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SEMESTER-I

Unit - I

Chapter 1 Meaning and Principles of Economics

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Table of Contents
CHAPTER 1 MEANING AND PRINCIPLE OF ECONOMICS .............................................................. 1
INTRODUCTION ......................................................................................................................................3
MEANING AND SCOPE OF BUSINESS ECONOMICS ....................................................................14
SCOPE OF BUSINESS ECONOMICS .......................................................................................................

19 6
Chapter Outline
Concept of Scarcity and Choice
What is Economics?
Ten Principles of Economics
How people make decision
How people interact
How whole economy work

Introduction
The word economy comes from the Greek word oikonomos, which means ‘one who manages a
household’. At first, this origin might seem peculiar. But, in fact, households and economies have
much in common.

A household faces many decisions. It must decide which members of the household do which tasks
and what each member gets in return: Who cooks dinner? Who does the laundry? Who gets the extra
slice of cake at tea time? Who chooses what TV programme to watch? In short, the household must
allocate its scarce resources among its various members, taking into account each member’s abilities,
efforts and desires.

Like a household, a society faces many decisions. A society must decide what jobs will be done and
who will do them. It needs some people to grow food, other people to make clothing and still others
to design computer software. Once society has allocated people (as well as land, buildings and
machines) to various jobs, it must also allocate the output of goods and services that they produce. It
must decide who will eat caviar and who will eat potatoes. It must decide who will drive a Mercedes
and who will take the bus.

Scarcity
An economy exists because of two basic facts. First, human wants for goods and services are
unlimited, and secondly, productive resources with which to produce goods and services are scarce.
With our wants being virtually unlimited and resources scarce, we cannot satisfy all our wants and
desires by producing everything we want. That being the case, a society has to decide how to use its
scarce resources to obtain the maximum possible satisfaction of its members. It is this basic problem
of scarcity which gives rise to many of the economic problems which have long been the concern of
economists.

Economic problem and economising choice

Since it is not possible to satisfy all wants with the limited means of production, every society must
decide some way of selecting those wants which are to be satisfied this creates necessity for
economising
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Thus a society is faced with the problem of choice-choice among the vast array of wants that are to
be satisfied. If it is decided to use more resources in one line of production, then resources must be
withdrawn from the production of some other goods. The scarcity of resources therefore compels
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Us to choose among the different channels of production to which resources are to be devoted. In
other words, we have the problem of allocating scarce resources so as to achieve the greatest
possible satisfaction of wants of the people. This is the economic problem. It is also called the
economising problem.

Thus, problem of scarcity gives rise to some problems generally known as basic economic problems
which a society has to solve so as to promote material well-being of its people. The three basic
questions that any society has to face:

• What goods and services should be produced?

• How should these goods and services be produced?
• Who should get the goods and services that have been produced?
Besides, economists have also been raising questions about the efficiency of the resource allocation
for the production of goods and their distribution among them people. This question of economic
efficiency is aimed at knowing whether or not a particular allocation of resources to the production
of various goods and distribution of income among them ensures maximum social welfare.

Meaning and definition of economics

The problem of choice from the viewpoint of the society as a whole refers to which goods and in
what quantities are to be produced and productive resources allocated for their production
accordingly so as to achieve greatest possible satisfaction of the people.

An eminent English economist Lord Robbins defines economics in terms of this basic economic
problem. According to him, "Economics is a science which studies human behaviour as a
relationship between ends and scarce resources which have alternative uses."

Here ends refer to wants which are considered to be unlimited. The use and allocation of scarce
resources to produce goods and services have to be such as would maximize satisfaction. This applies
both to the behaviour of the individual and of the society as a whole, Economists:
• Study how people make decisions: how much they work, what they buy, how much they save and
how they invest their savings.
• Study how people interact with one another. For instance, they examine how the multitude of buyers
and sellers of a good together determine the price at which the good is sold and the quantity that is
sold.
• Analyze forces and trends that affect the economy as a whole, including the growth in average
income, the fraction of the population that cannot find work and the rate at which prices are rising.

Self-Test- A (Observation Skill)

State any two real life examples where you face the problem of scarcity
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Self-Test – B (Observation Skill)
Does government face the problem of scarcity? Yes or No. Provide explanation

TEN PRINCIPLES OF ECONOMICS

Although the study of economics has many facets, the field is unified by several central ideas. In the
rest of this chapter we look at the Ten Principles of Economics. Don’t worry if you don’t understand
them all at first, or if you don’t find them completely convincing. In the coming chapters we will
explore these ideas more fully. The ten principles are introduced here just to give you an overview of
what economics is all about. You can think of this chapter as a ‘preview of coming attractions’

HOW PEOPLE MAKE DECISION

There is no mystery to what an ‘economy’ is. Whether we are talking about the economy of a group
of countries such as the European Union (EU), or the economy of one particular country, such as
India, or of the whole world, an economy is just a group of people interacting with one another as
they go about their lives.

Economy
The economy refers to all the production and exchange activities that take place every day – all the
buying and selling.

Economic Activities
The level of economic activity is how much buying and selling goes on in the economy over a period
of time.

PRINCIPLE 1: PEOPLE FACE TRADE-OFFS

The first lesson about making decisions is summarized in an adage popular with economists: ‘There
is no such thing as a free lunch.’ To get one thing that we like, we usually have to give up another
thing that we also like. Making decisions requires trading off the benefits of one goal against those
of another.

Case scenario -1
Consider a student who must decide how to allocate her most valuable resource – her time. She
can spend all of her time studying economics which will bring benefits such as a better class of
degree; she can spend all her time enjoying leisure activities which yield different benefits; or she
can divide her time between the two. For every hour she studies, she gives up an hour she could
have devoted to spending time in the gym, riding a bicycle, watching TV, napping or working at her
part-time job for some extra spending money.
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Case scenario-2
Consider parents deciding how to spend their family income. They can buy food, clothing or a
family holiday. Or they can save some of the family income for retirement or perhaps to help the
children buy a house or a flat when they are grown up. When they choose to spend an extra euro
on one of these goods, they have one less euro to spend on some other good.
When people are grouped into societies, they face different kinds of trade-offs. The classic trade- off
is between spending on defence and spending on food. The more we spend on national defence to
protect our country from foreign aggressors, the less we can spend on consumer goods to raise our
standard of living at home.

Also important in modern society is the trade-off between a clean environment and a high level of
income.
Another trade-off society faces is between efficiency and equity.

Efficiency means that society is getting the most it can (depending how this is defined) from its scarce
resources.
Equity means that the benefits of those resources are distributed fairly among society’s members.

In other words, efficiency refers to the size of the economic cake, and equity refers to how the cake
is divided. Often, when government policies are being designed, these two goals conflict

PRINCIPLE 2: THE COST OF SOMETHING IS WHAT YOU GIVE UP TO GET IT

Because people face trade-offs, making decisions requires comparing the costs and benefits of
alternative courses of action. In many cases, however, the cost of some action is not as obvious as it
might first appear.

Case scenario-3
Consider, for example, the decision whether to go to university. The benefit is intellectual
enrichment and a lifetime of better job opportunities. But what is the cost? To answer this
question, you might be tempted to add up the money you spend on tuition fees, books, room and
board. Yet this total does not truly represent what you give up to spend a year at university.

a. The first problem with this answer is that it includes some things that are not really costs of going
to university. Even if you decided to leave full-time education, you would still need a place to sleep
and food to eat. Room and board are part of the costs of higher education only to the extent that
they might be more expensive at university than elsewhere. Indeed, the cost of room and board at
your university might be less than the rent and food expenses that you would pay living on your
own. In this case, the savings on room and board are actually a benefit of going to university.
b. The second problem with this calculation of costs is that it ignores the largest cost of a university
education – your time. When you spend a year listening to lectures, reading textbooks and writing
essays, you cannot spend that time working at a job. For most students, the wages given up to
attend university are the largest single cost of their higher education.
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The opportunity cost of an item is what you give up to get that item. When making any decision, such
as whether to go to university, decision makers should be aware of the opportunity costs that
accompany each possible action. In fact, they usually are.

Case scenario -4
University-age rugby, basketball or golf players who can earn large sums of money if they opt out
of higher education and play professional sport are well aware that their opportunity cost of going
to university is very high. It is not surprising that they often decide that the benefit is not worth
the cost.

PRINCIPLE 3: RATIONAL PEOPLE THINK AT THE MARGIN

Decisions in life are rarely straightforward and usually involve problems.

Case scenario -5
At dinner time, the decision you face is not between fasting or eating as much as you can, but
whether to take that extra serving of pizza.

Case scenario-6
When examinations roll around, your decision is not between completely failing them or studying
24 hours a day, but whether to spend an extra hour revising your notes instead of watching TV.

Economists use the term marginal changes to describe small incremental adjustments to an existing
plan of action. Keep in mind that ‘margin’ means ‘edge’, so marginal changes are adjustments around
the edges of what you are doing.
In many situations, people make the best decisions by thinking at the margin.

Case scenario-7
Suppose, for instance, that you were considering whether to study for a Master’s degree having
completed your undergraduate studies. To make this decision, you need to know the additional
benefits that an extra year in education would offer (higher wages throughout your life and the
sheer joy of learning) and the additional costs that you would incur (another year of tuition fees
and another year of foregone wages).

By comparing these marginal benefits and marginal costs, you can evaluate whether the extra year
is worthwhile. Individuals and firms can make better decisions by thinking at the margin. A rational
decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal
cost.
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PRINCIPLE 4: PEOPLE RESPOND TO INCENTIVES

Because people make decisions by comparing costs and benefits, their behaviour may change when
the costs or benefits change. That is, people respond to incentives.

Case scenario -8
When the price of an apple rises, for instance, people decide to eat more pears and fewer apples
because the cost of buying an apple is higher. At the same time, apple farmers decide to hire more
workers and harvest more apples, because the benefit of selling an apple is also higher. As we shall
see, the effect of price on the behaviour of buyers and sellers in a market – in this case, the market
for apples – is crucial for understanding how the economy works.

Public policymakers should never forget about incentives, because many policies change the costs or
benefits that people face and, therefore, alter behaviour.

A tax on petrol, for instance, encourages people to drive smaller, more fuel efficient cars. It also
encourages people to switch and use public transport rather than drive, or to move closer to where
they work.
Many incentives that economists’ studies are straightforward and others more complex. No one is
surprised, for example, that people might switch to driving smaller cars where petrol taxes and thus
the price of fuel are relatively high.

Self-Test C (Interpretation and Application Skill)

You win $100 in a hockey pool. You have a choice between spending the money now or putting it
away for a year in a bank account that pays 5 percent interest. What is the opportunity cost of
spending the $100 now?

Self-test D (Interpretation and Application Skill)

The company that you manage has invested $5 million in developing a new product, but the
development is not quite finished. At a recent meeting, your sales people report that the
introduction of competing products has reduced the expected sales of your new product to $3
million. If it would cost $1 million to finish development and make the product, should you go
ahead and do so? What is the most that you should pay to complete development?

HOW PEOPLE INTERACT

The first four principles discussed how individuals make decisions. As we go about our lives, many of
our decisions affect not only ourselves but other people as well. The next three principles concern
how people interact with one another.
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PRINCIPLE 5: TRADE CAN MAKE EVERYONE BETTER OFF

America and China are competitors to Europe in the world economy. In some ways this is true,
because American and Chinese firms produce many of the same goods as European firms. Toy
manufacturers compete for the same customers in the market for toys. Fruit farmers compete for
the same customers in the market for fruit.

Yet it is easy to be misled when thinking about competition among countries. Trade between Europe
and the United States and China is not like a sports contest, where one side wins and the other side
loses (a zero-sum game). In fact, the opposite is true: trade between two economies can make each
economy better off.

To see why, consider how trade affects your family. Your family would never be better off isolating
itself from all other families. If it did, your family would need to grow its own food, make its own
clothes and build its own home. Clearly, your family gains much from its ability to trade with others.
Trade allows each person to specialize in the activities he or she does best, whether it is farming,
sewing or home building. By trading with others, people can buy a greater variety of goods and
services at lower cost.

Countries as well as families benefit from the ability to trade with one another. Trade allows countries
to specialize in what they do best and to enjoy a greater variety of goods and services. The Japanese
and the Americans, as well as the Koreans and the Brazilians, are as much Europe’s partners in the
world economy as they are competitors.

PRINCIPLE 6: MARKETS ARE USUALLY A GOOD WAY TO ORGANIZE

ECONOMIC ACTIVITY

Case Scenario -9
The collapse of communism in the Soviet Union and Eastern Europe in the 1980s may be the most
important change in the world during the past half century. Communist countries worked on the
premise that central planners in the government were in the best position to guide economic
activity and answer the three key questions of the economic problem. These planners decided
what goods and services were produced, how much was produced, and who produced and
consumed these goods and services. The theory behind central planning was that only the
government could organize economic activity in a way that promoted economic well-being for the
country as a whole.
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Today, most countries that once had centrally planned economies such as Russia, Poland, Angola,
Mozambique and the Democratic Republic of Congo have abandoned this system and are trying to
develop

MARKET ECONOMIES

In a market economy, the decisions of a central planner are replaced by the decisions of millions of
firms and households. Firms decide whom to hire and what to make. Households decide which firms
to work for and what to buy with their incomes. These firms and households interact in the
marketplace, where prices and self-interest guide their decisions

At first glance, the success of market economies is puzzling. After all, in a market economy, no one is
considering the economic well-being of society as a whole. Free markets contain many buyers and
sellers of numerous goods and services, and all of them are interested primarily in their own well-
being. Yet, despite decentralized decision making and self-interested decision makers, market
economies have proven remarkably successful in organizing economic activity in a way that promotes
overall economic well-being.

Note:
One of our goals in this book is to understand how Adam Smith’s invisible hand works its magic. As
you study economics, you will learn that prices are the instrument with which the invisible hand
directs economic activity. Prices reflect both the value of a good to society and the cost to society of
making the good. Because households and firms look at prices when deciding what to buy and sell,
they unknowingly take into account the social benefits and costs of their actions. As a result, prices
guide these individual decision makers to reach outcomes that, in many cases, maximize the welfare
of society as a whole.

PRINCIPLE 7: GOVERNMENTS CAN SOMETIMES IMPROVE MARKET

OUTCOMES

If the invisible hand of the market is so wonderful, why do we need government?

• One answer is that the invisible hand needs government to protect it. Markets work only if property
rights are enforced. A farmer won’t grow food if he expects his crop to be stolen, and a restaurant
won’t serve meals unless it is assured that customers will pay before they leave. We all rely on
government provided police and courts to enforce our rights over the things we produce.

• Yet there is another answer to why we need government: although markets are usually a good way
to organize economic activity, this rule has some important exceptions.
There are two broad reasons for a government to intervene in the economy – to promote efficiency
and to promote equity.
That is, most policies aim either to enlarge the economic cake or to change the way in which the cake
is divided. Although the invisible hand often leads markets to allocate resources efficiently, that is
not always the case.
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Economists use the term market failure to refer to a situation in which the market on its own fails to
produce an efficient allocation of resources. One possible cause of market failure is an Externality,
which is the uncompensated impact of one person’s actions on the well-being of a bystander (a third
party). For instance, the classic example of an external cost is pollution.

Another possible cause of market failure is market power, which refers to the ability of a single
person or business (or group of businesses) to unduly influence market prices. In the presence of
market failure, well designed public policy can enhance economic efficiency.

The invisible hand may also fail to ensure that economic prosperity is distributed equitably. One of
the three questions society has to address is who gets what is produced? A market economy rewards
people according to their ability to produce things for which other people are willing to pay. The
world’s best footballer earns more than the world’s best chess player simply because people are
willing to pay more to watch football than chess. That individual is getting more of what is produced
as a result of his earnings. The invisible hand does not ensure that everyone has sufficient food,
decent clothing and adequate health care.

Many public policies, such as income tax and the social security system, aim to achieve a more
equitable distribution of economic well-being.

HOW THE ECONOMY AS A WHOLE WORKS

We started by discussing how individuals make decisions and then looked at how people interact
with one another. All these decisions and interactions together make up ‘the economy’. The last
three of our ten principles concern the workings of the economy as a whole

PRINCIPLE 8: AN ECONOMY’S STANDARD OF LIVING DEPENDS ON ITS

ABILITY TO PRODUCE GOODS AND SERVICES

Many of the advanced economies have a relatively high income per capita; in Norway it is an enviable
$98,102, the Netherlands $50,087 and Germany $43,689.

