. As output increases AFC declines
and factors used efficiently so ATC declines. After an optimum output level is reached, ATC begins to
increase because variable factors cannot be used as efficiently as before and the advantages of lower
AFC is out weighed by the increase of AVC. Thus ATC curve is ‘U’ shaped. The Marginal Cost curve is
as
TC = TFC + TVC

The TFC is fixed at all output levels. So marginal cost equals the change in TVC. So the variations in
MC will be similar to that of AVC curve. That is MC curve is also ‘U’ shaped. Let us now portray all
four AFC, AVC, ATC and MC curves.

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2. Cost – out put relationship in the long-run:

 In the long- run all inputs including the plant, which was held constant in the short-run become
variable, so all costs are variable. In the long run many plant sizes are available and all other inputs
become elastic in supply.
 There fore the firm can even move form one plant to another, according to the size of output it
anticipates to produce.
 Cost output relation in the long-run implies the relationship between the long-run average variable
cost and the total output.
 The long run cost is derived from the short run costs because short run costs are the costs at which
the firm operates in any one period and the long run is operationally composed of a series of such
short run alternative cost situations. There fore the long run cost curve of a firm is composed of a
series of short run cost curves.
 There are three only three technically possible plant sizes at a particular point of time, they are small
size, medium and large plant. This is illustrated below

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 The small plant can be operated with cost denoted bySAC1 the medium plant can be operated with
the cost on SAC2 and the large plant can be operated with the cost on SAC3.
 The firm now chooses a plant size which is capable of producing the desired output at the minimum
possible cost.
 If the firm plans to produce OA or less, it will chose plan 1,
 If the firm wants to choose a little larger than OA, it will choose plant 2 because to produce OM1 out
put.
 Similarly if the firm expects that the demand will expand further than OB, it will install plant 3.
 The points of intersection of cost of consecutive plants are the crucial points for the decision whether
to switch a larger plant.
 Now image, there are very large number of plants with their corresponding short run curve.
 So there will be large number of points of intersection cost curves of consecutive plants which from
a smooth and continuous curve.
 LAC curve is ‘U’ shaped and it often called as the ‘envelop curve’ because it envelopes the SAC
curves. It is the locus of points denoting the least cost of producing the corresponding output.
 Note that the LAC curve is not the locus of the minimum points of each SAC curve. Since LAC is
‘U’ shaped, tangencies with SAC curves and then on positively sloping parts and the curve is
depends on the returns to scale.
 The unit cost of production decreases in the beginning as plant size increases due to the various
economies of scale. The economies of scale exist only up to a certain size of plant that is called
Optimum point.
 If plant size is increased further, diseconomies of scale will operate. Thus the shape of the cost
curves is determined by the production functions.
 LAC curve can be used to determine the optimum size of the firm. The optimum firm is the one
which produces optimum output with the optimum plant.
 The optimum plant is the one which produces output at the minimum point of the LAC curve. In the
diagram OM is the optimum size of the firm.
 LAC curve is a planning curve because only based on this curve, the firm plans its future
investments. Every entrepreneur, before an investment surveys the range of minimum costs. i.e. the
entrepreneur seeks to understand which plant size will minimize cost for production for the desired
out put.
 LAC curve provide him with the necessary information, as it represents a wide range of alternative
investments defined by the available state of technology. On the basis of this curve, the firm decides
what plant is to be setup in order to produce the expected level of output at possible minimum cost.
 There fore LAC curve is called the planning curve.
 The LAC suggests what, when, the firm is operating under decreasing cost.
 It is more economical to under use a slightly larger plant operating at a less than its minimum cost-
out put level than to over use a smaller plant. For out put OM, M1 L1 < M1 K1.
 On the other hand when firm is operating under increasing cost, it is more economical to over use
slightly smaller plant than to under use a slightly larger plant. For output OM2, M2 L2 > M2 K2.
 Thus LAC curve is very useful to businessman in planning their future investment.

Revenue Curves of Firms:

Average Revenue: (AR):

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Average Revenue is the revenue per unit of the commodity sold. It is found by as follows;

Total Re venue
AR =
Unitsold
Different units of a commodity are sold at the same price, in the market, average revenue equals price at
which the commodity is sold. Thus Average Revenue means price. The AR curve represents the relation
between price and amount demanded or price at which the various amounts of a commodity are sold.
Because the price offered by the consumer is revenue to the seller’s point of view. Therefore AR curve
of the firm is really the same thing as demand curve of the consumer.

Marginal Revenue: (MR):

Marginal revenue at any level of firm’s output is the net revenue earned by selling another or additional
unit of the product. Algebraically, it is the addition to the total revenue (TR), earned by selling, ‘n’ units
of product instead of n-1, where ‘n’ is any given number., where ‘n’ is any given number. If the price of
a product falls when more of it is offered for sale then that would involve a loss on the previous units
which were sold at a higher price before and will now be sold at the reduce price along with the
additional one. This loss in the previous units must deduct from the revenue earned by the additional
unit. MR can find by taking out the difference between total revenues before and after selling the
additional units.
TR when 7 units sold at the price of K16.
7 x 16 = K112
TR when 8 units are sold at the price of K15
8 x 15 = K120
MR or the net revenue earned by the 8th unit = 120 – 112 = K8. There fore
MR of the n th unit = difference in TR in increasing the sale from n-1 to n units
Or
Price of n th unit - loss in revenue on previous units resulting from price
reduction.

Relation between AR and MR:

The table helps to understand Total, Average, and Marginal Revenue Schedules,
No. of units sold Price or AR Total Revenue (TR) MR
(AR (or) Price x Quantity sold) (additional made to total
revenue)
1 22 22 22
2 21 42 (= 2 x 21) 20 (42-22)
3 20 60 (= 3x 30) 18 (60- 42)
4 19 76 16
5 18 90 14
6 17 102 12
7 16 112 10
8 15 120 8
9 14 126 6
10 13 130 4

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The table indicates that when average revenue (AR) is falling, marginal revenue (MR) is less than
average revenue.

(1) AR and MR curves Under Perfect Competition:

When competition is perfect, the average revenue curve of the firm is a horizontal straight line,
because an individual firm under perfect competition by its own action cannot influence the price. The
seller under perfect competition can sell any amount of the commodity at the ruling market cides with
the AR curves. This is so because additional units are sold at the same price as before and no loss is
incurred on the previous units which would have resulted if the sale of additional units are sold at the
same price as before and no loss is incurred on the previous units which would have resulted if the sale
of additional units would have force the price down. The curve is shown as below;

In this case, when AR curve is the horizontal line the MR curve coincides with AR curve. This is so
because additional units are sold at the same price as before and no loss is incurred on the previous units
which would have resulted if the sale of additional units would have forced the price down.

(2) AR and MR curves Under Imperfect Competition:

By converting the schedules of AR given in table along side into curves. We get two downward sloping
Y find that MR curve is below AR curve. This is shown in following diagram;
curves and

Revenue

B C D

AR

MR
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Quantity
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Its is quite obvious that when price is falling as indicated by the deciling AR curve, the MR must always
be less than AR. Because a falling price must mean some loss on the sale of additional supply. That is
why MR curves lies below AR curves

SUPPLY:
Supply means the amount offered for sale at a given price.
Meyers defines, “We may define supply as a schedule of the amount of a good that would be offered for
sale at all possible prices at any one instant of time, or during any one period of time, at any one instant
of time, or during any one period of time, for e.g. a day, a week and so on, in which the conditions of
supply remain the same.”
Stock and supply has the differences,
The Stock is the total volume of a commodity which can be brought into the market for sale at a sale at a
short notice. Stock is potential supply.
Supply means the quantity which is actually brought into the market.

LAW OF SUPPLY:
Supply has functional relationship with price.
“Other things remaining the same, as the price of a commodity raises its supply are extended, and as the
price falls its supply is extended, and as the price falls its supply is contracted.”
The quantity offered for sales varies directly with prices. i.e. the higher the price the larger is the supply
and vice versa.
The supply schedule represents the relationship between prices and the quantities that people are willing
to produce and sell. E.g. the following is the (market) supply schedule of supply.

Price per dozen Quantity supplied (in dozens)

(K)
700 43
600 40
500 36
400 31
300 25
200 18
100 10
It shows that price falls supply is contracted (or) amount supplied decreases and as price raises supply is
extended. This is the law of supply. It is represents by following chart,

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In this diagram, quantities supplied are measured along OX, and prices along OY, SS’ is the supply
curve. From any point P on the supply curve, PM is drawn perpendicular to OX and PO’ to OY.
Then at PM (=O’O), PO’ (=OM) quantity will be supplied. Note that supply curve slopes downwards
from right to left, as contrasted with demand curve, which slopes left to right. This because price rises,
supply is extended. If price falls too much, supply is extended. If price falls too much, supply may dry
up altogether. The price below which the seller will refuse to sell is called the reserve price.

Increase and Decrease in Supply:

Other things remaining same. Supply is said to increase, when at the same price more is offered for sale,
or the same quantity is offered at a lower price. The supply is said to be decrease, when at the same
price, less is offered for sale or the same quantity is offered at a higher price. This is illustrated as below;

Suppose SS is the supply curve before the changes. S’S’ shows a decrease in supply because at the same
price PM (=P’M’) less is offered for sale. i.e. OM’ instead of OM.
The S”S” shows an increase in supply because at the same price PM (=P”M”) more is offered for sale,
OM” instead of OM. The student should carefully distinguish between the increase in quantity supplied
(extension of supply) and increase in supply.
Increase in supply means that the whole supply curve has shifted to a new position to the right. It is a
new curve.
Increase in the quantity supplied means that more is being offered at a higher price. The supply curve is
the same, the movement along the same curve simply indicates changes in quantities offered as a result
of a change in price. It does not represent any change in the supply schedule or condition of supply.

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UNIT – IV
Pricing Methods and Strategies – Objectives – Factors – General
Consideration of Pricing – Methods of pricing – Role of Government –
Dual Pricing – Price Discrimination

What is Price?
Most of the Economist define price as the exchange value of a product or service always expressed in
money. The consumer considers the price is an agreement between seller and buyer concerning what
each is to receive. Price is the mechanism or device for translating into quantitative terms (KWACHA,
DOLLAR, RUPEES etc) the perceived value of the product to the customer at a point of time. The buyer
is interested in the ‘price’ of the whole ‘package’ consisting of the physical product plus bundle of
expectations or satisfactions. Since the consumer has a lot of expectations such as accessories, after-
sales service, replacement parts, technical guidance, extra services, credit and many other benefits, the
price must be equal to the total amount of benefits (physical, economic, social and psychological
benefits).

Pricing Objectives:
Pricing objectives are overall goals that describe the role of price in an organisation’s long- range plans.
Pricing objectives help the decision makers in formulating price policies, planning pricing strategies and
setting actual prices. One of the most important objectives of the companies is to have maximum profits.
However, the following are the overall objectives of pricing.
(i) To get return on investment (ROI):
The return on investment or net sales is one of the main objectives of pricing. The idea is to
secure a sufficient return on capital used for specific products or divisions so that the sales revenues will
ultimately yield a pre-determined average return for the whole company. This is generally a long-range
goal. This objective is commonly used by companies that are “industry leaders” and those that sell in
“protected markets”, such as those for new and uniquely different products. They fix up a percentage
markup on sales to include their operating costs plus a desired profit.
(ii) To get market share:
Market position or sales in relation to competition, is very meaningful bench mark of success. Therefore,
a company may set a target market share as its major pricing objectives, so they focusing attention on it,
it may not lose its former market position. It tries to at least maintain status quo or to improve its
position through continuous low pricing.
(iii) To meet or prevent competition:
This objective aims to meet or prevent competition. If a company is its industry’s price leader, it may set
prices designed to discourage new competitors from entering the market. Similarly, companies that are
price followers set their prices in order to meet competitors’ prices. When introducing a new product,
frequently low prices would be set in order discourage competition.
(iv)To maximize the profits:
This objective aims at making as much profit as possible. The goal should be to maximize profits on
total output rather than on each single item. Profits may be maximized by giving some extra article
which will attract the buyers’ attentions or will stimulate sales of other goods. A retailer may sell goods

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at very small profit but he attracts a large number of customers so that the overall profit is enhanced
considerably.

(v) To ensure survival:

The basic pricing objective is to survive. Most organisations will tolerate short run losses, internal
upheaval, and many other difficulties if these are necessary to continue existence. Price increase sale
volume to levels that match the organisations’ expenses.
(vi) To maintain image:
Companies’ image is important for its success. This is largely influenced by its pricing policy. A firm
with an established reputation based on existing price curves may introduce a new line either by high or
low prices to appeal to different market segment. If this segment has not earlier bought any of the
company’s products but is aware of its prestige, it might desire to purchase its products because price is
no longer a different factor.

The factors that influence the pricing decisions:

While setting a price, these are influenced by many interacting forces. Such decisions must be
consistent with the company’s desired public image. A businessman today has to consider various
factors like consumer demand, competition, political consequences, legal aspects and even ethical
aspects of pricing. He must also consider his own coast, the cost of the channels he uses to reach the
market, and the various activities he has to perform in connection with the sale. The factors that can
influence price decisions may be divided into two groups:

(1) Internal factors

(2) External factors

(1) Internal factors:

These are the factors which can be controlled by a firm to a certain extent. These are
(a) Organisational factors: It is the top management which generally has full authority over pricing.
The marketing manager’s role is to administer the pricing programme with in the guide lines laid down
by the top management. Pricing activities have such a direct effect on the sales volume and profit that
the marketing manager cannot keep him self aloof from pricing, policy making and strategy formulation.
It is the top management which should retain the primary responsibility for determining pricing
objectives, policies and strategies
(b) Marketing mix:
Price is one of the important elements of the marketing mix, and therefore must be co-ordinated
with the other three elements: production, promotion and distribution. In some industries, a firm may use
price reduction as a marketing technique; others may raise prices as a deliberate strategy to build a high-
prestige product line. In either case, the effort will fail if the price change is not commensurate with the
total marketing strategy that it supports.
(c) Product differentiation:
Generally speaking, the more differentiated a product is from competitive products, the greater
the leeway the firm has in setting prices. When its product is basically of the same quality as that of its
competitors, it may differentiate its own image by building a solid reputation among customers by
charging different prices.