Moving away from the prosperous economies of Western Europe, we begin to see differences in
income and living standards around the world that are quite staggering. For example, average income
in Yemen was $1,361 whilst in Afghanistan average income is just over a half a per cent of the size of
per-capita income in Norway

Not surprisingly, this large variation in average income is reflected in various other measures of the
quality of life and standard of living. Citizens of high-income countries have better nutrition, better
health care and longer life expectancy than citizens of low-income countries, as well as more TV sets,
more gadgets and more cars.

Changes in the standard of living over time are also large. Over the last 5 years, economic growth in
Albania has grown at about 4.68 per cent per year, in China at about 10.5 per cent a year but in Latvia
the economy has shrunk by around 1.4 per cent over the same time period (Source: World Bank).
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What explains these large differences in living standards among countries and over time? The answer
is surprisingly simple.

Almost all variation in living standards is attributable to differences in countries’ productivity – that
is, the amount of goods and services produced from each hour of a worker’s time. In nations where
workers can produce a large quantity of goods and services per unit of time, most people enjoy a
high standard of living; in nations where workers are less productive, most people must endure a
more meager existence. Similarly, the growth rate of a nation’s productivity determines the growth
rate of its average income.

The fundamental relationship between productivity and living standards is simple, but its
implications are far-reaching.
The relationship between productivity and living standards also has profound implications for public
policy. When thinking about how any policy will affect living standards, the key question is how it will
affect our ability to produce goods and services. To boost living standards, policymakers need to raise
productivity by ensuring that workers are well educated, have the tools needed to produce goods
and services, and have access to the best available technology.

PRINCIPLE 9: PRICES RISE WHEN THE GOVERNMENT PRINTS TOO MUCH

MONEY

High inflation is a problem because it imposes various costs on society; keeping inflation at a low level
is a goal of economic policymakers around the world. What causes inflation? In almost all cases of high
or persistent inflation, the culprit turns out to be the same – growth in the quantity of money. When
a government creates large quantities of the nation’s money, the value of the money falls. As outlined
above, the Zimbabwean government was issuing money at ever higher denominations. It is generally
accepted that there is a relationship between the growth in the quantity of money and the rate of
growth of prices.

PRINCIPLE 10: SOCIETY FACES A SHORT-RUN TRADE-OFF

Between Inflation and Unemployment When the government increases the amount of money in the
economy, one result is inflation. Another result, at least in the short run, is a lower level of
unemployment. The curve that illustrates this short-run trade-off between inflation and
unemployment is called the Phillips curve, after the economist who first examined this relationship
while working at the London School of Economics

The Phillips curve remains a controversial topic among economists, but most economists today
accept the idea that society faces a short-run trade-off between inflation and unemployment. This
simply means that, over a period of a year or two, many economic policies push inflation and
unemployment in opposite directions. Policymakers face this trade-off regardless of whether
inflation and unemployment both start out at high levels at low levels or somewhere in-between.
The trade-off between inflation and unemployment is only temporary, but it can last for several
years. The Phillips curve is, therefore, crucial for understanding many developments in the economy.
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In particular, it is important for understanding the business cycle – the irregular and largely
unpredictable fluctuations in economic activity, as measured by the number of people employed or
the production of goods and services.
Policymakers can exploit the short-run trade-off between inflation and unemployment using various
policy instruments. By changing the amount that the government spends, the amount it taxes and
the amount of money it prints, policymakers can influence the combination of inflation and
unemployment that the economy experiences. Because these instruments of monetary and fiscal
policy are potentially so powerful, how policymakers should use these instruments to control the
economy, if at all, is a subject of continuing debate.

You now have a taste of what economics is all about. In the coming chapters we will develop many
specific insights about people, markets and economies. Mastering these insights will take some
effort, but it is not an overwhelming task. The field of economics is based on a few basic ideas that
can be applied in many different situations. Throughout this book we will refer back to the Ten
Principles of Economics highlighted in this chapter and summarized in Table 1.2 which can be seen
as building blocks for your study of the subject; you should keep these building blocks in mind. Even
the most sophisticated economic analysis is built using the ten principles introduced here.

Case Scenario -10

In Zimbabwe in March 2007 inflation was reported to be running at 2,200 per cent. That meant
that a good priced at the equivalent of Z$2.99 in March 2006 would be priced at Z$65.78 just a year
later. In February 2008, inflation was estimated at 165,000 per cent. Five months later it was
reported as 2,200,000 per cent. In July 2008 the government issued a Z$100 billion note. At that
time it was just about enough to buy a loaf of bread. Estimates for inflation in Zimbabwe in July
2008 put the rate of growth of prices at 231,000,000 per cent. In January 2009, the government
issued Z$10, 20, 50 and 100 trillion dollar notes – 100 trillion is 100 followed by 12 zeros. This
episode is one of history’s most spectacular examples of inflation, an increase in the overall level
of prices in the economy.

Self-Test E (Observation Skill)

Give three examples of important tradeoffs that you face in your life

Self-Test F (Observation and Analytical Skill)

Water is necessary for life. Is the marginal benefit of a glass of water large or small?

Self-Test G (Interpretation and Application Skill)

Your roommate is a better cook than you are, but you can clean more quickly than your roommate
can. If your roommate did all of the cooking and you did all of the cleaning, would your chores take
you more or less time than if you divided each task evenly? Give a similar example of how
specialization and trade can make two countries both better off.
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Chapter 2 Meaning and Scope of Business

Economics

Chapter outline
• Meaning of Business Economics
• Nature of Business Economics
• Scope of Business Economics
• Mathematical Tools of Economics Analysis

INTRODUCTION TO BUSINESS ECONOMICS

Having understood the meaning of Economics, let us now understand what Business Economics is.
For this, consider the following situation:

Mr. G. Ramamurthy, the CEO of Worldwide Food Limited, on completion of his presentation turned
to his Board of Directors and raised the question “Well ladies and gentlemen, what you say? Shall
we go into soft drink business?”

“Give us some time, Sir” remarked Swami Nathan. “You are asking us to approve a major decision
which will have long term impact on the direction of the company”.

“I understand your concern for the company but now the time has come for us to expand our
business. Soft drinks market is growing fast and it is closely related to our core business: food”
answered Ramamurthy.

“But competition from White Soft Drinks Ltd. and Black Nectar Ltd. is tough. They are already into
this business for years” remarked another board member.

“That is right. But we must not forget that the statistics show that there is still room for growth in
this market. And also, food business is near maturity.” Replied Ramamurthy.

“Don’t forget that even Swati Foods tried entering the soft drink market and failed miserably”,
remarked Ashok Agrawal, another board member. “Moreover, the projections you are showing
are based on last ten years’ data. What is the guarantee that the trend will continue? He
questioned. “Also, we should not forget that Indians have become health conscious and who
knows tomorrow what will people prefer?” He continued.

“Well friends, all your concerns are logical, and believe me; I have given much thought to these ‘ifs’
and ‘buts’. My people have spent many days analyzing all available data to arrive at a judgement.
Our analysis indicates a strong possibility of earning above-average return on investment in this
market, a return that will be more than what we are earning in food industry. We are already
working on the details of production, cost, pricing, distribution, financing etc. I fear, if we wait for
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long, we will be missing an opportunity that may not come again for long. Let’s go ahead and make
the most of it” remarked Ramamurthy.

What do you notice in the hypothetical example given above?

The management of the company is faced with the problem of decision making.

As we are aware, the survival and success of any business depends on sound decisions. Decision
making refers to the process of selecting an appropriate alternative that will provide the most
efficient means of attaining a desired end, from two or more alternative courses of action. Decision
making involves evaluation of feasible alternatives, rational judgment on the basis of information
and choice of a particular alternative which the decision maker finds as the most suitable. As
explained above, the question of choice arises because our productive resources such as land, labour,
capital, and management are limited and can be employed in alternative uses. Therefore, more
efficient alternatives must be chosen and less efficient alternatives must be rejected.

The management of a business unit generally needs to make strategic, tactical and operational
decisions. A few examples of issues requiring decision making in the context of businesses are
illustrated below:

• Should our firm be in this business?

• Should the firm launch a product, given the highly competitive market environment?
• If the firm decided on launching the product, which available technique of production should be
used?
• From where should the firm procure the necessary inputs and at what prices so as to have
competitive edge in the market?
• Should the firm make the components or buy them from other firms?
• How much should be the optimum output and at what price should the firm sell?
• How will the product be placed in the market? Which customer segment should we focus on and
how to improve the customer experience? Which marketing strategy should be chosen? How much
should be the marketing budget?
• How to combat the risks and uncertainties involved?

Decision making on the above as well as similar issues is not simple and straightforward as the
economic environment in which the firm functions is highly complex and dynamic. The problem gets
aggravated because, most of the time, decisions are to be taken under conditions of imperfect
knowledge and uncertainty. Decision making, therefore, requires that the management be equipped
with proper methodology and appropriate analytical tools and techniques. Business Economics
meets these needs of the management by providing a large corpus of theory and techniques. Brie y
put, Business Economics integrates economic theory with business practice.

Business Economics, also referred to as Managerial Economics, generally refers to the integration of
economic theory with business practice. While the theories of Economics provide the tools which
explain various concepts such as demand, supply, costs, price, competition etc., Business Economics
applies these tools in the process of business decision making. Thus, Business Economics comprises
of that part of economic knowledge, logic, theories and analytical tools that are used for rational
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business decision making. In brief, it is Applied Economics that lls the gap between economic theory
and business practice.

Business Economics has close connection with Economic theory (Micro as well as Macro-Economic),
Operations Research, Statistics, Mathematics and the Theory of Decision-Making. A professional
business economist has to integrate the concept and methods from all these disciplines in order to
understand and analyses practical managerial problems. Business Economics is not only valuable to
business decision makers, but also useful for managers of ‘not-for-profit’ organisations.

DEFINITIONS OF BUSINESS ECONOMICS

Business Economics may be defined as the use of economic analysis to make business decisions
involving the best use of an organization’s scarce resources.

Joel Dean defined Business Economics in terms of the use of economic analysis in the formulation
of business policies.

Business Economics is essentially a component of Applied Economics as it includes application of

selected quantitative techniques such as linear programming, regression analysis, capital budgeting,
break even analysis and cost analysis.

Our approach in this text is to focus on the heart of Business Economics i.e. the Micro Economic
Theory of the behaviour of consumers and firms in competitive markets. This theory provides
managers with a basic framework for making key business decisions about the allocation of their
firm’s scarce resources.

NATURE OF BUSINESS ECONOMICS

Economics has been broadly divided into two major parts i.e. Micro Economics and Macro
Economics. Before explaining the nature of Business Economics, it is pertinent to understand the
distinction between these two.

Micro Economics is basically the study of the behaviour of different individuals and organizations
within an economic system. In other words, Microeconomics examines how the individual units
(consumers or firms) make decisions as to how to efficiently allocate their scarce resources. Here,
the focus is on a small number of or group of units rather than all the units combined, and therefore,
it does not explain what is happening in the wider economic environment. We mainly study the
following in Micro-Economics:

1. Product pricing;
2. Consumer behaviour;
3. Factor pricing;
4. The economic conditions of a section of people; 5. Behaviour of firms; and
6. Location of industry.
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Macro Economics is the study of the overall economic phenomena or the economy as a whole, rather
than its individual parts. Accordingly, in Macro-Economics, we study the behaviour of the large
economic aggregates, such as, the overall levels of output, total consumption, total saving and total
investment and also how these aggregates shift over time. It analyzes the overall economic
environment in which the firms, governments and households make decisions. However, it should
be kept in mind that this economic environment represents the overall effect of the innumerable
decisions made by millions of different consumers and producers. A few areas that come under
Macro Economics are:
1. National Income and National Output;
2. The general price level and interest rates;
3. Balance of trade and balance of payments;
4. External value of currency;
5. The overall level of savings and investment; and 6. The level of employment and rate of economic
growth.

While Business Economics is basically concerned with Micro Economics, Macro economic analysis
also has got an important role to play. Macroeconomics analyzes the background of economic
conditions in an economy which will immensely influence the individual firm’s performance as well
as its decisions. Business firms need a thorough understanding of the macroeconomic environment
in which they have to function. For example, knowledge regarding conditions of inflation and interest
rates will be useful for the business economist in framing suitable policies. Moreover, the long-run
trends in the business world are determined by the prevailing macroeconomic factors.

Having understood the meaning of Micro and Macro Economics, we shall examine the nature of
Business Economics:

Nature of Business Economics

The economic world is extremely complex as there is a lot of interdependence among the decisions
and activities of economic entities. Economic theories are hypothetical and simplistic in character as
they are based on economic models built on simplifying assumptions. Therefore, usually, there is a
gap between the propositions of economic theory and happenings in the real economic world in
which the managers make decisions. Business Economics enables application of economic logic and
analytical tools to bridge the gap between theory and practice.

The following points will describe the nature of Business Economics:

1. Business Economics is a Science: Science is a systematized body of knowledge which establishes

cause and effect relationships. Business Economics integrates the tools of decision sciences such as
Mathematics, Statistics and Econometrics with Economic Theory to arrive at appropriate strategies
for achieving the goals of the business enterprises. It follows scientific methods and empirically tests
the validity of the results.
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2. Based on Micro Economics: Business Economics is based largely on Micro-Economics. A business

manager is usually concerned about achievement of the predetermined objectives of his organization
so as to ensure the long-term survival and pro table functioning of the organization.
Since Business Economics is concerned more with the decision making problems of individual
establishments, it relies heavily on the techniques of Microeconomics.

3. Incorporates elements of Macro Analysis: A business unit does not operate in a vacuum. It is affected
by the external environment of the economy in which it operates such as, the general price level,
income and employment levels in the economy and government policies with respect to taxation,
interest rates, exchange rates, industries, prices, distribution, wages and regulation of monopolies.
All these are components of Macroeconomics. A business manager must be acquainted with these
and other macroeconomic variables, present as well as future, which may influence his business
environment.

4. Business Economics is an art :- as it involves practical application of rules and principles for the
attainment of set objectives.

5. Use of Theory of Markets and Private Enterprises: Business Economics largely uses the theory of
markets and private enterprise. It uses the theory of the firm and resource allocation in the backdrop
of a private enterprise economy.

6. Pragmatic in Approach: Micro-Economics is abstract and purely theoretical and analyses economic
phenomena under unrealistic assumptions. In contrast, Business Economics is pragmatic in its
approach as it tackles practical problems which the firms face in the real world.

7. Interdisciplinary in nature: Business Economics is interdisciplinary in nature as it incorporates tools

from other disciplines such as Mathematics, Operations Research, Management Theory, Accounting,
and marketing, Finance, Statistics and Econometrics.

8. Normative in Nature: Economic theory has developed along two lines – positive and normative. A
positive or pure science analyses cause and effect relationship between variables in an objective and
scientific manner, but it does not involve any value judgement. In other words, it states ‘what is’ of
the state of a airs and not what ‘ought to be’. In other words, it is descriptive in nature in the sense
that it describes the economic behaviour of individuals or society without prescriptions about the
desirability or otherwise of such behaviour. As against this, a normative science involves value
judgements. It is prescriptive in nature and suggests ‘what should be’ a particular course of action
under given circumstances. Welfare considerations are embedded in normative science.

Business Economics is generally normative or prescriptive in nature. It suggests the application of

economic principles with regard to policy formulation, decision-making and future planning.
However, if the firms are to establish valid decision rules, they must thoroughly understand their
environment.

This requires the study of positive or descriptive economic theory. Thus, Business Economics
combines the essentials of normative and positive economic theory, the emphasis being more on the
former than the latter.
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SCOPE OF BUSINESS ECONOMICS

The scope of Business Economics is quite wide. It covers most of the practical problems a manager
or a room faces. There are two categories of business issues to which economic theories can be
directly applied, namely:
• Microeconomics applied to operational or internal Issues
• Macroeconomics applied to environmental or external issues

Therefore, the scope of Business Economics may be discussed under the above two heads.
Microeconomics applied to operational or internal Issues
Operational issues include all those issues that arise within the organization and fall within the
purview and control of the management. These issues are internal in nature. Issues related to choice
of business and its size, product decisions, technology and factor combinations, pricing and sales
promotion, financing and management of investments and inventory are a few examples of
operational issues. The following Microeconomic theories deal with most of these issues.

1. Demand analysis and forecasting: Demand analysis pertains to the behaviour of consumers in the
market. It studies the nature of consumer preferences and the effect of changes in the determinants
of demand such as, price of the commodity, consumers’ income, prices of related commodities,
consumer tastes and preferences etc.

Demand forecasting is the technique of predicting future demand for goods and services on the basis
of the past behaviour of factors which affect demand. Accurate forecasting is essential for a firm to
enable it to produce the required quantities at the right time and to arrange, well in advance, for the
various factors of production viz., raw materials, labour, machines, equipment, buildings etc.
Business Economics provides the manager with the scientific tools which assist him in forecasting
demand.