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(d) Costs:
Often, cost plays an important part in influencing the marketer in his decision on what prices are
realistic in view of the demand and competition in the markets.

(e) Objectives:
The objectives set for pricing will determine what prices should be fixed for a particular product.

(2) External factors:

These are factors over which the firm has no control, and, therefore, marketers have to face many
difficulties while determining the price of their products. These factors are;

(a) Demand:
This has a large impact on pricing. Since demand is affected by such factors as the number and
size of competitors, what they are charging for similar products, the prospective buyers, their capacity
and willingness to pay and their preferences, these factors have to be taken into consideration while
fixing prices.
(b) Competition:
A knowledge of what prices the competitors are charging for a similar product and what possible
lie ahead for raising or lowering prices also affects pricing.
(c) Suppliers:
The price of finished products is intimately linked with the price of the raw material; etc. Hence,
if the supplier raises the price, the inevitable result is a rise in price by the manufacturer, who ultimately
passes it on to the consumers. Scarcity or abundance of the raw material, there fore, determines pricing.
(d) Buyers:
The nature and behaviour of consumers and users of a particular product, brand or service do
affect pricing, particularly if their number is large.
(e) Economic conditions:
This is a very important factor, for prosperity or depression influences demand to a very great
extent. Inflationary or deflationary tendencies also affect pricing. To meet shortages or rising prices and
decreased demand, several pricing decisions are available. Some of these are;
(i) Prices may be boosted to protect profit against rising costs.
(ii) Price protection system may be linked with the price on delivery to current costs;
(iii) The emphasis may be shifted form sales volume to profit margin and cost reduction.

(f) Government regulations:

The regulatory pressure and anti price rise and control measures effectively discourage
companies form cornering too large a share of the market or controlling prices.
(g) Among the other important factors the general price level are; pressure for higher wage, competition,
business productivity, buyer resistance, seller resistance, speculation, and government policy.

Price determination:
Price determination is an important managerial function. Pricing plays an important role in profit
planning. If the price set is too high, the seller may not find enough consumers to buy his product. If
price set is too high, the seller may not find enough consumers to buy his product. If price set is too low,
the seller may not be able to cover his cost, so setting price is important in every business firm. Good
price today need not be good price tomorrow. So the pricing decision should be reviewed and
reformulated from time to time. There are five basic determinants of the price of a commodity they are;

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(i) The demand for the commodity

(ii) The cost of production of the economy
(iii) Objective of the firm selling it
(iv) Nature of competition in its market and
(v) Government policy pertaining on it.

Pricing Methods:
The following pricing methods usually employed by business men, these methods are;
(1) Cost- plus or Full- cost pricing
(2) Pricing for a rate of return, also called Target pricing
(3) Marginal cost pricing
(4) Going rate pricing
(5) Customary prices.

The first three methods are cost- oriented as the prices are determined on the basis of costs. The last two
methods are competition- oriented; it is set on the basis of what competitors are changing though it is not
necessary to charge the same price as competitors are charging.

(1) Cost plus (or) Full- cost pricing:

This is the most common method used for pricing, under this method; the price is set to cover
costs and predetermined percentage for profit. The percentage may be different among industries,
among member firms and products of the same firm. This reflects in differences in competitive intensity,
differences in cost base and differences in the rate of turnover and risk. Usually profit margins under
price controls are so set as to make it possible for even the least efficient firms to survive. Thus the
margin of profits tends to higher than what would be possible under competitive conditions. It is adopted
because it is simple to apply full cost pricing.
Full cost pricing: it offers a means by which fair and plausible prices can be found with ease and speed,
no matter how many products the firm handles. Prices based on full cost look factual and precise and
may be more defensible on moral grounds than prices established by other means. Fixed cost must be
covered in the long-run and firms feel that if they are not covered in the short run, they will not be
covered in the long- run either.
Cost-plus pricing is use full in following cases: for public-utility pricing,
Product tailoring- this approach takes into account the market realities by looking from the view point of
the buyer in terms of what he wants and what he will pay.
Pricing products that are designed to the specification
Monopsony- where the buyer knows a great deal about suppliers costs.

(2) Pricing for a rate of return:

An important problem that a firm might have to face is one of adjusting the prices to changes in
costs for this purpose the popular policies that are often followed are as under;
o Revise prices to maintain a constant percentage mark-up over costs
o Revise prices to maintain profits as a constant percentage of total sales.
o Revise price to maintain a constant return on invested capital
o Rate of return pricing is a refined variant of full cost pricing. It has the same inadequacies, viz. it
tends to ignore demand and fails to reflect competition adequately.

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o It is based upon a concept of cost which may not be relevant to the pricing decision at hand and
overplays the precision of allocated. The fixed cost and capital employed.

(3) Marginal cost Pricing:

Under previous two pricing, the prices are based on total costs comprising fixed and variable costs.
Under marginal cost pricing, fixed costs are ignored and prices are determined on the basis of marginal
cost. The firms use only those costs that are directly attributable to the output of a specific product.
A pricing decision involves planning into the future, and as such it should deal solely with the
anticipated and therefore estimated revenues, expenses and capital outlays. All past outlays which give
rise to fixed costs. The firm seeks to fix its prices so as to maximize its total contribution to fixed costs
and profit, this objective is achieved by considering each product in isolation and fixing its price at a
level which is calculated to maximize its total contribution. These are two consumptions,
(a) The firms is able to segregated its markets so that it is able to charge higher price in some market and
lower price in others.
(b) There are no legal restrictions.

Advantages:

(a) With marginal cost pricing, prices are never rendered uncompetitive merely because hypothetical
unit fixed costs are higher than those of the competitors. The firm’s prices will only be rendered
uncompetitive by higher variable costs, and these are controllable in the short run while certain
fixed costs are not.
(b) It is more accurately reflect future as distinct from present cost levels and cost relationships,
when making a pricing decision one is more interested in the changes in cost that will result from
that decision. Marginal cost represents these changes; total costs include fixed costs which are
not incurred of the pricing decision.
(c) It permits a manufacturer to develop a far more aggressive pricing policy than does full- cost
pricing
(d) It is more useful for pricing over the life cycle of a product, which requires short- run marginal
cost and separable fixed cost data relevant to each particular stage of the cycle, not long run full
cost data.

Limitation:

(a) Some accountants are not fully conversant with the marginal cost techniques, themselves, and
are not, there fore, capable of explaining their uses to management.
(b) The encouragement to take on business which makes only a small contribution may be so strong
that when an opportunity for higher contribution business arises, such business may have to be
forgone because of inadequate free capacity, unless there is an expansion in organisation and
facilities with the attendant increase in fixed costs.
(c) In a period of business recession, firms using marginal cost pricing may lower prices in order to
maintain business and this may lead other firms to reduce their prices leading to cut-throat
competition with the existence of idle capacity and the pressure of fixed costs, firms may
successively cut down prices to a point at which no one is earning sufficient total contribution to
cover its fixed cost and earn fair return on capital employed.

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(4) Going Rate – Pricing:

Instead of the cost, the emphasis here is on the market. The firm adjusts its own price policy to
the general pricing structure in the industry. Where costs are particularly difficult to measure, this may
seem to be the logical first step in a rational pricing policy. It may also reflect the collective wisdom of
the industry. Many cases of this type are situations of price leadership. Where price leadership is well
established, charging according to what competitors are charging may be the only safe policy. It may
simply be a way in which firms try to escape the hazards or price rivalry in an oligopolistic market. It
may be less costly and troublesome to the business than the exact calculation of costs and demand and
superficially seems to have practical advantage over a highly individualistic pricing policy.
Many big American corporations have adopted a policy of following competitors usually
implying that they follow a price set either by the market or by a price leader.
It must be noted that ‘Going rate pricing’ is not quite the same as accepting a price impersonally
set by a near perfect market. Rather it would seem that the firm has some power to set its own price and
could be a price maker if it chooses to face all the consequences. It prefers, however, to take the safe
course and conform to the policy of others.

(5) Customary Prices:

Prices of certain goods become more or less fixed for considerable periods of time, for such
goods, changes in cost are usually reflected in changes in quality or quantity. Only when the costs
change significantly, the customary prices of these goods are changed. Customary prices may be
maintained event when products are changed.
For e.g. the new model of an electric fan may be priced at the same level as the discontinued model.
This is usually so even in the face of lower costs. A lower price may cause an adverse reaction on the
competitors leading them to a price war as also on the consumers who may think that the quality of the
new model is inferior. Perhaps, going along with the old price is the easiest things to do the maintenance
of existing prices as long as possible is a factor in the pricing of many products.
If a change in customary prices is intended, the pricing executive must study the pricing policies and
practices of competing firms and the behaviour and emotional make-up. Another way out, especially
when an up ward move is sought is to test the new prices on a limited market to determine the consumer
reaction.

General Considerations:
Formulating price policies and setting the price are the most important aspects of managerial decision
making. It is most important device a firm can use to expand its market for that certain general
considerations which must be kept in view while formulating the price policy are given below;

(1) Objectives of business:

Pricing is not an end in itself but a means to an end. The fundamental guides to pricing,
therefore, are the firm’s overall goals. The broadest of these is survival, or assured continued existence.
On a more specific level, objectives relate to rate of growth, market share, maintenance of control or
ownership and finally profit.
Very often companies fix a target rate of profit. Whether the company will be able to achieve the
target rate of profit, will depend upon the forces of competition. The various objectives may not always
be compatible and hence the need for their reconciliation. A pricing policy should never be established
without full consideration as to its impact on the other policies and practices of the firm.
(2) Competitive situation in which the company is placed:
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Situation in which the company is placed. An effective solution of the pricing problems requires
an understanding of the competitive environment. In perfect competition, sellers have no pricing
problems because they have no pricing discretion. Price policy has practical significance only where
there is considerable degree of imperfection in competition. Thus, we are concerned only with
competitive structures where there is some room for managerial price discretion.
Under present competitive conditions, it is more important for the firm to offer the product which
best satisfies the wants and desires of the consumers than the one which sells at the lowest possible
price. As a result, pricing policy should be governed more by the relative than by the absolute height of
prices.
(3) Product and promotional policies:
Pricing is only one aspect of market strategy and a firm must consider it together with its product
and promotional policies. Thus, before making a price change, the firm must be sure that the price is at
fault and not its sales promotion programme, the quality of the product, or some other element.

(4) Nature of price sensitivity:

Business often tends to exaggerate the importance of price sensitivity and ignore the many
identifiable factors at work which tend to minimize it. The various factors which may generate
insensitivity to price changes are variability in consumer behaviour, variation in the effectiveness of
marketing effort, nature of the product, importance of services after sales, the existence of highly
differentiated products difficult to compare and multiple dimensions of product quality.
(5) Conflicting interests of manufacturers and middlemen: The interest of manufacturers and
middlemen through whom the former often sell are sometimes in conflict. For instance, the
manufacturer would desire that the middleman should sell his product at a minimum mark-up, where as
the middleman should sell his product at a minimum mark-up, where as the middleman should sell his
product at a minimum mark-up, where as the middleman would like his margin to be large enough to
simulate him push up the product. Again, the manufacturer may like to control the middlemen’s prices
and even the retail prices; but the middlemen may seek to expand their sales through price-cuts or obtain
larger margin than allowed by the suggested prices. Further, if the manufacturer reduces the price, the
middlemen’s inventories may go down in value thereby causing resentment among them.
(6) Routinization of pricing: Pricing in practice is often routinized though its extent may differ from
company to company and product to product. For e.g. the management may prefer to depend on
suggested prices, mechanical formulae or price follower ship. The degree of Routinization, however,
depends on the following factors;
(a) Number of pricing decisions
(b) Speed required by pricing decisions
(c) Quality of available information
(d) Competitive market
(7) Active entry of non-business groups into the determination of prices:
The government acting on behalf of the public seeks to prevent the abuse of monopolistic power
and collusion among businessmen. There is a complex body of laws and even more confusing series of
judicial decisions. Very often, the government elects to control certain prices. Collective bargaining and
strikes by the labour unions attempt to raise wages. The entry of the government into the pricing
process, in alliance with farmer and labour interests, tends to inject politics in price determination.

Government Intervention and Pricing:

Government in most countries today plays an important role in product pricing. The types of
Government Interventions are as follows;

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Government Intervention

Direct Indirect

Price pegging Price floors / Ceiling Taxes Subsidies

All output Profit

Partial or Dual pricing Real estate

Sales

Specific

Advalorem

Government interventions in product pricing by direct as well as indirect. They are;

Price pegging: All output: The government itself an entrepreneur and thus is engaged in the production
of many goods and services, whose prices for all outputs are obviously set by the government agencies.
These include services rendered by railways, post and telegraph networks, Telephone Company,
electricity, nationalized banks etc. and commodities produced by nationalized textile mills, oil and
natural gas networks, government owned iron and steel manufacturing units, cement firms etc.

Partial or Dual pricing: Besides government produced goods and services, the government pegs the
prices of certain other products which are produced under the private sector. These include major drugs,
cement, paper, fertilizers, sugar, coal, school and college fees, and a few other essential goods and
services. In case of some drugs and school fees in many institutions, government fixes the price for all
their outputs.

Dual pricing: The price is pegged for a part of the output and has its effect on the free market price for
the rest of the output. The levy price is lower than, while the free market price is higher than, the price
that would have prevailed in the market, had there been no government intervention of this sort.
Consequently, through the dual pricing system, government subsidises the consumption of the quantity
available through ration shop (subsidised shops), and the taxes the consumption of the quantity bought
in the open market.
While in some case of cement, paper and sugar, there is a dual pricing- a fixed part of the total output
has to be sold at the government fixed price. Where a fixed part of out put to be sold at the levy prices
and the remaining at the free market price.

Price floors/ Ceilings: Price floors and Price ceilings have repercussions both on the price as well as the
availability of the goods. Price ceilings are found in the case of rent on residential and other
accommodations, on the goods manufactured by monopolists and oligopolists and on goods of essential
consumption. It exists for many important agricultural goods for the services of unskilled labours,
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minimum or guaranteed prices for all agricultural crops, minimum wages, etc. The agricultural prices
commission announces what they call the support, minimum or guaranteed prices for all important
agricultural crops. Also, there is a minimum wage rate, below which no worker, however unqualified he
or she may be, could be hired by any organization. Similarly, there are ceiling on a few prices. These
include rent on residential or office accommodations, prices of life saving and other basic drugs etc.
Thus effective price ceilings lead to an excess demand.