2. Production and Cost Analysis: Production theory explains the relationship between inputs and
output. A business economist has to decide on the optimum size of output, given the objectives of
the rm. He has also to ensure that the firm is not incurring undue costs. Production analysis enables
the firm to decide on the choice of appropriate technology and selection of least - cost input-mix to
achieve technically efficient way of producing output, given the inputs. Cost analysis enables the firm
to recognize the behavior of costs when variables such as output, time period and size of plant
change. The firm will be able to identify ways to maximize profits by producing the desired level of
output at the minimum possible cost.

3. Inventory Management: - Inventory management theories pertain to rules that firms can use to
minimize the costs associated with maintaining inventory in the form of ‘work-in-process,’ ‘raw
materials’, and ‘finished goods’. Inventory policies affect the profitability of the rm. Business
economists use methods such as ABC analysis, simple simulation exercises and mathematical models
to help the firm maintain optimum stock of inventories.
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4. Market Structure and Pricing Policies: Analysis of the structure of the market provides information
about the nature and extent of competition which the firms have to face. This helps in determining
the degree of market power (ability to determine prices) which the firm commands and the strategies
to be followed in market management under the given competitive conditions such as, product
design and marketing. Price theory explains how prices are determined under different kinds of
market conditions and assists the firm in framing suitable price policies.

5. Resource Allocation: Business Economics, with the help of advanced tools such as linear
programming, enables the firm to arrive at the best course of action for optimum utilization of
available resources.

6. Theory of Capital and Investment Decisions: For maximizing its profits, the firm has to carefully
evaluate its investment decisions and carry out a sensible policy of capital allocation. Theories related
to capital and investment provides scientific criteria for choice of investment projects and in
assessment of the efficiency of capital. Business Economics supports decision making on allocation
of scarce capital among competing uses of funds.

7. Profit Analysis: Profits are, most often, uncertain due to changing prices and market conditions.
Profit theory guides the firm in the measurement and management of profits under conditions of
uncertainty. Profit analysis is also immensely useful in future profit planning.

8. Risk and Uncertainty Analysis: Business firms generally operate under conditions of risk and
uncertainty. Analysis of risks and uncertainties helps the business firm in arriving at efficient decisions
and in formulating plans on the basis of past data, current information and future prediction.

Macroeconomics applied to environmental or external issues

Environmental factors have significant influence upon the functioning and performance of business.
The major macro-economic factors relate to:

1. The type of economic system

2. stage of business cycle
3. The general trends in national income, employment, prices, saving and investment.
4. Government’s economic policies like industrial policy, competition policy, monetary and fiscal policy,
price policy, foreign trade policy and globalization policies
5. working of financial sector and capital market
6. Socio-economic organisations like trade unions, producer and consumer unions and cooperatives.
7. Social and political environment.

Business decisions cannot be taken without considering these present and future environmental
factors. As the management of the firm has no control over these factors, it should ne-tune its policies
to minimize their adverse effects.

Self-Test A (Conceptual Skill)

Why Business economics is normative in nature
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Self-Test B (Conceptual Skill)

State any three Differences between Micro and Macroeconomics

MATHEMATICAL TOOLS FOR ECONOMIC ANALYSIS

Variables:
Variables play an important role in economic theories. It is a magnitude of interest which can be
defined and quantified. It is a symbol whose value keeps on changing. It assumes different values at
different times or places. E.g. of variables are prices, profit, income, etc. Variables can be endogenous
or exogenous. Endogenous are those which lie within the theory while exogenous lie outside the
theory.

Constant:
Constant is a symbol whose value remains the same throughout a particular problem. E.g. =
Constants are of two types namely (a) absolute and (b) arbitrary or parametric. In the case of absolute
constant, the value will remain the same. In the case of arbitrary or parametric constant, the value
will remain the same in the particular problem but it will change its value in other problems.

Function:
A function describes the relation between two or more than two variables. That is, a function
expresses dependence of one variable on one or more other variables. Thus, if the value of a variable
V depends on another variable X, we may write:

Y=f (X) …. (1)

Where f stands for function.

This expression (1) is read as ‘Y is function of X’. This implies that every value of the variable Y is
determined by a unique value of the variable X. In the function (1) Y is known as the dependent
variable and X is the independent variable. Thus in function (1) Y is called the dependent variable and
its value depends on the value of X. Further, the independent variable is interpreted as the cause and
the dependent variable as the effect. An important function which is extensively used in economics
is a demand function which expresses quantity demanded of a commodity is a function of its price,
other factors being held constant.

Thus, demand for a commodity X is described as under: Dx

=f (Px)
Where Dx is the quantity demanded of commodity X and Px is its price.

Similarly, supply function of a commodity X is expressed as: Sx

= f (Px)
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When the value of the variable Y depends on more than two variables X1, X2….. Xn this function is
written in general form as: Y = f (X1, X2, X3, X4 .......... Xn)

This shows the variable Y depends on several independent variables X1, X2……Xn where n is the
number of independent variables. Again note that in economics we write ’causes’ as the independent
variables and ‘effect’ as the dependent variable.

For example, demand for a product is generally considered to be a function of its own price prices of
other commodities (which may be substitutes or complements) income of the consumers, tastes and
preferences of the consumers and advertising expenditure made by a firm to promote its product.
Thus,
Dx = f (Px, PY, M, T, A)
Where
Dx = demand for the commodity X
Px = price of the commodity X
Py = price of a substitute product
M= income of the consumers
T = tastes and preferences of the consumer for the product. A
= advertising expenditure incurred by the firm.

The exact nature of relation of dependent variable with the independent variables can be known
from the specific form of the function. The specific form of a unction can take a variety of
mathematical forms. We explain below some specific types of functions.

1. Linear Functions:
A widely used mathematical form of a function is a linear function.
A linear function can be stated in the following general form: Y = a
+ box
Where a and b are positive constants and are called parameters of the function. Note that
parameters of a function are variables that are fixed and given in a specific function. The values of
constants a and b determine the specific nature of a linear function.

The linear demand function with price as the only independent variable is written as:
Qd = a – bP
The minus sign before coefficient b indicates that quantity demanded of a commodity is negatively
related with price of the commodity. That is, if price of a commodity falls, its quantity demand
increases and vice versa.

If a equals 7 and b equals 0.5, the linear demand function can be expressed in the following specific
form:
Qd = 7 – 0.5 P
The above specific demand function shows that a unit fall in price of the commodity will cause 0.5
units increase in the quantity demanded of the commodity. If price (P) is zero, the second term (0.5P)
in the demand function drops out and the quantity demanded is equal to 7.
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We can take various values of P and find out different quantities (Qd) of a commodity demanded at
them. In Figure 5.1 we have noted these price-quantity combinations on a graph and have obtained
demand curve DD of the commodity representing the given demand function (Qd = 7- 0.5P).

It is worth noting that slope of the demand function curve in Figure 5.1 will represent ∆P/ ∆Q.
However, if we represent quantity demanded (Qd) on the y-axis, and price (Px) on the x-axis; the
slope of the demand curve so drawn would be equal to ∆Q/∆P.

Multivariate Linear Demand Function:

Linear demand function with more than one independent variables can be written in the following
way:
Qx = a + b1 Px + b2 Py+ b3 M + b4 T + b5 A
Where b1, b2, b3, b4, are the coefficients of the respective variables.

The linear multivariate function is written in the following form:

Y = 4 – 0.4X1 + 0.2X2+ 0.3X3 + 0.5 X4
In this function the coefficients 0.4, 0.2, 0.3 and 0.5 show the precise impact of the independent
variables X1, X2, X3, X4 on the dependent variable Y.

2. Power Functions:
The linear functions stated above are known as first degree functions where the independent
variables X1, X2, X3, etc. are raised to the first power only. We now turn to explain power functions.
In economics power functions of the quadratic and cubic forms are extensively used.

a. Quadratic Functions:
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In quadratic function one or more of the independent variables are squared, that is, raised to the
second power. Note that power is also referred to as exponent a quadratic function may be written
as
Y = a + bX+ cX2
This implies that value of the dependent variable Y depends on the constant a plus the coefficient b
times the value of the independent variable X plus the coefficient c times the square of the variable
X Suppose a = 4, b = 3 and c = 2 then quadratic function takes the following specific form. Y = 4 +
3X+2X2

Multivariable Quadratic Function:

When there are more than one independent variable such as X1, X2, and they have a quadratic
relationship with the dependent variable Y, such a function is called multivariable quadratic function.
In case of two independent variables X1 and X2 such a function may be expressed as under:
Y = a + bX1 – cX21 + dX2– eX22
If such a function is graphically shown, it will be represented by a three dimensional surface and not
a two dimensional curve.

b. Cubic Function:
A cubic function is the power function in which there is a third degree term relating to an
independent variable. Thus, cubic functions may have first degree, second degree and third degree
terms.
A cubic function may have the following form: Y
= a+ bX+cX2 + dX3
a is the intercept term, the dependent variable X has the first degree, second degree and third degree terms. When
the signs of all the coefficients a, b, c and d are positive, then the values of y will increase by
progressively larger increments as the value of X increases. However, when the signs of various
coefficients differ in the cubic function, that is, some have positive signs and some have negative
signs, then the graph of the function may have both convex and concave segments depending on the
values of the coefficients.
Such a cubic function where signs of the coefficients of variables differ may be expressed as follows:
Y = a + bX-cX2 + dX3
In which the sign of the coefficient c of variable X^ is negative whereas the coefficients of others are
positive.

Slopes of functions:
In economics it is important to know the rate at which a variable changes in response to a change in
another variable, the slope of a variable measures this rate. For example, it is important to know the
rate at which quantity demanded of a commodity changes in response to a change in price of a
commodity.

In the field of economics we find both linear and non¬linear functions. Let us first take the slope of a
linear function.

Slope of linear function

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Consider the following linear function: Y

= f (X) = 2 + 0.5 X
In Table 5.1 we have calculated the values of the variable Y by taking different values of X such as 1,
2, 3, 4 etc. Further, we have plotted the different values of Table 5.1 on a graph shown in Fig. 5.4.

The slope of the function, (Y = 2 + 0.5X) between two points, say, A and B in Figure 5.4 is given by the
ratio of change in Y to the change in X. That is, slope = ∆Y / ∆X.

For example, at point A of the given function value of variable X is 3 and corresponding to it the value
of variable Vis 3.5. When value of X rises from 3 to 4, value of Y increases from 3.5 to 4.

Thus, the slope of the function (Y=2 + 0.5X) is: ∆Y/

∆X = 4-3.5/ 0.5 = 0.5 / 1 = 0.5

This implies that value of Y increases by 0.5 when value of X increases by 1. It should be noted that
slope of a linear function is constant throughout.

However, the slope of a linear function can be directly known from the linear function itself and for
that purpose there is no need to plot the data. Consider the following linear function Y = a + bX

It will be seen from this linear function that when the value of X is zero, the value of Y will be equal
to a. Thus a is Y intercept. Further, in this function b is the coefficient of X and measures change in Y
due to change in X that is, ∆Y/∆X. Thus, b represents the slope of the linear function. In linear function
26 | P a g e

Y= 2 + 0.5X, 2 is the Y-intercept, that is, value of Y when X is zero, 0.5 is the b coefficient which
measures the slope of the linear function.

Slope of a non-linear function:

We now turn to explain how slope of a non-linear function, say, a quadratic function (Y= a + bX+ cX2)
can be measured. On plotting the non-linear function in a graph, we get a non-linear curve.

Let us take the following specific quadratic function:

Y = 5 + 3X+X2
In Table 5.2 we have calculated the various values of Y by taking different values of X (0, 1, 2, 3, etc.)

The data so obtained have been plotted to get a curve in Figure 5.5. It will be seen from this Figure
5.5 that slope of the line AB which connects two points A and B on a curve representing quadratic
function can be measured by taking the change in the value of Y divided by the change in value of X.
At point A, value of X is 1 and the corresponding value of Y is 9 and at point B, the value of X is 4 to
which the corresponding value is 33. Thus, here ∆X = 4 – 1 = 3 and ∆y = 33 – 9 = 24.

Thus, the slope of the line AB is:

∆Y/ ∆X =24/3 =8

Similarly, slope of straight line AC in Fig.5.5. can be measured. Between two points A and C, ∆X = 3
– 1 = 2 and ∆Y = 23 – 9 = 14, Thus, the slope of straight line AC is
∆Y/ ∆X = 14/2 =7

In a similar fashion, the slope of the straight line AD connecting points A and D on the non-linear
quadratic function curve in Figure 5.5 is given by
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∆Y/ ∆X = 15-9/2-1 = 6/1 = 6

It will thus be seen that as AX decreases; it was 3 between A and B, 2 between and C and 1 between
A and D, slope of the non-linear curve goes on declining. It was 8 of the line AB 7 of the line AC and
6 of the line AD. As AX further decreases, slope of the line connecting two points of the non-linear
curve will further decline.

It should also be noticed that the slope of the straight line AD connecting points and D is very close
to the slope of the tangent drawn to the curve at point As AX becomes smaller and smaller slope of
the line connecting the two points on a curve will become extremely close to the slope of the tangent
drawn to the curve at point A. Therefore, the slope at a point on the non-linear function curve can
be measured by the slope of a tangent drawn to the curve at that point.

Biblography
For Detail study and further Reference
1. Gregory Mankiw principle of Economics
2. Bruce Flynn - Economics
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Chapter 3: Market Equilibrium

Chapter outline
• Meaning of demand
• Demand Schedule and Demand Curve
• Factor affecting demand
• Law of demand
• Expansion and Contraction in Demand
• Increase and Decrease in Demand
• Meaning of Supply
• Supply Schedule and Supply Curve
• Law of Supply
• Expansion and Contraction in Supply
• Increase and Decrease in Supply
• Equilibrium
• Change in Demand and Supply

INTRODUCTION
Case Scenario 1
In April 2012, the price of winter wheat on global markets was around €209 per metric tonne. By
September 2012 the price had risen to €277 per metric tonne, a rise of around 33 per cent. One of
the reasons for the rise in price was that wheat-producing states in the United States suffered a
drought which damaged the wheat crop. Other crops such as corn and soya beans had also been
rising in price. One of the consequences of this is that livestock farmers faced increased costs of
production – some arable crops are used in livestock feedstuffs. Some farmers had been unable to
afford to feed their animals and so had to send them for slaughter which led to beef prices falling.

Case Scenario 2
In November 2006, the average house price in the UK was £200,000 (€250,000). In January 2009,
this had fallen to £164,000 (€205,000). When major sporting events are held in a country, such as
the World Cup or the Olympics, hotel prices in the areas around the venues tend to rise.

Case Scenario 3
In the Holy month of Ramadan, many Muslims find that the price of food rises quite sharply. If you
book an airline flight several months in advance of a trip the seat prices tend to be lower than if
you try booking two weeks before your trip.

What do these events have in common? They all show the workings of supply and demand.
Supply and demand are the two words that economists use most often – and for good reason. Supply
and demand are the forces that make market economies work. They determine the quantity of each
good produced and the price at which it is sold. If you want to know how any event or policy will affect
29 | P a g e

the economy, you must think first about how it will affect supply and demand. This chapter introduces
the theory of supply and demand. It considers how buyers and sellers behave and how they interact
with one another. It shows how supply and demand determine prices in a market economy and how
prices, in turn, allocate the economy’s scarce resources.

MEANING OF DEMAND
The concept ‘demand’ refers to the quantity of a good or service that consumers are willing and able
to purchase at various prices during a period of time.

It is to be noted that demand in economics is something more than desire to purchase though desire
is one element of it. A beggar, for instance, may desire food, but due to lack of means to purchase it,
his demand is not effective.

Thus effective demand for a thing depends on

(i) Desire
(ii) Means to purchase and
(iii) Willingness to use those means for that purchase.

Two things are to be noted about quantity demanded.

1. Quantity demanded is always expressed at a given price. At different prices different
quantities of a commodity are generally demanded.
2. Quantity demanded is a flow. We are concerned not with a single isolated purchase, but with
a continuous flow of purchases at various prices and per unit of time.