Indirect: It means through which government controls prices are various kinds of commodity taxes
(excise duty, sales tax and custom duties), tax on profit, tax on real estate and subsidies. A large number
of commodities fall under one or more kinds of taxes, and there are subsidies available for the
production of the selected goods across the country and for most goods if they are manufactured in the
notified backward areas.

Pricing Policy:
The firm has to formulate its pricing policies, particularly, when it deals in multiple products. The
pricing policies are intended to bring consistency in the pricing pattern. For instance, to maintain price
differentials between the deluxe models and so on. Pricing policy defines how to handle complex issues
such as price discrimination and so forth.

Price Discrimination:
Price discrimination refers to the practice of a seller of selling the same product at different prices to
different buyers. A seller makes price discrimination between different buyers when it is both possible
and profitable for him to do so. This is very difficult to change different prices for the identical product
from the different buyers. More often, the product is slightly differentiated to successfully practice price
discrimination. Thus the concept broadened to include the sale of the various varieties of the same good
at prices which are not proportional to their marginal costs.

Definition:
Prof. Stigler defines, “the sales of technically similar products at prices which are not proportional to
marginal costs.” i.e. the seller is indulging in price discrimination when he is charging different prices
from different buyers for the different varieties of the same good if the differences in price are not the
same as or proportional to the differences in the cost of producing them.
e.g. A book publisher publishes the books the cost for one book is K10,000 for the deluxe edition and
K8000 for ordinary edition per unit, then he practice price discrimination if he sells the ordinary book
for K10000 and deluxe for K15000 per unit. The price difference between the two editions is the
difference is K15000 – K10000 = K5000 and the Cost is K10000 – K8000 = K2000.
Thus to simple the case the price discrimination is the sale of the same product at different pries to
different buyers.

Types of Price discrimination:

The types of price discrimination can be as;
(1) Personal
(2) Local
(3) According to use or trade

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(1) Personal: Price discrimination is personal when the seller charges different prices for different
persons.
(2) Local: Price discrimination is local when the seller changes different prices from people of
different local or places. For instance producer may sell a commodity at one price at home place
and at another price abroad.
(3) According to use or trade: Price discrimination according to use when different prices of a
commodity are charged according to the uses to which the commodity is put. E.g. electricity is
usually sold at a cheaper rate for industrial than for the domestic purpose.

Degrees of Price discrimination:

Prof. A.C. Pigou has distinguished between the three types of price discrimination; the degrees of price
discrimination are,
(1) Price discrimination of the first degree (or) Perfect Price discrimination:
(2) Price discrimination of the second degree
(3) Price discrimination of the third degree

(1) First degree: It is also known as perfect price discrimination because this involves maximum
possible exploitation of each buyer in the interest of sellers’ profits. It is said to occur when the
monopolist is able to sell each separate unit of the output at a different price. The seller leaves no
consumer’s surplus to any buyer.
(2) Second degree: It would occur if a monopolist were able to charge separate prices in such a way
that all units with a demand price greater than. The buyers are divided into different groups and
from each group a different price is charged, the price which he charges form each group is that
which a marginal individual of that group, is just willing to pay.
(3) Third degree: This degree is mostly commonly found in the real world. It is said to occur when
the seller divides his buyers into two or more than two sub-markets or groups and charges a
different price in each submarket. The price charged in each submarket depends upon the output
sold in that submarket and the demand conditions of the submarket. This Price discrimination is
most common.

Conditions essential for Price discrimination (or) Possible of Price discrimination:

Price discrimination cannot be practiced indiscriminately by a monopolist. It is possible under specific
conditions which are follows,

(1) Existence of two or more than two markets:

There must be at least two markets in which a monopolist can classify his customer and charges
different prices for an identical product.

(2) Existence of different elasticities of demand indifferent market:

In different markets the elasticity of demand for a monopolist’s product must be different. With
different elasticities, the monopolist will succeed in charging high price in the inelastic market and low
price in the elastic market.

(3) No possibility of resale:

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It should neither be permissible, nor possible, to purchase commodity from a cheaper market and
resell it in the costlier one. If buyer themselves become sellers, it will prevent a discriminating
monopoly firm from selling the commodity in the costlier or higher priced market.

(4) Full control over the supply:

Existence of monopoly element is essential for the success of price discrimination. If there is
keen competition among the sellers, then uniform price will prevail in the entire market.

(5) No contact among buyer:

If price discrimination, is to succeed, communication between buyer in different sectors of the
monopolist’s market must be impossible or at any rate extremely difficult.

Advantages of Price discrimination:

Though the price discrimination apparently looks unfair, it has the following advantages,
(1) It helps to meet the challenges of competitors as lower prices are charged when there is high
degree of competition in the markets.
(2) The surplus production, if any can be disposed off.
(3) It may lead to increase in demand for products and services from such group of customers who
are charged lower price. At relatively higher price levels, such customers may not afford to buy
at all.
(4) The production costs can be lowered due to increase in the volume of production. The firm can
make the best use of unutilized capacity if any.
(5) Even in a high priced market, the customers may obtain goods at lower prices than they would
otherwise pay in a single market. For instance, a large export market may bring in economies of
scale for the firm. As a result, consumers in the domestic market also may be charged a relatively
lower price than before.

UNIT – V
Market Forms – Market structure – Basis of Market classification –
output determination – Perfect competition – Monopoly – Monopolistic
Competition – Duopoly – Oligopoly

Market:
Market in generally understood to mean a particular place or locality where goods are sold and
purchased. According to economics market as follows, Prof. Cournot defines, “The term market is not
any particular market place in which things are bought and sold but the whole of any region in which
buyer and sellers are in such free intercourse with one another that the price of the same goods tends to
equality easily and quickly.”

Essential of a Market:
They are as follows;
(a) Commodity which is dealt with
(b) The existence of buyers and sellers
(c) A place, be it a certain region, a country or the entire world

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(d) Such intercourse between buyer and sellers that only one price should prevail for the same
commodity at the same time.

Classifications of Markets:
Markets may be classified as follows;
(a) On the basis of area:
On the basis of area or coverage markets are classified into local, regional, national and
international markets.
A local market refers to the market which is confined to a particular locality, village or a city. For e.g.
market of milk, fresh vegetables etc.
A regional market extends to a larger area or region. E.g. the market of a durable good may extend to a
particular district or a state.
A national market extends over the whole country. E.g. market of cars, refrigerators, etc. extends over
the whole country.
An international market extends over two or more countries. Buyers and sellers of the different
countries participate in this market.

(b) On the basis of Time:

When a market is classified on the basis of time the essential element involved is the time taken
by suppliers (or Producer) to adjust their supplies to changed demand conditions. It is divided into
(i) Very short period: In this type market the time is so short that the supply of a commodity
cannot adjust itself to the changes in demand. The supply remains inelastic in such a market.
(ii) Short period: In short period, the time is too short to adjust to the changes in demand. The
small changes in supply are possible through the better utilization of the existing resources.
(iii) Long period: Long period is periods sufficiently long enough to adjust supply to changes in
demand. The number and size of firms can vary in response to the change in demand. Firms
can expand and contract the scale of production according to changes in the demand.
(iv) Very long period: The time is so long that a full account can be taken of the changes in
income, tastes, fashions and even technology, etc. Supply can be fully adjusted to the
changes in demand through the introduction of new techniques of production, innovation,
etc.
(c) On the basis of Nature of Transactions: If the exchange transactions are confined to a particular
spot, it is called spot market. In case the goods are to be exchanged in future, it is called future market.
(d) On the basis of Volume of the business: When goods are exchanged in large quantities it is called
wholesale market and when exchanged in small quantities, it is called retail market.