Meaning of Individual Demand and Market Demand

• Individual Demand is the quantity of a commodity demanded by a consumer at a given price
during a given period of time.
• Market Demand is the total quantity of a commodity demanded by a all the consumer at a given
price during a given period of time

Demand Schedule
Demand schedule a table that shows the relationship between the price of a good and the quantity
demanded

Individual Demand Schedule

• Individual Demand schedule is tabular representation showing different quantities of

commodities that an individual consumer is prepared to buy at various prices over a given period
of time

Price of Chocolate (Rs.) Quantity demanded of Chocolate(in units)

10 1
8 2
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6 3
4 4
2 5

Market Demand Schedule

• Market Demand schedule is tabular representation showing different quantities of commodities
which all consumers are prepared to buy at various prices over a given period of time
• It is obtained by Horizontal Summation (Addition of all Consumer)
Price In (Rs.) A’s B’s C’s Market
QD QD QD Demand
10 5 10 15 30
8 10 15 20 45
6 15 20 25 60
4 20 25 30 75
2 25 30 35 90

Demand Curve
Demand curve a graph of the relationship between the price of a good and the quantity demanded

Individual Demand Curve

• Individual Demand schedule is tabular representation showing different quantities of

commodities that an individual consumer is prepared to buy at various prices over a given period
of time

12
D
10

6
D
4

0
0 1 2 3 4 5 6

Quantity Demanded Of Chocolate

Market Demand Curve

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Market Demand schedule is tabular representation showing different quantities of commodities

demanded by all consumer at various prices over a given period of time

12

10 D
8

2 D
0
0 15 30 45 60 75 90

Quantity Demanded Of Chocolate

Self-Test –A (Observation Skill)

Draw your own Individual Demand Schedule and Individual demand curve for pizza and state your
interpretation with respect to relationship and slope of Curve

Self-Test –B (Problem solving and Application Skill)

Complete the Given Table and Draw Individual Demand Curve and Market Demand Curve

Price A’s demand B’s Demand C’s Demand Market

Demand
100 5000 10000 15000
200 4000 8000 12000
300 3000 6000 9000
400 2000 4000 6000
500 1000 2000 3000

Self-Test –C (Problem solving and Application Skill)

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Complete the Given Table and Draw Individual Demand Curve and Market Demand Curve

Price A’s demand B’s Demand C’s Demand Market

Demand
100 1500 7000 14500
200 1200 4800 12300
300 4200 5600 10700
400 3600 4900
500 300 4200

DETERMINANTS OF DEMAND
There are a number of factors which influence household demand for a commodity. Important
among these are
1. Price of the commodity: Ceteris paribus i.e. other things being equal, the demand of a
commodity is inversely related to its price. It implies that a rise in price of a commodity brings about
a fall in its purchase and vice-versa.

2. Price of related commodities: Related commodities are of two types (a) complementary
goods and (ii) competing goods or substitutes. Complementary goods are those goods which are
consumed together or simultaneously. For example, tea and sugar, automobiles and petrol, pen and
ink are used together. When commodities are complements, a fall in the price of one (other things
being equal) will cause the demand of the other to rise. For example, a fall in the price of cars would
lead to a rise in the demand for petrol. Similarly, a fall in the price of pens will cause rise in the
demand for ink. The reverse will be the case when the price of a complement rises.

Competing goods or substitutes are those goods which can be used with ease in place of one another.
For example, tea and coffee, ink pen and ball pen, are substitutes for each other and can be used in
place of one another easily. When goods are substitutes, a fall in the price of one (ceteris paribus)
leads to a fall in the quantity demanded of its substitutes. For example, if the price of tea falls, people
will substitute it for coffee and demand more of it and less of coffee i.e. the demand for tea will rise
and that of coffee will fall.

3. Level of income of the household: Other things being equal, the demand for a commodity
depends upon the money income of the household. In most cases, the larger the average money
income of the household, the larger is the quantity demanded of a particular good. Thus, generally
there is a direct relationship between income and demand for goods.
However, there are certain commodities for which quantities demanded decrease with an increase
in money income. These goods are called inferior goods.

4. Tastes and preferences of consumers: The demand for a commodity also depends upon
tastes and preferences of consumers and changes in them over a period of time. Goods which are
more in fashion have higher demand than goods which are out of fashion. Consumers may even
discard a good even before it is fully utilized and choose another good which is in fashion. For
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example, there is a greater demand for cultured television then more and more people will discard
their black and white television even though they could have still used it for some more years.

‘Demonstration effect’ plays an important role in affecting the demand for a product. An individual’s
demand for color television may be affected by his seeing a T.V. in neighbor’s or friend’s house. A
person may develop a taste or preference for wine after tasting some, but he may also develop it
after discovering that serving it raises his prestige. In any case, people have tastes and preferences
and they change, due to various external and sometimes due to internal causes.

5. Other factors : Apart from the above factors, the demand for a commodity depends upon
the following factors.

a. Size of population: Generally, larger the size of population of a country or a region, greater is
the demand for commodities in general.

b. Composition of population: If there are more old people in a region, the demand for
spectacles, walking sticks, etc. will be high; similarly, if the population consists of more of children,
demand for toys, baby foods, toffees, will be more.

c. Distribution of income: The wealth of a country may be so distributed that there are a few
very rich people while the majority are very poor. Under such conditions the propensity to consume
of the country will be relatively less as the propensity to consume of the rich people is less than that
of poor people. Consequently the demand for consumer goods will be comparatively less. If the
distribution of income is more equal than the propensity to consume of the country as a whole will
be relatively high indicating higher demand for goods.
LAW OF DEMAND

Introduction

The law of demand is one of the most important laws of economic theory. The law was proposed by
Prf. Alfred Marshall in his book “Principle of Economics” – published in year 1890

Statement
According to law of demand other things beings equal, if the price of a commodity falls, the quantity
demanded of it will rise and if the price of a commodity rises, its quantity demanded will decline,

Explanation
The law of demand is a qualitative statement because it shows the quality of demand to change with
the changes in prices. There is an inverse relationship between price and quantity demanded, other
things being same.
These other things are known as assumptions of the law of demand they are as under

Assumptions of the Law:

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This law will hold valid only when certain assumptions are made. The law will hold well only when
the following conditions are satisfied.
• Prices of all other goods, except the price of the product under discussion are constant.
• The no. of the consumers remains constant.
• The income of the buyers is constant.
• Their tastes and preferences are constant.
• The product is a normal product.
• The future prices of the product do not change.
• Buyers behave rationally.
Depending upon these assumptions, we can explain the law of demand as follows. Here we will
prepare a demand schedule to understand the law

Market Demand Schedule

When we add up the various quantities demanded by the number of consumers in the market we
can obtain the market demand schedule. Suppose there are three individual buyers of commodity
goods in the market. The Table shows their individual demands at various prices.

Market Demand Schedule

Price (` ) P Q R Total market demand

5 10 8 12 30
4 15 12 18 45
3 20 17 23 60
2 35 25 40 100
1 60 35 45 140
When we add quantities demanded at each price by consumers P. Q, R we get total market demand.
Thus when price is ` 5 per unit, the demand for commodity ‘X’ in the market are 30 units (i.e. 10+8+12).
When price falls to ` 4, market demand is 45 units. At Re. 1, 140 units are demanded in the market.
The market demand schedule also indicates inverse relationship between price and quantity
demanded of ‘X’.

Market Demand Curve:

If we plot market demand schedule on a graph we get market demand curve. Figure 2 shows market
demand curve for commodity ‘X’. The market demand curve, like individual demand curve, slopes
downwards to the right because it is nothing but lateral summation of individual demand curves.
Besides, as the price of the good falls, it is very likely that new buyers will enter the market which will
further raise the quantity demanded of the goods.
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RATIONALE FOR THE LAW OF DEMAND

1. Law of diminishing marginal utility: According to Marshall People will buy more quantity at
lower price because they want to equalize the marginal utility of the commodity and its price. So a
rational consumer will not pay more for lesser satisfaction. He is induced to buy additional units in
order to maximize his satisfaction or utility. The diminishing marginal utility and equalizing it with the
price is the cause for the downward sloping demand curve.

2. Income Effect: When the price of a commodity falls, the consumer can buy the same quantity
of the commodity with lesser money or he can buy more of the same commodity with the same
money. In other words, as a result of fall in the price of the commodity, consumer’s real income or
purchasing power increases. ‘This increase in the real income induces him to buy more of that
commodity. Thus, demand for that commodity (whose price has fallen) increases. This is called
income effect.

3. Substitution effect: Hicks and Allen have explained the law in terms of substitution effect and
income effect. When the price of a commodity falls, it becomes relatively cheaper than other
commodities. It induces consumers to substitute the commodity whose price has fallen for other
commodities which have now become relatively expensive. The result is that the total demand for
the commodity whose price has fallen increases. This is called substitution effect.
According to Prof. Hicks when the price of a commodity decreases the quantity demanded of the
commodity increases. This is known as price effect. Thus, what is law of demand according to
Marshall is the price effect according to Hicks. This price effect is the combination of the substitution
effect and the income effect described above.

4. Arrival of new consumers: When the price of a commodity falls, more consumers start buying
it because some of those who could not afford to buy it previously may now afford to buy it. This
raises the number of consumers of a commodity at a lower price and hence the demand for the
commodity in question.

5. Different uses: Certain commodities have multiple uses. If their prices fall they will be used
for varied purposes and demand for such commodities will increase. When the price of such
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commodities are high, rises they will be put to limited uses only. Thus, different uses of a commodity
make the demand curve slope downwards reacting to changes in price.

EXPANSION AND CONTRACTION

Expansion of Demand
When the price of a commodity decreases its quantity demanded increases. This result is known as
expansion of demand.

Contraction of Demand
When the price of the commodity goes up its quantity demanded decreases. This is known as
contraction of demand
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INCREASE IN DEMAND AND DECREASE IN DEMAND:

Increase in demand
The increase in demand can be said to have taken place when the price of the product remaining
constant, its quantity demanded increases due to other various factors, e.g. increase in the no. of the
buyers, favorable changes in the tastes and preferences of buyers, increase in the prices of
substitutes and decrease in the prices of the complementary goods or due to an increase in exports
or in the future prices etc.
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Decrease in Demand
On the other hand decrease in demand can be said to have taken place when the quantity demanded
of the product decreases at the same price due to the factors like decrease in population, a decrease
in the income of the buyers, an unfavorable change in the tastes and preferences of buyers of the
product, decrease in exports, decrease in the prices of substitutes, increase in the prices of
complementary goods etc.

Self-Test D (Interpretation and Observation Skill)

Give an example of something that would cause the demand curve to shift to the right. Draw a
diagrammatical presentation of demand curve shifting right

Self-Test E (Interpretation and Observation Skill)

Give a different example of something that would cause the demand curve to shift to the left. Draw
a diagrammatical presentation of demand curve shifting right

Self-Test F (Conceptual Skill)

Explain the concept of Complementary goods and Substitute goods with real life example

MEANING OF SUPPLY
The term ‘supply’ refers to the amount of a good or service that the producers are willing and able
to refer to the market at various prices during a given period of time.
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Thus Supply for a commodity depends on a.

Ability to sell
b. Willingness to offer

Two important points apply to supply:

• Supply refers to what a firm offer for sale in the market, not necessarily to what they succeed in
selling. What is offered may not get sold.
• Supply is a flow. The quantity supplied is ‘so much’ per unit of time, per day, per week, or per
year.

Meaning of Individual Supply and Market Supply

• Individual Supply is the quantity of a commodity offered by a single seller at a given price during
a given period of time.
• Market Supply is the total quantity of a commodity offered by all seller at a given price during a
given period of time

Supply Schedule
Supply schedule a table that shows the relationship between the price of a good and the quantity
Supplied

Individual Supply Schedule

• Individual Demand schedule is tabular representation showing different quantities of
commodities that an individual seller is willing to offer at various prices over a given period of
time

Price of Chocolate (Rs.) Quantity Supply of Chocolate(in

units)
10 100
20 200
30 300
40 400
50 500

Market Supply Schedule

• Market Supply schedule is tabular representation showing different quantities of commodities

which all sellers are willing to offer at various prices over a given period of time
• It is obtained by Horizontal Summation (Addition of all Consumer)
Price In (Rs.) A’s B’s C’s Market
QD QD QD Supply
10 100 200 300 600
20 200 300 400 900
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30 300 400 500 1200

40 400 500 600 1500
50 500 600 700 1800

Supply Curve
Supply curve a graph of the relationship between the price of a good and the quantity Supplied

Individual Supply Curve

• Individual Supply curve is graphical representation showing different quantities of commodities

that an individual seller is willing to offer at various prices over a given period of time

60

50

40
S
30

20

10

0
S
0 100 200 300 400 500 600

Quantity Supplied Of Chocolate

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Market Supply Curve

• Market Supply schedule is graphical representation showing different quantities of commodities
offered by all seller at various prices over a given period of time

60
50
40
S
30
20
10
S
0
0 300 600 900 1200 1500 1800 2100

Quantity Supplied Of Chocolate

Self-Test –G (Observation Skill)

Assume you are cloth store owner Draw your own Individual supply Schedule and Individual supply
curve for Jeans and state your interpretation on the basis of relationship and slope of curve
Self-Test –H (Problem Solving and Application Skill)
Complete the Given Table and Draw Individual Supply Curve and Market Supply Curve

Price A’s B’s C’s Market

Supply Supply Supply Supply
500 5000 10000 15000
400 4000 8000 12000
300 3000 6000 9000
200 2000 4000 6000
100 1000 2000 3000
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Self-Test –I (Problem Solving and Application Skill)

Complete the Given Table and Draw Individual Supply Curve and Market Supply Curve

Price A’s B’s C’s Market

Supply Supply Supply Supply
500 1500 7000 14500
400 1200 4800 12300
300 4200 5600 10700
200 3600 4900
100 300 4200

DETERMINANTS OF SUPPLY
Although price is an important consideration in determining the willingness and desire to part with
commodities, there are many other factors which determine the supply of a product or a service.
These are discussed below:
1. Price of the good: Other things being equal, the higher the relative price of a good the greater
the quantity of it that will be supplied. This is because goods and services are produced by the firm
in order to earn profits and, ceteris paribus, profits rise if the price of its product rises.

2. Prices of related goods: If the prices of other goods rise, they become relatively more pro
table to the room to produce and sell than the good in question. It implies that, if the price of Y rises,
the quantity supplied of X will fall. For example, if price of wheat rises, the farmers may shift their
land to wheat production away from corn and soya beans.

3. Prices of factors of production: Cost of production is a significant factor that affects supply.
A rise in the price of a particular factor of production will cause an increase in the cost of making
those goods that use a great deal of that factor than in the costs of producing those that use relatively
small amount of the factor. For example, a rise in the cost of land will have a large effect on the cost
of producing wheat and a very small effect on the cost of producing automobiles. Thus, a change in
the price of one factor of production will cause changes in the relative profitability of different lines
of production and will cause producers to shift from one line to another and thus supplies of different
commodities will change.

4. State of technology: The supply of a particular product depends upon the state of technology
also. Inventions and innovations tend to make it possible to produce more or better goods with the
same resources, and thus they tend to increase the quantity supplied of some products and to reduce
the quantity supplied of products that are displaced. Availability of spare production capacity and
the ease with which factor substitution can be made and the cost of such substitution also determine
supply.

5. Government Policy: The production of a good may be subject to the imposition of commodity
taxes such as excise duty, sales tax and import duties. These raise the cost of production and so the
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quantity supplied of a good would increase only when its price in the market rises. Subsidies, on the
other hand, reduce the cost of production and thus provide an incentive to the firm to increase
supply. When government imposes restrictions such as import quota on inputs, rationing of input
supply etc., production tends to fall.

6. Nature of competition and size of industry: Under competitive conditions, supply will be
more than that under monopolized conditions. If there are large number of firms in the market,
supply will be more. Besides, entry of new firms, either domestic or foreign, causes the industry
supply curve to shift rightwards.

7. Other Factors: The quantity supplied of a good also depends upon government’s industrial
and foreign policies, goals of the firm, infrastructural facilities, natural factors such as weather,
floods, earthquake and man-made factors such as war, labour strikes, communal riots and etc.

LAW OF SUPPLY

Introduction
The law was proposed by Prof. Alfred Marshall in his book “Principle of Economics” – published in
year 1890

Statement
The law of supply can be stated as: Other things remaining constant, the quantity of a good produced
and offered for sale will increase as the price of the good rises and decrease as the price falls.

Explanation
This law is based upon common sense, because the higher the price of the good, the greater the
profits that can be earned and thus greater the incentives to produce the good and offer it for sale.

Assumptions of the Law:

This law will hold valid only when certain assumptions are made. The law will hold well only when
the following conditions are satisfied.
• Prices of factor of production
• Price of related goods
• Government policy
• State of technology
• The future prices of the product do not change.
Depending upon these assumptions, we can explain the law of demand as follows. Here we will
prepare a demand schedule to understand the law

The law of supply can be explained through a supply schedule and a supply curve. A supply schedule
is the tabular presentation of the law of supply. It shows the different prices of a commodity and the
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corresponding quantities that suppliers are willing to offer for sale. Consider the following
hypothetical supply schedule of good X.

Market Supply Schedule

Supply Schedule of Good ‘X’

Price (`) Quantity supplied

(per kg) (kg)
1 5
2 35
3 45
4 55
5 65

The table shows the quantities of good X that would be produced and offered for sale at a number
of alternative prices. At ` 1, for example, 5 kilograms of good X are offered for sale and at ` 3 per kg.
45 kg. would be forthcoming.

Market Supply Curve

In Figure price is plotted on the vertical axis and quantity on the horizontal axis, and various price-
quantity combinations of the schedule 9 are plotted.
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When we draw a smooth curve through the plotted points, what we get is the supply curve for good
X. The supply curve is a graphical presentation of the supply schedule. It shows the quantity of X that
will be offered for sale at each price of X. It slopes upwards towards right (positive slope) showing
that as price increases, the quantity supplied of X increases and vice-versa.

The market supply, like market demand, is the sum of supplies of a commodity made by all individual
firms or their supply agencies. The market supply is governed by the law of supply. The market supply
curve for ‘X’ can be obtained by adding horizontally the supply curves of various rms.

EXPANSION AND CONTRACTION

Expansion of Supply
When the price of a commodity increases its quantity supply increases. This result is known as
expansion of supply.

Contraction of Supply

When the price of the commodity decreases its quantity supply decreases. This is known as
contraction of supply
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INCREASE AND DECREASE IN SUPPLY:

Increase in Supply
The increase in Supply can be said to have taken place when the price of the product remaining
constant, its quantity supply increases due to other various factors, e.g. increase in the no. of the
seller, fall in cost of production New technology etc.

Decrease in Supply
Decrease in supply can be said to have taken place when the quantity supply of the product decreases
at the same price due to the factors like decrease in number of seller increase in price of factor of
production outdated technology etc.
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Self-Test J (Observation and Application Skill)

Give an example of something that would cause the supply curve to shift to the right. Draw a
diagrammatical presentation of Supply curve shifting right

Self-Test K (Observation and Application Skill)

Give a different example of something that would cause the Supply curve to shift to the left. Draw
a diagrammatical presentation of Supply curve shifting right

SUPPLY AND DEMAND TOGETHER

Having analyzed supply and demand separately, we now combine them to see how they determine
the quantity of a good sold in a market and its price.

EQUILIBRIUM
Equilibrium, remember, is defined as a state of rest, a point where there is no force acting for change.
Economists refer to supply and demand as being market forces. In any market the relationship
between supply and demand exerts force on price. If supply is greater than demand or vice versa,
then there is pressure on price to change. Market equilibrium occurs when the amount consumers
wish to buy at a particular price is the same as the amount sellers are willing to offer for sale at that
price. The price at this intersection is called the equilibrium or market price, and the quantity is called
the equilibrium quantity.
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At the equilibrium price, the quantity of the good that buyers are willing and able to buy exactly
balances the quantity that sellers are willing and able to sell. The equilibrium price is sometimes
called the market-clearing price because, at this price, everyone in the market has been satisfied:
Buyers have bought all they want to buy, and sellers have sold all they want to sell; there is no shortage
in the market where demand is greater than supply and neither is there any surplus where supply is
greater than demand

The determination of market price is the central theme of micro economic analysis. Hence, micro-
economic theory is also called price theory.

The following table explains the equilibrium price

Table 10 : Supply and Demand Schedule

Quantity Quantity Impact on
Price (`) Demanded Supplied price
5 6 31 Downward
4 12 25 Downward
3 19 19 Equilibrium
2 25 12 Upward
1 31 6 Upward

The equilibrium between demand and supply is depicted in the diagram below. Demand and supply
are in equilibrium at point E where the two curves intersect each other. It means that only at price `
3 the quantity demanded is equal to the quantity supplied. The equilibrium quantity is 19 units and
these are exchanged at price ` 3. If the price is more than the equilibrium level, excess supply will
push the price downwards as there are few takers in the market at this price. For example, in Table
10, if price is say ` 5, quantity demanded is 6 units which is quite less than the quantity supplied (31
units). There will be excess supply in the market which will force the sellers to reduce price if they
want to sell o their product. Hence the price will fall and continue falling down till the level where
quantity demanded becomes equal to the quantity supplied. Opposite will happen when quantity
demanded is more than quantity supplied at a particular price.

The equilibrium price is determined by the intersection between demand and supply. It is also called
the market equilibrium.

The market will remain in equilibrium until something causes either a shift in the demand curve or a
shift in the supply curve (or both). If one or both curves shift, at the existing equilibrium price, there
will now be either a surplus or a shortage. The market mechanism takes time to adjust – sometimes
it can be very quick (which tends to happen in highly organized markets like stock and commodity
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markets) and sometimes it is much slower to react. When the market is in disequilibrium and a
shortage or surplus exists, the behaviour of buyers and sellers act as forces on price.

IF SURPLUS EXIST
When there is a surplus or excess supply of a good, suppliers are unable to sell all they want at the
going price. Sellers find stocks of milk increasing so they respond to the surplus by cutting their prices.
As the price falls, some consumers are persuaded to buy more milk and so there is a movement along
the demand curve. Equally, some sellers in the market respond to the falling price by reducing the
amount they are willing to offer for sale (a movement along the supply curve). Prices continue to fall
until the market reaches a new equilibrium. The effect on price and the amount bought and sold
depends on whether the demand curves or supply curve shifted in the first place (or whether both
shifted). This is why analysis of markets is referred to as comparative statics because we are
comparing one initial static equilibrium with another once market forces have worked their way
through. If the shift in demand or supply that causes the equilibrium to be disturbed creates a
shortage in the market, buyers’ and sellers’ behaviour again ‘forces’ price to change to bring the
market back into equilibrium.

IF SHORTAGE EXIST
A shortage or situation of excess demand occurs where the quantity of the good demanded exceeds
the quantity supplied at the going price; buyers are unable to buy all they want at that price. With
too many buyers chasing too few goods, sellers can respond to the shortage by raising their prices
without losing sales. As the price rises, some buyers will drop out of the market and quantity
demanded falls (a movement along the demand curve). Rising prices encourage some farmers to
offer more milk for sale as it is now more profitable for them to do so and the quantity supplied rises.
Once again this process will continue until the market once again moves toward the equilibrium.
Thus, the activities of the many buyers and sellers ‘automatically’ push the market price towards the
equilibrium price. Individual buyers and sellers don’t consciously realize they are acting as forces for
change in the market when they make their decisions but the collective act of all the many buyers
and sellers does push markets towards equilibrium. This phenomenon is so pervasive that it is called
the law of supply and demand: the price of any good adjusts to bring the quantity supplied and
quantity demanded for that good into balance.
CHANGE IN DEMAND AND SUPPLY

AN INCREASE IN DEMAND:
In Figure 8, the original demand curve of a normal good is DD and supply curve is SS. At equilibrium
price OP, demand and supply are equal to OQ.

Now suppose the money income of the consumer increases and the demand curve shifts to D1D1
and the supply curve remains the same. We will see that on the new demand curve D1D1 at OP price,
demand increases to OQ2 while supply remains the same i.e. OQ and there is excess demand in the
market equal to Q Q2. Since supply is short of demand, price will go up to OP1. With the higher price,
supply will also shoot up generating an increase in the quantity supplied or an upward movement
along the supply curve. Ultimately, a new equilibrium between demand and supply will be reached.
At this equilibrium point, OP1 is the price and OQ1 is the quantity which is demanded and supplied.
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Fig. 8: Increase in Demand, causing an increase in equilibrium price and quantity

Thus, we see that, with an increase in demand, there is an increase in equilibrium price, as a result
of which the quantity supplied rises. As such, the quantity sold and purchased also increases.

Decrease in Demand: The opposite will happen when demand falls as a result of a fall in income,
while the supply remains the same. The demand curve will shift to the left and become D1D1 while
the supply curve remains as it is. With the new demand curve D1D1, at original price OP, OQ2 is
demanded and OQ is supplied. As the supply exceeds demand, price will come down and quantity
demanded will go up. A new equilibrium price OP1 will be settled in the market where demand OQ1
will be equal to supply OQ1.

Decrease in Demand Resulting in a Decrease in Price and Quantity Demanded

Thus, with a decrease in demand, there is a decrease in the equilibrium price and quantity demanded
and supplied.
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Increase in Supply: Let us now assume that demand does not change, but there is an increase in
supply say, because of improved technology.

Increase in Supply, Resulting In Decrease in Equilibrium Price and Increase in Quantity Supplied The
supply curve SS will shift to the right and become S1S1. At the original equilibrium price OP, OQ is
demanded and OQ2 is supplied (with new supply curve). At the original price, a surplus now exists;
as a result, the equilibrium price falls and the quantity demanded rises. A new equilibrium price OP1
will be settled in the market where demand OQ1 will be equal to supply OQ1. Thus, as a result of an
increase in supply with demand remaining the same, the equilibrium price will go down and the
quantity demanded will go up.

Decrease in Supply: If because of some reason, there is a decrease in supply we will find that
equilibrium price will go up, but the amount sold and purchased will go down as shown in figure 11.

Decrease in Supply Causing an Increase in the Equilibrium Price and a fall in Quantity Demanded

Simultaneous Changes in Demand and Supply

Till now, we were considering the effect of a change either in demand or in supply on the equilibrium
price and quantity sold and purchased. It sometimes happens that events shift both the demand and
supply curves at the same time. This is not unusual; in real life, supply curves and demand curves for
many goods and services typically shift quite often because of continuous change in economic
environment. During a war, for example, shortage of goods will often lead to decrease in their supply
while full employment causes high total wage payments which increase demand.

What happens when the demand and supply curves shift in the same direction? We may discuss the
effect on equilibrium price and quantity when both demand and supply increase simultaneously with
the help of the diagrams below:
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Simultaneous Change in Demand and Supply

It shows simultaneous change in demand and supply and its effects on the equilibrium price. In the
figure, the original demand curve DD and the supply curve SS meet at E at which OP is the equilibrium
price and OQ is the quantity bought and sold.

(a) Shows that increase in demand is equal to increase in supply. The new demand curve D1D1
and S1S1 meet at E1. The new equilibrium price is equal to the old equilibrium price (OP). However,
equilibrium quantity is more.

(b) Shows that increase in demand is more than increase in supply. Hence, the new equilibrium
price OP1 is higher than the old equilibrium price OP. The opposite will happen i.e. the equilibrium
price will go

CaseStudy- Scenario (Interpretation and Application Skill)

Explain each of the following statements using supply and-demand diagrams.

a. When a cold snap hits Florida, the price of orange juice rises in supermarkets throughout the
country.
b. When the weather turns warm in New England every summer, the prices of hotel rooms in
Caribbean resorts plummet.

c. When a war breaks out in the Middle East, the price of gasoline rises, while the price of a used
Cadillac falls

CaseStudy- Scenario (Interpretation and Application Skill)

Using supply-and-demand diagrams show the effect of the following events on the market for
sweatshirts.

a. A hurricane in South Carolina damages the cotton crop.

b. The price of leather jackets falls.

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c. All colleges require morning calisthenics in appropriate attire.

d. New knitting machines are invented.

Biblography

For Detail study and further Reference

1. Gregory Mankiw principle of Economics

2. Bruce Flynn – Economics
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B.COM (ENTREPRENEURSHIP)

Semester I

Unit 2
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Table of Contents
ELASTICITY OF DEMAND ........................................................................................................................................ 3
DEMAND FORECASTING ................................................................................................................................................... 17
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CHAPTER 4 : ELASTICITY OF DEMAND

Chapter Outline
• Meaning of elasticity
• Methods of measuring Elasticity
• Price elasticity and its types
• Determinants of elasticity
• Importance of Price elasticity
• Income elasticity and its types
• Cross elasticity and its types
• Promotional elasticity and its types

INTRODUCTION
Till now we were concerned with the direction of the changes in prices and quantities demanded. From the point of view
of a business firm, it is more important to know the extent of the relationship or the degree of responsiveness of demand
to changes in its determinants. Now we will try to measure these changes, or to say, we will try to answer the question
“by how much does demand change due to a change in price”?

Consider the following situations:

• As a result of a fall in the price of radio from Rs. 500 to Rs. 400, the quantity demanded increases from 100 radios to
150 radios.
• As a result of fall in the price of wheat from Rs. 20 per kilogram to Rs. 18 per kilogram, the quantity demanded
increases from 500 kilograms to 520 kilograms.
• As a result of fall in the price of salt from Rs. 9 per kilogram to Rs. 7.50, the quantity demanded increases from 1000
kilogram to 1005 kilograms.

What do you notice? You notice that as a result of a fall in the price of radios, the quantity demanded of radios increases.
Same is the case with wheat and salt. Thus, we can say that demand for radios, wheat and salt all respond to price changes.
Then, what is the difference? The difference lies in the degree of response of demand which can be found out by
comparing the percentage changes in prices and quantities demanded. Here lies the concept of elasticity.

MEANING OF ELASTICITY OF DEMAND

Elasticity of demand is defined as the responsiveness of the quantity demanded of a good to changes in one of the
variables on which demand depends. More precisely, elasticity of demand is the percentage change in quantity demanded
divided by the percentage change in one of the variables on which demand depends.

These variables are price of the commodity, prices of the related commodities, income of the consumers and other factors
on which demand depends. Thus, we have price elasticity, cross elasticity, income elasticity, advertisement elasticity and
elasticity of substitution,. It is to be noted that when we talk of elasticity of demand, unless and until otherwise mentioned,
we talk of price elasticity of demand. In other words, it is price elasticity of demand which is usually referred to as elasticity
of demand.

PRICE ELASTICITY
The price elasticity of demand measures how much the quantity demanded responds to a change in price.
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• Demand for a good is said to be elastic or price sensitive if the quantity demanded responds substantially to changes in the
price.
• Demand is said to be inelastic or price insensitive if the quantity demanded responds only slightly to changes in the price.

Price elasticity of demand a measure of how much the quantity demanded of a good responds to a change in the price of
that good, computed as the percentage change in quantity demanded divided by the percentage change in price

Price elasticity of demand expresses the response of quantity demanded of a good to a change in its price, given the
consumer’s income, his tastes and prices of all other goods. In other words, it is measured as the percentage change in
quantity demanded divided by the percentage change in price, other things remaining equal.

Percentage Formula
Ed = % change in QD/% change in Price
=% ∆QD/% ∆P
Where
%∆QD (Percentage change in Quantity Demand) = ∆QD/QD x 100
%∆P (Percentage change in Price) = ∆P/P x 100

Ratio or Proportionate Formula

Ed = Change in QD/Change in Price x Original Price/Original QD
= ∆QD/∆P x P/Q

Note:
Strictly speaking, the value of price elasticity varies from minus infinity to approach zero from the negative ∆q sign,
because ∆p has a negative sign. In other words, since price and quantity are inversely related (with a few exceptions) price
elasticity is negative. But, for the sake of convenience, we ignore the negative sign and consider only the numerical value
of the elasticity. Thus if a 1% change in price leads to 2% change in quantity demanded of good A and 4% change in
quantity demanded of good B, then we get elasticity of A and B as 2 and 4 respectively, showing that demand for B is
more elastic or responsive to price changes than that of A. Had we considered minus signs, we would have concluded that
the demand for A is more elastic than that for B, which is not correct. Hence, by convention, we take the absolute value
of price elasticity and draw conclusions

Self-Test A (Problem Solving Skill)

There is 50% change in QD and 25% Change in Price. Calculate Price elasticity

Self-Test B (Problem solving Skill)

Calculate the Price elasticity when price changed from Rs.10 to Rs.15 and Quantity changed to 100 to 50

Self-Test C (Problem solving Skill)

Yesterday, the price of envelopes was $3 a box, and Julie was willing to buy 10 boxes. Today, the price has gone up to
$3.75 a box, and Julie is now willing to buy 8 boxes. Is Julie's demand for envelopes elastic or inelastic? What is Julie's
elasticity of demand?

Self-Test D (Problem solving Skill)

 If Neil's 58 | P a g e
elasticity of demand for hot dogs is constantly 0.9, and he buys 4 hot dogs when the price is $1.50 per hot dog, how many
will he buy when the price is $1.00 per hot dog?