(e) On the basis of Competition: On the basis of competition among the firms markets are classified
into (i) Perfect competition
(ii) Imperfect competition – it is divided as Monopoly, Monopolist competition, Duopoly,
Oligopoly, Monopsony, Oligopsony.

Market Structure:
Market structure refers to the characteristics of a Market that influence the behaviour and performance
of firms that sell in that market. The structure of Market is based on its following features:
(a) The degree of seller concentration:

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This refers to the number of sellers and their market share of a given product or service in the
market.
(b) The degree of buyer concentration:
This refers to the number of buyers and their extent of purchases of a given product or services in
the market.
(c) The degree of product differentiation:
This refers to the extent by which the product of each trader is differentiated from that of the
order. Product differentiation can take several forms such as varieties, brands, all of which are
sufficiently similar to distinguish them, as a group, from other products. E.g. Cars.
(d) The conditions of entry into the market:
More often, there could be certain restriction to enter into or exit from the market. The degree of
ease with which one can enter the market or exit from the market also determines the market of firms if
the number of restrictions to enter the market is low and vice versa.

Types of Competition:
Based on degree of competition, the markets can be divided into perfect markets and imperfect
markets. In perfect markets, it is said to prevail perfect competition and in case of imperfect markets,
imperfect competition. Perfect competition is said to exit when certain conditions are fulfilled, these
conditions are ideal and hence only imaginative, not realistic.

Perfect Competition:
A market is said to be perfect when there is a large number of buyers and sellers of the product.
The products are homogeneous so that the consumers do not mind purchasing a commodity.
A market structure in which all firms in an industry are price takers and in which there is freedom of
entry into and exit from the industry is called Perfect competition. The market with perfect competition
condition is known as Perfect market.

Features of Perfect competition (or) Assumptions underlying Perfect market:

(a) Large number of buyers and sellers:

There should be significantly large number of buyers and sellers in the market. The number
should be so large that it should not make any differences in terms of price or quantity supplied even if
differences in terms of price or quantity supplied even if one enters the market or one leaves the market.

(b) Homogeneous products or services:

The products and services of each seller should be homogeneous. They cannot be differentiated
from that of one another. It makes no difference to the buyers whether he buy from firm A or firm B. the
price is one and the same in every firm. There are no concessions or discounts.

(c) Freedom to enter or exit the market:

There should not be any restrictions on the part of the buyer and sellers to enter the market or
leave the market. There should not be any barriers. They buyers can enter the market or leave the market
whenever they want.

(d) Perfect information available to the buyers and sellers:

Each buyer and seller has total knowledge of the price prevailing in the market, quantity
supplied, costs, demand, nature of product, other relevant information.
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(e) Perfect mobility of factors of productions:

There should not be any restrictions on the utilisation of factors of production such as land,
labour, capital and so on. In other words, the firm or buyer should have free access to the factors of
production. Whenever capital or labour is required, it should instantly be made available.

(f) Each firm is a price taker:

An individual firm can alter its rate of production or sales without significantly affecting the
market price of the product. A firm in a perfect market cannot influence the market through its own
individual actions. It has no alternative other than selling its products at the price prevailing in the
market. It cannot sell as much as it wants at its own set price.

Imperfect competition:
A competition is said to imperfect when it is not perfect. In other words when any or most of the perfect
market conditions do not exist in a given market, it is referred to as an imperfect market. A market is
said to be imperfect when some of the buyers or sellers or both are not fully aware of prices at which
transaction take place and offers made by other buyers and sellers. It is based on the number of buyers
and sellers the structure of market varies as, they follows, here ‘poly’ means seller and ‘posny’ means
buyer.

(1) Monopoly:
It is derived from the Greek words, ‘Monos’ means single and ‘plus’ means seller. Monopoly
refers to a market situation in which there is a single seller or producer of a product he has full control
over the supply of that product and which has no close substitutes of that product. The demand of its
product constitutes the total demand for the product in the market.

Features of Monopoly:
(i) There is a single firm dealing in a particular product or service
(ii) There are no close substitutes and no competitors.
(iii) The monopolistic can decide either the price or quantity, not both
(iv) The products and services provide by the monopolist bear in elastic demand
(v) Monopoly may be created through statutory grant of special, privileges, such as licenses,
permits, patent rights etc.
What causes Monopoly?
There are several factors that lead to monopoly, they are,
(1) Government policies and legal provisions: By an act of legislation often create and maintain
monopoly. Railways have absolute monopoly as government has restricted others to enter the rail
transport business.

(2) Mergers and acquisitions: It enables the business organisations to emerge stronger with higher
market share. E.g. Standard charted bank has acquired ANG Grind lays bank and emerged much
stronger and bigger, leading to enlargement of economies of scale, cost advantages, and
elimination of competition from Grind lays.

(3) Through research and development (R&D) and latest technology: The firm can replace its
old product with superior ones. HP (Hewlett & Packard) emerged stronger with their laser
printers fast replacing the dot matrix printers.
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(4) Control over key inputs: Such as raw materials, skilled labour, technology, financial resources
and so on also lead to monopoly.

Disadvantages of Monopoly:
It gains control over a given market over a period of time with his products and services.

(a) Inefficient allocation of resources:

A monopolist explicit the consumers by charging a higher price for his produce. This is because
there is no competition; the monopolist is free to charge any price as long as the government does not
interfere.

(b) Exploitation of consumers:

A monopolist will restrict the output of his product to increase the price and maximize profits.
This simply means that he intentionally will reduce the output using fewer resources.

(c) Wide gap between rich and poor:

This may result to a widen in the gap between the rich and the poor. The monopolist makes the
large profit by charging higher prices. The incomes in the hands of consumers are taken away by the
monopolist in this way. This leads to concentrations of economic power and wealth in the hands of a
few. This causes the income inequalities to widen.

(d) Restricted output:

The monopolist may intentionally restrict the output though he has scope to increase the
production. This could be one of the strategies to continue to hold control over price in the market.

(e) Unfair trade practices:

Gaining control over price or supply the monopolist may resort to unfair trade practices e.g.
blocking the entry of new firms into the market.

Difference between Perfect competition and Monopoly:

S.no Points Perfect competition Monopoly

.
1. Relation ship between AR and AR = MR AR > MR
MR
2. Profits Normal profits in the long run Super normal profits in the
long run also.
3. Number of sellers Large number of sellers Single seller
4. Barriers to entry and exit Free entry and exit, no barriers There are strong barriers.
5. Control on Price The seller is only the price Monopolist is the price maker.
taker
6. Nature of demand curve Perfectly elastic Inelastic
7. Relation between firm and Each firm is a part of the Firm and industry are one and
industry industry the same.