TYPES OF PRICE ELASTICITY

1. Perfectly Elastic Demand

Definition: When a small change (rise or fall) in the price results in a large change (fall or rise) in the quantity demanded, it
is known as perfectly elastic demand. Under such type of elasticity of demand, a small rise in price results in a fall in
demand to zero, while a small fall in price causes an increase in demand to infinity. In such a case, the demand is perfectly
elastic or ep =∞. In perfectly elastic demand, the demand curve is represented as a horizontal straight line (in parallel to X-
axis)

2. Perfectly Inelastic Demand

Definition: When a change (rise or fall) in the price of a product does not bring any change (fall or rise) in the quantity
demanded, the demand is called perfectly inelastic demand.
In this case, the elasticity of demand is zero and represented as ep = 0.
Graphically, perfectly inelastic demand curve is represented as a vertical straight line (parallel to Y-axis). Figure shows the
perfectly inelastic demand curve.

3. Relatively Elastic Demand

Definition: When a proportionate or percentage change (fall or rise) in price results in greater than the proportionate or
percentage change (rise or fall) in quantity demanded, the demand is said to be relatively elastic demand. In other words,
a change in demand is greater than the change in price. Therefore, in this case, elasticity of demand is greater than 1 and
represented as ep > 1. The demand curve of relatively elastic demand is gradually sloping

4. Relatively Inelastic Demand

Relatively Inelastic Demand Definition: When a percentage or proportionate change (fall or rise) in price results in less
than the percentage or proportionate change (rise or fall) in demand, the demand is said to be relatively inelastic demand.
In other words, a change in demand is less than the change in price. Therefore, the elasticity of demand is less than 1 and
represented as ep < 1. The demand curve of relatively inelastic demand is rapidly sloping.

5. Unitary Elastic Demand

Definition: Unitary elastic demand occurs when a change (rise or fall) in price results in equivalent change (fall or rise) in
demand. The numerical value for unitary elastic demand is equal to one, i.e., ep =1. The demand curve for unitary elastic
demand is a rectangular hyperbola.

OTHER METHOD OF MEASURING ELASTICITY OF DEMAND

A. DERIVATIVE METHOD
 59 | P a g e
Algebraically Elasticity of demand at specific Point = -dq/dp x p/q
Where
• dq/dp is the derivative of quantity with respect to price at that point
• p – Price at that point
• q – Quantity demanded at that Point
Note: Point elasticity is, therefore, the product of price quantity ratio at a particular point on the demand curve and the
reciprocal of the slope of the demand line.

Self-Test – E (Problem solving Skill)

Demand Function is Qx = 150 – 5Px, Calculate Price elasticity at Rs. 5

B. GEOMETRIC METHOD
In point elasticity, we measure elasticity at a given point on a demand curve.
It is to be noted that elasticity is different at different points on the same demand curve. Given a straight line demand curve
tT, point elasticity at any point say R can be found by using the formula

Geometrically Ed at Point = Lower segment / Upper segment

Using the above formula we can get elasticity at various points on the demand curve.

Linear Demand Curve: Lower Segment /Upper Segment Curve

Non Linear Demand Curve: Lower segment of Tangent /Upper segment of Tangent

Elasticity of Demand at different points of Demand Curve

 60 | P a g e

Points Lower Formula E Elasticity

Upper Segment
segment = L/U

M 4 0 4/0 = ∞ E=∞

A 3 1 3/1 = 3 E>1

P 2 2 2/2 = 1 E=1

B 1 3 1/3 = E<1
0.33

N 0 4 0/4 = 0 E =0

Thus, we see that as we move from T towards t, elasticity goes on increasing. At the mid-point it is equal to one, at point t
it is infinity and at T it is zero.

C. ARC-ELASTICITY (AVERAGE ELASTICITY)

This is the third method of measuring the elasticity of demand. When the price change is somewhat larger or when price
elasticity is to be found between the two ‘prices [or two points on the demand curve say A and B], the question arise
which price and quantity should be taken as base. This is because elasticity found by using original price and quantity
figures as base will be different from the one derived by using new price and quantity figures.

Therefore, in order to avoid confusion, generally averages of the two prices and quantities are taken as (i.e. original and
new) base. The arc elasticity can he found out by using the formula:

Elasticity of demand = ∆Q (Q2-Q1) / ∆P (P2-P1) x P1+P2/Q1+Q2

Where p1, q1 are the original price and quantity and p2, q2 are the new ones.

Self-Test F (Problem Solving Skill)

If we have to find elasticity of radios between
P1 = Rs. 500 Q1 = 100
P2 = Rs. 400 Q2 = 150

D. TOTAL OUTLAY OR TOTAL EXPENDITURE METHOD:

The price elasticity of demand for a commodity and the total expenditure or outlay made on it is significantly related to
each other. As the total expenditure (price of the commodity multiplied by the quantity of that commodity purchased)
made on a commodity is the total revenue received by the seller (price of the commodity multiplied by quantity of that
commodity sold of that commodity), we can say that the price elasticity and total revenue received are closely related to
each other.
By 61 | P a g e
analysing the changes in total expenditure (or total revenue) in response to a change in the price of the commodity, we can
know the price elasticity of demand for it.

• Price Elasticity of demand equals one or Unity:

When, as a result of the change in price of a good, the total expenditure on the good or the total revenue received from
those good remains the same, the price elasticity for the good is equal to unity.
This is because the total expenditure made on the good can remain the same only if the proportional change in quantity
demanded is equal to the proportional change in price.
Thus, if there is a given percentage increase (or decrease) in the price of a good and if the price elasticity is unitary, total
expenditure of the buyer on the good or the total revenue received from it will remain unchanged.

Demand is said to be unitary elastic when the total expenditure on a product remains constant irrespective of price change.
Price Quantity demanded Total outlay
10 120 1200
15 80 1200
8 150 1200

• Price elasticity of demand is greater than unity:

When, as a result of increase in the price of a good, the total expenditure made on the good or the total revenue received
from that good falls or when as a result of decrease in price, the total expenditure made on the good or total revenue
received from that good increases, we say that price elasticity of demand is greater than unity.

The demand is said to be elastic when total expenditure on a product increases with a decrease in price and decreases with
an increase in price. See the following case.
Price Quantity demanded Total outlay
10 100 1000
15 60 900
8 200 1600

• Price elasticity of demand is less than unity:

When, as a result of increase in the price of a good, the total expenditure made on the good or the total revenue received
from that good increases or when as a result of decrease in its price, the total expenditure made on the good or the total
revenue received from that good falls, we say that the price elasticity of demand is less than unity.

According to this method the demand is said to be inelastic when total expenditure on a product increases with increase in
price and decreases with a decrease in price. See the following case.

Price Quantity demanded Total outlay

10 100 1000
15 90 1350
8 110 880
 62 | P a g e
The main
drawback of this method is that by using this we can only say whether the demand for a good is elastic or inelastic; we
cannot find out the exact coefficient of price elasticity.

Why should a business firm be concerned about elasticity of demand? The reason is that the degree of elasticity of
demand predicts how changes in the price of a good will affect the total revenue earned by the producers from the sale
of that good. The total revenue is defined as the total value of sales of a good or service. It is equal to the price multiplied
by the quantity sold.

Total Revenue
Total revenue (TR) = Price × Quantity sold
Except in the rare case of a good with perfectly elastic or perfectly inelastic demand, when a seller raises the price of a good,
there are two effects which act in opposite directions on revenue.
• Price effect: After a price increase (decrease), each unit sold sells at a higher (lower) price, which tends to raise (lower) the
revenue.

• Quantity effect: After a price increase (decrease), fewer (more) units are sold, which tends to lower (increase) the revenue.

What will be the net effect on total revenue? It depends on which effect is stronger. If the price effect which tends to
raise total revenue is the stronger of the two effects, then total revenue goes up. If the quantity effect, which tends to
reduce total revenue, is the stronger, then total revenue goes down.However method does not give exact measurement
of elasticity of demand.

FACTORS AFFECTING ELASTICITY THE PRICE ELASTICITY OF DEMAND

There are many factors which affect the price elasticity. They are known as determinants of elasticity of demand.

1. Nature of commodity:
For all basic needs such as milk, food, electricity, telephone, medicines etc. the demand is inelastic. While for various
comforts such as Washing machine, Refrigerators, etc. the demand is elastic.

2. Availability of substitutes:

One of the most important determinants of elasticity is the degree of availability of close substitutes. Some commodities
like butter, cabbage, Maruti, Coca Cola, have close substitutes — margarine, other green vegetables, Santro or other cars,
Pepsi or any other cold drink. A change in price of these commodities, the prices of the substitutes remaining constant,
can be expected to cause quite substantial substitution— a fall in price leading consumers to buy more of the commodity
in question and a rise in price leading consumers to buy more of the substitutes.

3. Position of a commodity in a consumer’s budget:

The greater the proportion of income spent on a commodity; generally the greater will be its elasticity of demand and
vice-versa. The demand for goods like common salt, matches, buttons, etc. tend to be highly inelastic because a
household spends only a fraction of its income on each of them. On the other hand, demand for goods like clothing, tends
to be elastic as households generally spend a good part of their income on clothing.

4. Storable or Perishable:
 If 63 | P a g e
product is storable e.g. soaps then the demand for it would be elastic. The buyers would buy more of them and stock
them at a low price. On the other hand the demand for perishable goods like green vegetables, milk, curd etc. would be
inelastic because they cannot be stored for a long period.

5. Number of uses to which a commodity can be put:

The more the possible uses of a commodity the greater will be its price elasticity and vice versa. To illustrate, milk has
several uses. If its price falls, it can be used for a variety of purposes like preparation of curd, cream, ghee and sweets.
But if its price increases, its use will be restricted only to essential purposes like feeding the children and sick persons.

6. The duration of time period:

The longer the time period one has, the more completely one can adjust. A homely example of the effect can be seen in
motoring habits. In response to a higher petrol price, one can, in the short run, make fewer trips by car. In the longer run
not only can one make fewer trips but he can purchase a car with a smaller engine capacity when the time comes for
replacing the existing one. Hence one’s demand for cars falls by a larger amount when one has made long term adjustment
to higher prices.

7. Consumer habits:

If a consumer is a habitual consumer of a commodity no matter how much its price change, the demand for the commodity
will be inelastic.

8. Tied demand:

The demand for those goods which are tied to others is normally inelastic as against those whose demand is of
autonomous nature. For example, the demand for car batteries. Even if the price of the batteries goes up, the carowners
will have to buy them to run their cars.

9. Price range:

Goods which are in very high range or in very low price range have inelastic demand but those in the middle range have
elastic demand.

10. Unavoidability of consumption:

There are many goods whose consumptions cannot be postponed to some future date even when their prices are high.
For example life-saving medicines. They are to be purchased compulsorily even at high prices. Naturally the demand for
them is found to be inelastic.

Self-test G (Observation and interpretation Skill)

In general what will be elasticity of demand for given product? Why? a.
Milk
b. Car
c. Tata Salt
d. Xerox Machine
e. Penthouse
 64 | P a g e
IMPORTANCE OF PRICE ELASTICITY OF DEMAND
Knowledge of the price elasticity of demand and the factors that may change it is of key importance to business managers
because it helps them recognise the effect of a price change on their total sales and revenues. Firms aim to maximise their
profits and their pricing strategy is highly decisive in attaining their goals. Knowledge of the price elasticity of demand for
the goods they sell helps them in arriving at an optimal pricing strategy.

If the demand for a firm’s product is relatively elastic, the managers need to recognize that lowering the price would
expand the volume of sales and result in an increase in total revenue. On the contrary, when the demand is elastic, they
have to be very cautious about increasing prices because a price increase will lead to a decline in total revenue as fall in
sales would be more than proportionate. If the firm finds that the demand for their product is relatively inelastic, the firm
may safely increase the price and thereby increase its total revenue as they can be assured of the fact that the fall in sales
on account of a price rise would be less than proportionate.

Knowledge of price elasticity of demand is important for governments while determining the prices of goods and services
provided by them, such as, transport and telecommunication. Further, it also helps the governments to understand the
nature of responsiveness of demand to increase in prices on account of additional taxes and the implications of such
responses on the tax revenues. Elasticity of demand explain

INCOME ELASTICITY OF DEMAND

Income elasticity of demand is the degree of responsiveness of quantity demanded of goods to a small change in the income
of consumers. In symbolic form,

Percentage Formula
Ey = % ∆Q /% ∆Y

Ratio Formula
Ey = ∆Q /∆Y x Y/Q

There is a useful relationship between income elasticity for a goods and proportion of income spent on it. The relationship
between the two is described in the following propositions:
• If the percentage change in quantity demanded is smaller than the percentage change in income then income elasticity for
the goods is less than one. Such goods are known as necessities.
• If the percentage change in quantity demanded is greater than the percentage change in income then the income elasticity
for the goods is greater than one. Such goods are known as luxury goods.
• If there is inverse relationship between the percentage changes in income and the percentage change in the quantity
demanded of a commodity the income elasticity of demand is said to be negative.
• If the percentage change in quantity demanded is the same as the percentage change in income then income elasticity for
the goods is equal to one.
• If there is no change in quantity demanded in response to the changes in income then the income elasticity of demand is
said to be zero

Commodity Income for Comment

Elasticity
household
 65 | P a g e
Wheat 5%/10% = 0.5(e<1) Since 0 < .5 < 1, wheat is a normal good and fulfils
a necessity.
TV 20%/10% = 2(e>1) Since 2 > 1, T.V. is a luxurious commodity.
Bajra (-2)%/10% =(-0.2) Since –0.2 < 0, Bajra is an inferior commodity in
the eyes of the household.
X 7%/7% =1 Since income elasticity is 1, X has unitary income
elasticity.
Button 0%/10% Buttons have zero income-elasticity

It is to be noted that the words luxury, necessity, inferior goods do not signify strict dictionary meanings here. In economic
theory we distinguish them in the manner shown above.

IMPORTANCE OF INCOME ELASTICITY

An important feature of income elasticity is that income elasticity differs in the short run and long run. For nearly all goods
and services the income elasticity of demand is larger in the long run than in the short run
Knowledge of income elasticity of demand is very useful for a business firm in estimating the future demand for its
products. Knowledge of income elasticity of demand helps firms measure the sensitivity of sales for a given product to
incomes in the economy and to predict the outcome of a business cycle on its market demand. For instance, if EY = 1,
sales move exactly in step with changes in income. If EY >1, sales are highly cyclical, that is, sales are sensitive to changes
in income. For an inferior good, sales are countercyclical, that is, sales move in the opposite direction of income and EY <
0. This knowledge enables the firm to carry out appropriate production planning and management

Self-Test H (Application and Interpretation skill)

Income elasticity of Demand
A car dealer sells new as well as used cars. Sales during the previous year were as follows;
Car type Price Quantity ( Nos)
New 6 .5 lakhs 400
Used 60,000 4000
During the previous year, other things remaining the same, the real incomes of the customers rose on average by 10%.
During the last year sales of new cars increased to 500, but sales of used cars declined to 3,850.

What is the income elasticity of demand for the new as well as used cars? What inference do you draw from these
measures of income elasticity?

CROSS ELASTICITY OF DEMAND

The cross elasticity of demand shows the relationship between the percentage change in quantity demanded of a
commodity X with reference to the percentage change in price of some other commodity Y. The formula for finding out
the cross elasticity of demand is as follows:

Percentage Formula
Ec = % ∆Q (X) /% ∆P (Y)

Ratio Formula
Ec = ∆Q (X) /∆P (Y) x P(Y) / Q(X)
Qx 66 | P a g e
stands
for original quantity demanded of X Qx stands
for change in quantity demanded of X Py stands
for the original price of good Y.
py stands for a small change in the price of Y.

Types of Cross Elasticity

When two goods are ordinary substitutes then the cross elasticity of demand would be positive. For example, Tea and
Coffee are substitutes. When there is an increase in the price of tea the consumers would buy less of tea and more of
coffee. Conversely when the price of tea falls people would buy more of tea and less of coffee. Thus there is a direct
relationship between the changes in the price of tea and the quantity demanded of coffee.

When two goods are complements then the cross elasticity of demand would be negative. For example, Car and Petrol.
When the price of car increases the demand for the cars would decrease and there would also be a decrease in the
quantity demanded of petrol. Likewise when there is decrease in the price of the car the demand for cars would increase
and also there would be an increase in the quantity demanded of petrol. Thus there is an inverse relationship between
the changes in the price of the car and the quantity demanded of the petrol

IMPORTANCE OF CROSS ELASTICITY

The concept of cross elasticity of demand is useful for a manager while making decisions regarding changing the prices of
his products which have substitutes and complements. If cross elasticity to change in the price of substitutes is greater
than 67 | P a g e one,
the firm
may lose by increasing the prices and gain by reducing the prices of his products. With proper knowledge of cross
elasticity, the firm can plan policies to safeguard against fluctuating prices of substitutes and complements.

Cross- price elasticity of demand

Self-Test I (Application Skill)

A shopkeeper sells only two brands of note books Imperial and Royal. It is observed that when the price of Imperial
raises by 10% the demand for Royal increases by 15%.What is the cross price elasticity for Royal against the price of
Imperial?

Self-Test J (Problem Solving skill)

The cross price elasticity between two goods X and Y is known to be - 0.8. If the price of good Y rises by 20%, how will the
demand for X change?

Self-Test k (Application skill)

The price of 1kg of tea is Rs 30. At this price 5kg of tea is demanded. If the price of coffee rises from Rs 25 to Rs 35 per kg,
the quantity demanded of tea rises from 5kg to 8kg. Find out the cross price elasticity of tea.

Self-Test L (Application and Interpretation skill)

The price of 1 kg of sugar is Rs 50. At this price 10 kg is demanded. If the price of tea falls from Rs 30 to Rs 25 per kg, the
consumption of sugar rises from 10 kg to 12 kg. Find out the cross price elasticity and comment on its value.

ADVERTISEMENT ELASTICITY
Advertisement elasticity of demand (sales) or promotional elasticity of demand is the responsiveness of a good’s demand to
changes in firm’s spending on advertising.

The advertising elasticity of demand measures the percentage change in demand that occurs given a one percent change
in advertising expenditure. Advertising elasticity measures the effectiveness of an advertisement campaign in bringing
about new sales.

Advertising elasticity of demand is generally positive.

Higher the value of advertising elasticity greater will be the responsiveness of demand to change in advertisement.
Advertisement elasticity varies between zero and infinity.

Formula of Aed:
Ea
Where
“Qd denotes change in demand.
“A denotes change in expenditure on advertisement.
 Qd 68 | P a g e
denotes initial demand.
A denotes initial expenditure on advertisement

Advertisement Elasticity
Elasticity Interpretation
Ea= o Demand does not respond to increase in advertisement expenditure.
0<Ea<1 Change in demand is less than proportionate to the change in advertisement expenditure
Ea =1 Demand changes in the same proportion in which advertisement expenditure changes
1<Ea<∞ Demand changes at a higher rate than change in advertisement expenditure

Case Scenario
Why the governments are inclined to raise the indirect taxes on those goods that have a relatively inelastic demand, such
as alcohol and tobacco products.

Biblography

For Detail study and further Reference

1. Gregory Mankiw principle of Economics
2. Bruce Flynn - Economics

CHAPTER 5 : DEMAND FORECASTING

Chapter Outline
• Meaning of demand forecasting
• Significance of demand forecasting
• Scope of demand forecasting
• Types of forecasts
• Types of demand distinction
• Factor affecting demand of various goods
• Methods of demand forecasting

MEANING OF DEMAND FORCASTING

Forecasting, in general, refers to knowing or measuring the status or nature of an event or variable before it occurs.
Forecasting of demand is the art and science of predicting the probable demand for a product or a service at some future
 date on 69 | P a g e the
basis of
certain past behaviour patterns of some related events and the prevailing trends in the present. It should be kept in mind
that demand forecasting is no simple guessing, but it refers to estimating demand scientifically and objectively on the
basis of certain facts and events relevant to forecasting Usefulness

SIGNIFICANCE OF DEMAND FORECASTING

The significance of demand or sales forecasting in the context of business policy decisions can hardly be over emphasized.
The effectiveness of the plans of business managers depends upon the level of accuracy with which future events can be
predicted. Forecasting of demand plays a vital role in the process of planning and decision-making, whether at the national
level or at the level of a firm. The importance of demand forecasting has increased all the more on account of mass
production and production in response to demand. A good forecast enables the firm to perform efficient business
planning. Forecasts offer information for budgetary planning and cost control in functional areas of finance and
accounting. Good forecasts help in efficient production planning, process selection, capacity planning, facility layout and
inventory management. A firm can plan production scheduling well in advance and obtain all necessary resources for
production such as inputs, and finances. Capital investments can be aligned to demand expectations and this will check
the possibility of overproduction and underproduction, excess of unused capacity and idle resources. Marketing relies on
sales forecasting in making key decisions. Demand forecasts also provide the necessary information for formulation of
suitable pricing and advertisement strategies.

It is said that no forecast is completely fool-proof and correct. However, the very process of forecasting helps in evaluating
various forces which affect demand and is in itself a reward because it enables the forecasting authority to know about
various forces relevant to the study of demand behaviour.

SCOPE OF FORECASTING

Demand forecasting can be at the international level depending upon the area of operation of the given economic
institution. It can also be confined to a given product or service supplied by a small firm in a local area. The scope of the
forecasting task will depend upon the area of operation of the firm in the present as well as what is proposed in future.
Much would depend upon the cost and time involved in relation to the benefit of the information acquired through the
study of demand. The necessary trade-o has to be struck between the cost of forecasting and the benefits owing from
such forecasting.

TYPES OF FORECASTS
• Macro-level forecasting deals with the general economic environment prevailing in the economy as measured by the Index
of Industrial Production (IIP), national income and general level of employment etc.
• Industry- level forecasting is concerned with the demand for the industry’s products as a whole. For example, demand for
cement in India.
• Firm- level forecasting refers to forecasting the demand for a particular firm’s product, say, and the demand for ACC cement.

Based on time period, demand forecasts may be short-term demand forecasting and long-term demand forecasting.
• Short-term demand forecasting covers a short span of time, depending of the nature of industry. It is done usually for six
months or less than one year and is generally useful in tactical decisions.
• Long-term forecasts are for longer periods of time, say two to five years and more. It provides information for major strategic
decisions of the firm such as expansion of plant capacity.
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DEMAND DISTINCTIONS

Business managers should have a clear understanding of the kind of demand which their products have. Before we
analyses the different methods of forecasting demand, it is important for us to understand the demand distinctions which
are as follows:

Producer’s goods and Consumer’s goods

Producer’s goods are those which are used for the production of other goods - either consumer goods or producer goods
themselves. Examples of such goods are machines, plant and equipment. Consumer’s goods are those which are used for
final consumption. Examples of consumer’s goods are readymade clothes, prepared food, residential houses, etc.

Durable goods and Non-durable goods

Goods may be further sub-divided into durable and non-durable goods. Non-durable goods are those which cannot be
consumed more than once. Raw materials, fuel and power, packing items etc are examples of non-durable producer
goods. Beverages, bread, milk etc are examples of non-durable consumer goods. These will meet only the current
demand. On the other hand, durable goods do not quickly wear out, can be consumed more than once and yield utility
over a period of time. Examples of durable consumer goods are: cars, refrigerators and mobile phones. Building, plant
and machinery, o ce furniture etc are durable producer goods. The demand for durable goods is likely to be derived
demand. Further, there are semi-durable goods such as, clothes and umbrella.

Derived demand and Autonomous demand

The demand for a commodity that arises because of the demand for some other commodity called ‘parent product’, ‘is
called derived demand. For example, the demand for cement is derived demand, being directly related to building activity.
In general, the demand for producer goods or industrial inputs is derived demand. Also the demand for complementary
goods is derived demand. If the demand for a product is independent of the demand for other goods, then it is called
autonomous demand. It arises on its own out of an innate desire of the consumer to consume or to possess the
commodity. But this distinction is purely arbitrary and it is very di cult to and out which product is entirely independent
of other products.

Demand for firm’s product and industry demand

The term industry demand is used to denote the total demand for the products of a particular industry, e.g. the total
demand for steel in the country. On the other hand, the demand for firm’s product denotes the demand for the products
of a particular firm, i.e. the quantity that a firm can dispose of at a given price over a period of time. E.g. demand for steel
produced by the Tata Iron and Steel Company. The demand for a firm’s product when expressed as a percentage of
industry demand signifies the market share of the rm.

Short-run demand and Long-run demand

This distinction is based on time period. Short-run demand refers to demand with its immediate reaction to changes in
product price and prices of related commodities, income fluctuations, ability of the consumer to adjust their consumption
pattern, their susceptibility to advertisement of new products etc. Long-run demand refers to demand which exists over
 a long 71 | P a g e
period.
Most generic goods have long- term demand. Long term demand depends on longterm income trends, availability of
substitutes, credit facilities etc. In short, long-run demand is that which will ultimately exist as a result of changes in
pricing, promotion or product improvement, after enough time is allowed to let the market adjust to the new situation.
For example, if electricity rates are reduced, in the short run, the existing users will make greater use of electric appliances.
In the long-run, more and more people will be induced to use electric appliances.

The above distinction is important because each of these goods exhibit distinctive characteristics which should be taken into
account while analyzing demand for them.

Self-test A (Observation Skill)

State the 3 real world examples of firms demand and industry demand Self-test
B (Observation skill)

State the 3 real world examples of producers goods and consumer goods

FACTORS AFFECTING DEMAND FOR VARIOUS GOODS

A. Factors affecting demand for non-durable consumer goods:

There are three basic factors which influence the demand for these goods:
• Disposable income: Other things being equal, the demand for a commodity depends upon the disposable income of the
household. Disposable income is found out by deducting personal taxes from personal income.
• Price: Other things being equal, the demand for a commodity depends upon its own price and the prices of related goods
(its substitutes and complements). While the demand for a good is inversely related to its own price and the price of its
complements, it is positively related to the price of its substitutes.
• Demography: This involves the characteristics of the population, human as well as non-human, using the product
concerned. For example, it may pertain to the number and characteristics of children in a study of demand for toys and
characteristics of automobiles in a study of the demand for tyres or petrol.
Non-durables are purchased for current consumption only. From a business firm’s point of view, demand for nondurable
goods gets repeated depending on the nature of the non-durable goods. Usually, non-durable goods come in wide
varieties and there is competition among the sellers to acquire and retain customer loyalty.

B. Factors affecting the demand for durable-consumer goods:

Demand for durable goods has certain special characteristics. Following are the important factors that affect the demand
for durable goods.
A consumer can postpone the replacement of durable goods. Whether a consumer will go on using the good for a long
time or will replace it depends upon factors like his social status, prestige, level of money income, rate of obsolescence
etc.
• These goods require special facilities for their use e.g. roads for automobiles, and electricity for refrigerators and radios.
The existence and growth of such factors is an important variable that determines the demand for durable goods
• As consumer durables are used by more than one person, the decision to purchase may be influenced by family
characteristics like income of the family, size, age distribution and sex composition. Likely changes in the number of
households should be considered while determining the market size of durable goods.
 72 | P a g e
• Replacement demand is an important component of the total demand for durables. Greater the current holdings of
durable goods, greater will be the replacement demand. Therefore, all factors that determine replacement demand
should be considered as a determinant of the demand for durable goods.
• Demand for consumer durables is very much influenced by their prices and credit facilities available to buy them.

C. Factors affecting the demand for producer goods:

Since producers’ goods or capital goods help in further production, the demand for them is derived demand, derived from
the demand of consumer goods they produce. The demand for them depends upon the rate of profitability of user
industry and the size of the market of the user industries. Hence data required for estimating demand for producer goods
(capital goods) are:
1. Growth prospects of the user industries;
2. Norms of consumption of capital goods per unit of installed capacity.

An increase in the price of a substitutable factor of production, say labour, is likely to increase the demand for capital
goods. On the contrary, an increase in the price of a factor which is complementary may cause a decrease in the demand
for capital.

Higher the profit making prospects, greater will be the inducement to demand capital goods. If firms are optimistic about
selling a higher output in future, they will have greater incentive to invest in producer goods. Advances in technology
enabling higher efficiency at reduced cost on account of higher productivity of capital will have a positive impact on
investment in capital goods. Investments in producer goods will be greater when lower interest rates prevail as firms will
have lower opportunity cost of investments and lower cost of borrowing.

Self-test C (Observation Skill)

State important 3 factors affecting demand for cars

Self-test d (Observation Skill)

State important 3 factors affecting demand for power loom machine

METHODS OF DEMAND FORECASTING

There is no easy method or simple formula which enables an individual or a business to predict the future with certainty
or to escape the hard process of thinking. The firm has to apply a proper mix of judgment and scientific formulae in order
to correctly predict the future demand for a product. The following are the commonly available techniques of demand
forecasting:

A. SURVEY OF BUYERS’ INTENTIONS:

The most direct method of estimating demand in the short run is to ask customers what they are planning to buy during
the forthcoming time period, usually a year. This method involves direct interview of potential customers. Depending on
the purpose, time available and costs to be incurred, the survey may be conducted by any of the following methods:
• Complete enumeration method where nearly all potential customers are interviewed about their future purchase plans
• Sample survey method under which only a scientifically chosen sample of potential customers are interviewed
• End– 73 | P a g e use
method, especially used in forecasting demand for inputs, involves identification of all final users, fixing suitable technical
norms of consumption of the product under study, application of the norms to the desired or targeted levels of output and
aggregation.

Thus, under this method the burden of forecasting is put on the customers. However, it would not be wise to depend
wholly on the buyers’ estimates and they should be used cautiously in the light of the seller’s own judgement. A number
of biases may creep into the surveys. The customers may themselves misjudge their

requirements, may mislead the surveyors or their plans may alter due to various factors which are not identified or
visualised at the time of the survey. This method is useful when bulk of sale is made to industrial producers who generally
have definite future plans. In the case of household customers, this method may not prove very helpful for several reasons
viz. irregularity in customers’ buying intentions, their inability to foresee their choice when faced with multiple
alternatives, and the possibility that the buyers’ plans may not be real, but only wishful thinking.

B. COLLECTIVE OPINION METHOD:

This method is also known as sales force opinion method or grass roots approach. Firms having a wide network of sales
personnel can use the knowledge, experience and skills of the sales force to forecast future demand. Under this method,
salesmen are required to estimate expected sales in their respective territories. The rationale of this method is that
salesmen being closest to the customers are likely to have the most intimate feel of the reactions of customers to changes
in the market. These estimates of salesmen are consolidated to find out the total estimated sales. These estimates are
reviewed to eliminate the bias of optimism on the part of some salesmen and pessimism on the part of others. These
revised estimates are further examined in the light of factors like proposed changes in selling prices, product designs and
advertisement programmes, expected changes in competition and changes in secular forces like purchasing power,
income distribution, employment, population, etc. The final sales forecast would emerge after these factors have been
taken into account.

Although this method is simple and based on firsthand information of those who are directly connected with sales, it is
subjective as personal opinions can possibly influence the forecast. Moreover salesmen may be unaware of the broader
economic changes which may have profound impact on future demand. Therefore, forecasting could be useful in the
short run, for long run analysis however, a better technique is to be applied.

C. EXPERT OPINION METHOD:

In general, professional market experts and consultants have specialised knowledge about the numerous variables that
affect demand. This, coupled with their varied experience, enables them to provide reasonably reliable estimates of
probable demand in future. Information is elicited from them through appropriately structured unbiased tools of data
collection such as interviews and questionnaires.

The Delphi technique, developed by Olaf Helmer at the Rand Corporation of the USA, provides a useful way to obtain
informed judgments from diverse experts by avoiding the disadvantages of conventional panel meetings. Under this
method, instead of depending upon the opinions of buyers and salesmen, firms solicit the opinion of specialists or experts
through a series of carefully designed questionnaires. Experts are asked to provide forecasts and reasons for their
forecasts. Experts are provided with information and opinion feedbacks of others at different rounds without revealing
the identity of the opinion provider. These opinions are then exchanged among the various experts and the process goes
on until convergence of opinions is arrived at. This method is best suited in circumstances where intractable changes are
occurring and the relevant knowledge is distributed among experts. Delphi technique is widely accepted due to its broader
applicability and ability to address complex questions. It also has the advantages of speed and cheapness.
 74 | P a g e

D. STATISTICAL METHODS:

Statistical methods have proved to be very useful in forecasting demand. Forecasts using statistical methods are
considered as superior methods because they are more scientific, reliable and free from subjectivity. The important
statistical methods of demand forecasting are:

Trend Projection method : This method, also known classical method, is considered as a ‘naive’ approach to demand
forecasting. A firm which has been in existence for a reasonably long time would have accumulated considerable data on
sales pertaining to di erent time periods. Such data, when arranged chronologically, yield a ‘time series’. The time series
relating to sales represent the past pattern of e ective demand for a particular product. Such data can be used to project
the trend of the time series. The trend projection method assumes that factors responsible for the past trend in demand
will continue to operate in the same manner and to the same extent as they did in the past in determining the magnitude
and direction of demand in future. The popular techniques of trend projection based on time series data are;

• Graphical Method : This method, also known as ‘free hand projection method’ is the simplest and least expensive. This
involves plotting of the time series data on a graph paper and tting a free-hand curve to it passing through as many points
as possible. The direction of the curve shows the trend. This curve is extended into the future for deriving the forecasts.
The direction of this free hand curve shows the trend. The main draw-back of this method is that it may show the trend
but the projections made through this method are not very reliable.