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(2) Monopolistic Competition:

When the large number of sellers produces differentiated products, Monopolistic Competition is said to
exist. A product is said to be differentiated when its important features vary. It may be differentiated
based on real or perceived differences. In other words it is said to exist when there are many firms and
each one produces such goods and services that are close substitutes to each other. They are similar but
not identical.

Features of Monopolistic Competition:

(1) Larger number of firms: The number of firms’ constitution an industry is large. The individual
firm has not to bother about the reactions of the rival firms. It can follow its independent price
and output policy.
(2) Free entry and Exit: Firms under Monopolistic Competition are free to join or leave the
industry at their will. Free entry of firms makes it possible for them to produce close substitutes
of the existing products. Similarly each firm commands such a merge resources so that in the
event of loss it may easily quit the market.
(3) Product differentiation: Under Monopolistic Competition firms produce differentiated products
as differentiating the quality of the product, sales techniques.

(4) Independent pricing: Monopolistic Competition a firm can independently determine the price
and change it at its convenience.

(5) Group behaviour: The firms produce differentiated goods which are close substitutes to goods
produce by rival firms. Firms charge different prices fro the differentiated products. The
collection of Monopolistic Competition is called ‘group’.

(6) Blend of Competition and Monopoly: Existence of large number if firms and free entry and
exit are the features of perfect competition that are also found in Monopolistic Competition. The
firms enjoy certain monopoly power in the sense that it has protected market of its won and can
fix up the price independently.

(3) Duopoly:
A market structure with tow firms is called duopoly. The two firms confront large number of
buyers, homogeneous or differentiated product, entry barriers, and high price. If there are two sellers,
duopoly is said to exit. E.g. If PEPSI and COKE are the two companies in soft drink, this market is
called Duopoly.

(4) Oligopoly:
Another variety of imperfect competition is Oligopoly. The term refers to a market situation in
which a few firms produce goods which are either close substitutes or homogeneous products. If there is
competition among a few sellers or firms or producers, Oligopoly is said to exit. In Oligopoly small
number of firms confronts large number of buyers, homogeneous or differentiated product, entry
individual seller or firm can affect the market price. Oligopoly market situations are very common in the
sectors relating to manufacturing, communication and so on. E.g. News paper, mobile phone service
providers etc.

Characteristics of Oligopoly:

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Some of the important features of Oligopoly are as follows;

(a) Interdependence: Under Oligopoly, a firm cannot take independent price and output decision. As
the number of competing firms is limited, therefore, each firm has to take into account the reactions of
the rival firms. Price and output decisions of one Oligopoly firm have considerable effect on the price
and output decisions of the rival firms.

(b) Indeterminate demand curve: An Oligopoly firm can never predict its sales correctly. It can never
be certain about the nature and position of its demand curve. Any change in price or output by one firm
leads to a series of reactions by the rival firms. As a result, the demand curve of the Oligopoly firm
remains indeterminate.

(c) Role of selling cost: Advertisement, publicity and other sales techniques play an important role in
Oligopoly pricing. Oligopoly firm employs various techniques of sales promotion to attract large
number of buyers and maximize the profits. Selling cost has a direct bearing on the sales of he
Oligopoly firm.

(d) Price Rigidity: Oligopoly firm generally sticks to a price which is determined after a greater deal of
planning, deliberations and negotiations, with the competing firms. A firm will not resort to price- cut as
it would lead to retaliatory actions by the rival firms culminating into price-war. Oligopolies will also
not raise the price because the rival firms may not follow and as a result, the firm will lose many of its
customers.

(e) Group behaviour: Price and output decisions of one Oligopoly firm have direct effect on the
competing firms. Interdependence of the firms compels them to think in terms of mutual co-operation.
Firms try to maximize their profits through collusive action. Instead of independent price output strategy
oligopoly firms prefer group decisions that will protect the interest of all the firms.

(5) Monopsony:
If there is only one buyer, Monopsony market is said to exit. The single buyer confronts large
number of firms, homogeneous, product, free entry, tendency to pay lowest possible price. E.g.
Government organisation, purchases the agricultural products like Maize, Rice, sugar etc.

(6) Oligopsony:
If there are a few buyers, Oligopsony is said to exist. There are a good number of computer
assembly operators who buy the computer components on whole sale basis.

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Distinction between Perfect and Monopolistic Competition:

S.No. Differences Perfect Competition Monopolistic Competition
1. Nature of firms: Large number of firms. The firms has Comparing to perfect competition the
not determine price, it is fixed by the number of firms is limited. The firms
industry. No individual firm can are smaller in size, yet they can
influence the price of the commodity. influence the market price by their
individual actions. Every firm has to
fix up the price of its product
independently.
2. Nature of Homogeneous goods are produced. Firms produce differentiated products
Product: From buyer point of view the products from buyers point of view to each
of different firms are perfect variety of the commodity is full
substitutes. The cross elasticity of fledged commodity in itself.
demand among the goods is infinite.
3. Level of output The size of output of firms is large. The reason for the smaller output is
and price: The price is lesser than other market that downward sloping demand curve
situation. Here (AR) does not touch average cost
MC=MR=AC=AR=Price curve at the lowest cost point. The
average cost is not the minimum at the
equilibrium point, the level of output
is also less than optimum. The firms
charges higher prices.
4. Selling cost: Homogeneous goods are sold at the Each firm produces differentiated
uniform price i.e. selling cost does not products. The firms have to incur
arise. heavy expenditure on sales promotion
activities.
5. Economic Economic welfare is maximized under The total level of production is low
welfare: the condition of perfect competition. and price is higher than the marginal
Ideal level of production and low cost. Consumers get very little amount
prices stimulate economic welfare. consumer surplus. Both efficient and
Consumer get enormous amount of in efficient firms can maintain their
consumer surplus. The industry gets existence.
larger economies of scale and the
optimal allocation of the resources
also help in the promotion of welfare.
Only efficient firms can maintain their
existence in the market, therefore the
wastage of the scarce resources is
minimized.
6. Innovation and Perfect competition firms get Every firm tries to attract as many
Researches: abnormal profits only in the short buyers as it can to maximize its
period. In long run the firms have to profits. Buyers is attraction only when

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go contented with the normal profits. commodity is a quality product.

Price- Out put determination in case of Perfect competition:

Short-run:
The price and output of the firm are determined, under Perfect competition based on the industry price
and its own costs. The industry price has greater say in this process because the firms own sales are very
small and significant. The firm’s demand curve is horizontal at the price determined in the industry
(MR=AR=Price). This demand curve is also known as average revenue curve.
This is because if all the units are sold at the same price, on an average, the revenue to the firms equals
its price.

Y MC
AC

D
C C
AR=MR

F E

O Q X

Equilibrium output determination of a firm under Perfect competition in the short-run.

When the average revenue is constant, it will coincide with marginal revenue curve. Thus CC is the
demand curve representing the price, average revenue and also marginal revenue curves. Average cost
(AC) and Marginal cost (MC) are the firm’s average and marginal cost curves. The firms satisfies both
conditions
(a) MR = MC
(b) MC curve must cut the MR curve from below.

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The firm attain equilibrium at point D where MR=MC. The MC curve passes through the minimum
point of AC curve. The firm gets higher profits as long as the price. It receives for each unit exceeds the
AC of production.
OC=QD, which is the price
OF= QE, which is average cost
OQ= FE, which is the equilibrium out put
Average Profit= Price - Average cost.
i.e. DE is the Average profit and the constitutes the ‘Supernormal or Abnormal profits’. Base on its cost
function and market condition the firm may make profits, losses or just break even in the short-run.

Short- run Supply curve:

In the short run, if the market price is below the average cost, the firms still supply goods provided the
market price is above the variable cost. If the market price is below the average variable cost, the firm
refuses to sell the goods even in the short-run for the simple reason that by not selling the goods, the
firm suffers a loss equal to average fixed cost only. If it sells the goods, the loss will be more than the
average fixed costs. Thus short-run curve will be that portion of the Marginal cost curve which is above
the Average variable cost curve.

Firm’s Short-run Supply Curve under Perfect Competition

It can be seen that if the market price is P1 or more, the firm is willing to sell. If the price is less than P1.
The firm refuses to sell, as the price is less than the average variable cost. The firms supply curve is that
portion of the Marginal cost curve which begins from point F. Point refers to the equilibrium point
where MR=MC.

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Long- run:
Having been attracted by supernormal prices, more and more firms enter the industry. With the result,
there will be a scramble for scarce inputs among the competing firms pushing the input prices. Hence
the average cost increases. The entry of more and more firms will expand the supply pulling down the
market price. The supernormal profits hitherto enjoyed by the firms get eroded. In the long-run, the
firms will be in a position to enjoy only normal profits but not supernormal profits. It is to be noted that
normal profits are included in the average cost curve. All those firms that are not able to earn at least
normal profits will leave the industry.
The diagram shows the long run equilibrium position of the firm under perfect competition. Two
conditions are to be fulfilled in the long run.
(a) MR=MC
(b) AR=AC and AC must be tangential to AR at its lowest point.
QE is the price and also the long-run average cost (LAC). Long run marginal cost (LMC) curve passes
through the minimum point of the long-run average const curve at E, while passing through the marginal
revenue curve. E is the equilibrium point and the firm produces OQ units of output. It can be noted that
normal profits are not visible to the naked eye since normal profits are included in the average cost.
Long-run average cost includes the opportunity cost of saying in business.
If the market price is below long-run average cost of the firm, the firm will have to quit the industry
since in the long-run, the firms have to recover average costs.

Price-Output Determination in Case of Long-run Under Perfect Competition.

Price- Output determination in Monopoly:

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Under monopoly, the average revenue curve for a firm is a downward sloping one. It is because, if the
monopolist reduces the price of his product, the quantity demanded increases and vice versa. In
monopoly, marginal revenue is less than the average revenue. In other words, the marginal revenue
curve lies below the average revenue curve. The monopolist always wants to maximize his profits. To
achieve maximum profits, it is necessary that the marginal revenue should be more than the marginal
cost.
He can continue to sell as long as the marginal revenue exceeds marginal cost. At the point F, where
MR=MC, profits will be maximized. Profits will diminish if the production is continued beyond this
point. Form the diagram, it can be seen that the demand curve or average revenue curve is represented
by AR, marginal revenue curve by MR, average cost by AC, and marginal cost curve by MC. OQ is the
equilibrium output, OA is the equilibrium price, QC is the average cost, and BC is the average profit
(AR minus AC is the average profit).
Up to OQ output, MR is greater than MC and beyond OQ, MR is less than MC. There fore, the
monopolist will be in equilibrium at output OQ where MR=MC and profits are maximum. OA is the
corresponding price to the output level of OQ. The rectangle ABCD represents the profits earned by the
monopolist in the equilibrium position in the short-run.

Price –out put determination in Monopolistic competition:

It is common that every firm whether operating under perfect market or imperfect market, wants to
maximize the profits. It means that the firm under monopolistic competition also will reach equilibrium
when its marginal cost equals its marginal revenue (MC=MR). The demand curve for the firm in case of
monopolistic competition is just similar to that of monopolist.
As the products are differentiated, the demand curve has a downward slope. The each firm has a limited
control over price. These firms are price makers as far as a given group of customers are concerned. The
demand for their products and services is relatively inelastic. The degree of elasticity of demand of a

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firm in monopolistic competition depends upon the extent to which the firm can resort to product
differentiation. The greater the ability of the firm to differentiate the product, the less elastic the demand
is. The firm’s influence to increase the price depends upon the extent to which it can differentiate the
product. At lower prices, the firm can sell more. There is no significant variation in the cost functions
also.

Short run:
In the short-run, firms may experience supernormal or normal profits or even losses. When there is a fall
in costs or increase in demand, the firms may enjoy supernormal profits. If the firm satisfies the
following two conditions, it may make supernormal profits:
(a) where marginal cost is equal to marginal revenue (MC=MR)
(b) where average revenue is less than average cost (AR<AC)
The firm may be in losses when the costs rise or demand decreases. The diagram shows that the demand
curve is a down wards sloping curve because of product differentiation. The cost functions of a firm are
not different from those of earlier market situations. At F, marginal cost (MC) is equal to marginal
revenue (MR), extend F to point B on average revenue (AR) curve and point Q on X axis.
OQ is the equilibrium output, OA=QB= Equilibrium price and QC is the average cost. Average profit =
Average revenue minus average cost. BC is the average profit. Profit x Quantity = Total profit.
There are ABCD represent the supernormal profits earned by a firm under monopolistic competition in
the short run.

Long run:
More and more firms will be entering the market having been attracted by supernormal profits enjoyed
by the existing firms in the industry. As a result, competition becomes intensive on one hand; firms will
compete with one another for acquiring scare inputs pushing up the prices of factor inputs. On the other
hand, on the entry of several firms the supplying the market will increase, pulling down the selling price

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of the products. In order to cope with competition, the firms will have to increase the budget on
advertising. The entry of new firms continue till the supernormal profits of the firms completely get
eroded and ultimately firms in the industry will earn only normal profits. Those firms which are not able
to earn at least normal profits will get closed. Thus in the long run, every firm in the monopolistic
competitive industry will earn only normal profits, which are just sufficient to stay in the business. It is
to be noted that normal profits are part of average costs. In long run, in order to achieve equilibrium
position, the firm has to full fill dual equilibrium conditions as mentioned above. But when compared to
long run equilibrium position of a perfectly competitive firm, even though AR=AC, AC will not be at its
minimum point at equilibrium level of output. And also, MR is not equal to either AR or AC, MR is
well below AR in the case of monopolistic competitive firm.
The Average cost (AC) is not equal to Average revenue (AR) at its minimum point because the AC can
be tangential to the down ward sloping AR curve only at higher than its minimum point. The AC is
higher in case of monopolistic competitive firms because of excess or idle capacity and high advertising
cost.
Monopolistic competitive industry provides a variety of products and more varieties result in greater
consumer satisfaction. Consumers will be happy only when they have more choice as variety is the spice
of life. From the diagram it can be observed that in the long-run, the AC curve will be tangential to the
downward sloping AR curve at point E. It can be noted that AC curve is tangential to the AR curve at
higher than its minimum point F. MR=MC at point K. OQ is the equilibrium output and OP is the
equilibrium price. Thus, in the long run a firm under monopolistic competition achieves equilibrium
price and output when both conditions of equilibrium are satisfied.

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