• Fitting trend equation: Least Square Method: It is a mathematical procedure for fitting a line to a set of observed data
points in such a manner that the sum of the squared differences between the calculated and observed value is minimized.
This technique is used to find a trend line which best t the available data. This trend is then used to project the dependant
variable in the future. This method is very popular because it is simple and inexpensive. Moreover, the trend method
provides fairly reliable estimates of future demand.

The least square method is based on the assumption that the past rate of change of the variable under study will continue
in the future. The forecast based on this method may be considered reliable only for the period during which this
assumption holds. The major limitation of this method is that it cannot be used where trend is cyclical with sharp turning
points of troughs and peaks. Also, this method cannot be used for short term forecasts.

Regression analysis:

This is the most popular method of forecasting demand. Under this method, a relationship is established between the
quantity demanded (dependent variable) and the independent variables (explanatory variables) such as income, price of
the good, prices of related goods etc. Once the relationship is established, we derive regression equation assuming the
relationship to be linear. The equation will be of the form Y = a + bX. There could also be a curvilinear relationship between
the dependent and independent variables. Once the regression equation is derived, the value of Y i.e. quantity demanded
can be estimated for any given value of X.
E. 75 | P a g e
CONTROLLED EXPERIMENTS:

Under this method, future demand is estimated by conducting market studies and experiments on consumer behaviour
under actual, though controlled, market conditions. This method is also known as market experiment method. An e ort is
made to vary separately certain determinants of demand which can be manipulated, for example, price, advertising, etc.,
and conduct the experiments assuming that the other factors would remain constant. Thus, the effect of demand
determinants like price, advertisement, packaging, etc., on sales can be assessed by either varying them over different
markets or by varying them over different time periods in the same market. The responses of demand to such changes
over a period of time are recorded and are used for assessing the future demand for the product. For example, different
prices would be associated with different sales and on that basis the price-quantity relationship is estimated in the form
of regression equation and used for forecasting purposes. It should be noted however, that the market divisions here
must be homogeneous with regard to income, tastes, etc.

The method of controlled experiments is used relatively less because this method of demand forecasting is expensive as
well as time consuming. Moreover, controlled experiments are risky too because they may lead to unfavourable reactions
from dealers, consumers and competitors. It is also di cult to determine what conditions should be taken as constant and
what factors should be regarded as variable so as to segregate and measure their influence on demand. Besides, it is
practically di cult to satisfy the condition of homogeneity of markets.

Market experiments can also be replaced by ‘controlled laboratory experiments’ or ‘consumer clinics’ under which
consumers are given a specified sum of money and asked to spend in a store on goods with varying prices, packages,
displays etc. The responses of the consumers are studied and used for demand forecasting

F. BAROMETRIC METHOD OF FORECASTING:

The various methods suggested till now are related with the product concerned. These methods are based on past
experience and try to project the past into the future. Such projection is not effective where there are economic ups and
downs. As mentioned above, the projection of trend cannot indicate the turning point from slump to recovery or from
boom to recession. Therefore, in order to nd out these turning points, it is necessary to find out the general behaviour of
the economy. Just as meteorologists use the barometer to forecast weather, the economists use economic indicators to
forecast trends in business activities. This information is then used to forecast demand prospects of a product, though
not the actual quantity demanded. For this purpose, an index of relevant economic indicators is constructed. Movements
in these indicators are used as basis for forecasting the likely economic environment in the near future. There are leading
indicators, coincidental indicators and lagging indicators. The leading indicators move up or down ahead of some other
series. For example, the heavy advance orders for capital goods give an advance indication of economic prosperity. The
lagging indicators follow a change after some time lag. The heavy household electrical connections confirm the fact that
heavy construction work was undertaken during the past with a lag of some time. The coincidental indicators, however,
move up and down simultaneously with the level of economic activities. For example, rate of unemployment

Self-test E (Application Skill)

Which method will be more useful for demand forecasting of producers goods? Why

Self-test F (Application Skill)

In an economy facing huge business cycle which demand forecasting is useful
 76 | P a g e
Self- test G
(Observation Skills)
Give three indicators which is useful for barometric demand forecasting

Bibliography

For Detail study and further Reference

1. Gregory Mankiw principle of Economics
2. Bruce Flynn - Economics

B.COM (ENTREPRENEURSHIP)
Semester I

Unit 3
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Table of Contents

CHAPTER 6 PRODUCTION ANALYSIS ....................................................................................................................... 3

CHAPTER 7 COST ANALYSIS ..................................................................................................................................... 32

CHAPTER 6 : PRODUCTION ANALYSIS

Chapter Outline
• Meaning of production
• Production function
• Short run and Long run Production Function
• Law of variable proportion
• Law of return to scale
• Isoquant and Isocost
• Producer Equilibrium
• Expansion and Ridge Lines

PRODUCTION
Production is a very important economic activity. In common parlance, the term ‘production’ is used to indicate an activity
of making something material. The growing of wheat, rice or any other agricultural crop by farmers and manufacturing of
cement, radio-sets, wool, machinery or any other industrial product is often referred to as production.

In Economics the word ‘production’ is used in a wider sense to denote the process by which man utilises resources such
as men, material, capital, time etc. working upon them to transform them into commodities and services so as to make
them satisfy human wants. In other words, production is any economic activity which converts inputs into outputs which
are capable of satisfying human wants. Whether it is making of material goods or providing a service, it is included in
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production provided it satisfies the wants of some people. Therefore, in Economics, activities such as making of cloth by
an industrial worker, the services of the retailer who delivers it to consumers, the work of doctors, lawyers, teachers,
actors, dancers, etc. are production.

Note 1:

It should be noted that production should not be taken to mean as creation of matter because, according to the
fundamental law of science, man cannot create matter. What a man can do is only to create or add utility to things that
already exist in nature. Production can also be de need as creation or addition of utility. For example, when a carpenter
produces a table, he does not create the matter of which the wood is composed of; he only transforms wood into a table.
By doing so, he adds utility to wood which did not have utility before

Note 2:

It should be noted that the production process need not necessarily involve conversion of physical inputs into physical
output but also involves intangible inputs to produce intangible output. For example, production of services such as those
of lawyers, doctors, musicians, consultants etc.

Note 3:

Production does not include work done within a household by anyone out of love and affection, voluntary services and goods
produced for self-consumption. Intention to exchange in the market is an essential component of production

Self-Test – A (Observation Skill)

Is the act of selling goods by retailer a production activity yes or no? Explain

Self-Test- B (Observation Skill)

Does an act of dancing as a personal hobby act of production yes or no? Explain

PRODUCTION FUNCTION
The production function is a statement of the relationship between a firm’s scarce resources (i.e. its inputs) and the output
that results from the use of these resources. More specifically, it states technological relationship between inputs and
output.

The production function can be algebraically expressed in the form of an equation in which the output is the dependent
variable and inputs are the independent variables. The equation can be expressed as: Q = f (a, b, c, d …….n)
Where
• ‘Q’ stands for the rate of output of given commodity
• a, b, c, d…….n, are the different factors (inputs) and services used per unit of time.

Assumptions of Production Function:

There are three main assumptions underlying any production function.

1. First we assume that the relationship between inputs and outputs exists for a specific period of time. In other words, Q is
not a measure of accumulated output over time.
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2. Second, it is assumed that there is a given “state-of-the-art” in the production technology. Any innovation would cause
change in the relationship between the given inputs and their output. For example, use of robotics in manufacturing or a
more efficient software package for financial analysis would change the input-output relationship.
3. Third assumption is that whatever input combinations are included in a particular function, the output resulting from their
utilization is at the maximum level.

The production function can be defined as:

The relationship between the maximum amount of output that can be produced and the input required to make that
output. It is defined for a given state of technology i.e., the maximum amount of output that can be produced with given
quantities of inputs under a given state of technical knowledge. (Samuelson)
It can also be defined as the minimum quantities of various inputs that are required to yield a given quantity of output.

The output takes the form of volume of goods or services and the inputs are the different factors of production i.e., land,
labour, capital and enterprise. For the purpose of analysis, the whole array of inputs in the production function can be
reduced to two; L and K.

Restating the equation given above, we get:

Q = f (L, K).
Where Q = Output
L= Labour
K= Capital

Self-Test C (Observation Skill)

Assume that there is college which provide teaching service state what the inputs that are required for teaching

Self-Test – D (Observation Skill)

Explain the concept of production function and give two real life example of production function

SHORT RUN PRODUCTION FUNCTION VS. LONG RUN PRODUCTION FUNCTION

In economics, we study two types of production-functions. In other words, there are two kinds of input-output relations in
production-functions. These are:

Fixed Factors

The factor inputs which cannot be varied in the short-period, as and when required are called fixed factors. Examples
of Fixed Factors are: Plant, machinery, heavy equipment's, factory building, land etc.

Variable Factors

The factor inputs which can easily be varied, in the short-period as and when required, are called variable factors. Examples
of variable factors are: labor, raw material, power, fuel etc.

Note: The distinction between fixed factors and variable factors appears only in the short-period. In the long-run, all the
factors of production become variable factors.
 Short 80 | P a g e Period
or Short
Run Production Function
A period will be considered short-run period if the amount of at least one of the inputs used remains unchanged during that
period.
Thus, short-run production function shows the maximum amount of a good or service that can be produced by a set of
inputs, assuming that the amount of at least one of the inputs used remains unchanged.

Long Period or Long run Production Function

The production function can also be studied in the long run. The long run is a period of time (or planning horizon) in which
all factors of production are variable.
A long run production function shows the maximum quantity of a good or service that can be produced by a set of inputs,
assuming that the firm is free to vary the amount of all the inputs being used.

CONCEPT OF PRODUCT/ OUTPUT

Output is studied three key terms:-
1. Total Product - It refers to the total output of the firm per period of time
2. Average Product - Average Product is total output per unit of the variable input. Thus Average Product is total product
divided by the number of units of the variable factor.
AP = TP/QVF where TP is Total Product, QVF is the quantity of labour.
3. Marginal Product - Marginal Product is the change in total product resulting from using an additional unit of the variable
factor. MP = dTP/dQVF, where d is the rate of change

Fixed Factor (I) Variable Factor (I) MP(O) TP (O) AP(O)

5 1 5 5 5

5 2 9 14 7

5 3 16 30 10

5 4 26 56 14

5 5 19 75 15

5 6 15 90 15

5 7 8 98 14

5 8 4 102 12.8

5 9 0 102 11.3

5 10 -4 98 9.8
 81 | P a g e
Self-Test E (Problem Solving Skill)
Complete the following Table
Find out the missing number if this is short run
VF FF TP AP MP
1 10 200
2 450
3 750
4 1100
5 1350
6 1500
7 1550
8 1600
9 1600

Self-test F (Problem Solving Skill)

Complete the following Table
Find out the missing number if this is short run
VF FF TP AP MP
1 5 20 20.00
2 20
3 30
4 27.50
5 160
6 30.00
7 10
8 195
9 -10

LAW OF VARIABLE PROPORTION

Introduction
In the short run, the input output relations are studied with one variable input (labour) with all other inputs held constant.
The laws of production under these conditions are known under various names as the law of variable proportions (as the
behavior of output is studied by changing the proportion in which inputs are combined) the law of returns to a variable
input (as any change in output is taken as resulting from the additional variable input) or the law of diminishing returns
(as returns eventually diminish).

Statement
The law states that as we increase the quantity of one input which is combined with other fixed inputs, the marginal physical
productivity of the variable input must eventually decline.
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Assumption
The law operates under certain assumptions which are as follows:
1. Technology is assumed to be given and unchanged
2. Some inputs (that is at least one input) whose quantity is kept fixed
3. The law does not apply to those cases where the factors must be used in fixed proportions to yield output.
4. We consider only physical inputs and outputs and not economic profitability in monetary terms.

Production Schedule

FF VF MP TP AP Stage Law

4 1 5 5 5

4 2 9 14 7

4 3 16 30 10

4 4 26 56 14

4 5 19 75 15

4 6 15 90 15 Stage 1 Law of Increasing Returns

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4 7 8 98 14

4 8 4 102 12.8

4 9 0 102 11.3 Stage 2 Law of Diminishing Retur

ns

4 10 -4 98 9.8 Stage 3 Law of Negative Returns

 84 | P a g e
Diagrammatical Representation

Stage 1: The Stage of Increasing Returns:

In this stage, the total product increases at an increasing rate up to a point (in figure up to point F), marginal product also
rises and is maximum at the point corresponding to the point of inflexion and average product goes on rising. From point
F onwards during the stage one, the total product goes on rising but at a diminishing rate. Marginal product falls but is
positive. The stage 1 ends where the AP curve reaches its highest point.

Thus in the first stage, the AP curve rises throughout whereas the marginal product curve first rises and then starts falling
after reaching its maximum. It is to be noted that the marginal product although starts declining, remains greater than
the average product throughout the stage so that average product continues to rise.

Explanation of law of increasing returns: The law of increasing returns operates because
• Indivisibility of fixed factor
• Division of Labour and Specialization

Stage 2: Stage of Diminishing Returns:

In stage 2, the total product continues to increase at a diminishing rate until it reaches its maximum at point H, where the
second stage ends. In this stage, both marginal product and average product of the variable factor are diminishing but are
positive. At the end of this stage i.e., at point M (corresponding to the highest point H of the total product curve), the
marginal product of the variable factor is zero. Stage 2, is known as the stage of diminishing returns because both the
 85 | P a g e
average and marginal products of the variable factors continuously fall during this stage. This stage is very important
because the firm will seek to produce within its range.

Explanation of law of diminishing returns: The question arises as to why we get diminishing returns after a certain amount
of the variable factor has been added to the fixed quantity of that factor. It is because of
• Imperfect Substitute of labour and capital
• Indivisibility of Fixed factor

Stage 3: Stage of Negative Returns:

In Stage 3, total product declines, MP is negative, average product is diminishing. This stage is called the stage of negative
returns since the marginal product of the variable factor is negative during this stage.

Explanation the law of negative returns: As the amount of the variable factor continues to be increased to a constant
quantity of the other, a stage is reached when the total product declines and marginal product becomes negative. This is
because of
• Excessive variable factor compared to fixed factor

Stage of Operation:

An important question is in which stage a rational producer will seek to produce.

A rational producer will never produce in stage 3 where marginal product of the variable factor is negative. This being so,
a producer can always increase his output by reducing the amount of variable factor. Even if the variable factor is free of
cost, a rational producer stops before the beginning of the third stage.

A rational producer will also not produce in stage 1 as he will not be making the best use of the fixed factors and he will
not be utilizing fully the opportunities of increasing production by increasing the quantity of the variable factor whose
average product continues to rise throughout stage 1. Even if the fixed factor is free of cost in this stage, a rational
entrepreneur will continue adding more variable factors.

It is thus clear that a rational producer will never produce in stage 1 and stage 3. These stages are called stages of ‘economic
absurdity’ or ‘economic non-sense’.

A rational producer will always produce in stage 2 where both the marginal product and average product of the variable
factors are diminishing. At which particular point in this stage, the producer will decide to produce depends upon the
prices of factors. The optimum level of employment of the variable factor (here labour) will be determined by applying
the principle of marginalism in such a way that the marginal revenue product of labour is equal to the marginal wages.
(The principle of marginalism is explained in detail in the chapter discussing equilibrium in different types of markets.)

Economics in Practice

Learning about Growing Pineapples in Ghana

In the 1990s, an area of Ghana changed from an exclusive reliance on maize as the agricultural crop to the development
of pineapple farms.
The choice of how much fertilizer to use was highly dependent on how much fertilizer more successful neighbor farmers
used.
Social learning plays a role in the diffusion of technology.
Self- 86 | P a g e Test G
Thinking practically
In many high-tech firms, executives must sign non-compete agreements, preventing them from working for a
competitor after they stop working for their current firm. These agreements are much less common in mature
manufacturing firms. Why?

How Soon Should Preventive Maintenance Be Employed?

For a large-scale, plant-based industry the most important aspect is how gains can be realized in a competitive
environment. One crucial measure is to have better maintenance practices.
With more than one input, the optimal “technology” to use in manufacturing depends on costs and productivity of
maintenance services. Modern technology allows a modern manufacturing firm to observe and recognize the benefits
of maintenance services within a production department.

Self-Test H Thinking practically

Apart from those mentioned in this case, what other inputs and technological decisions do manufacturing firms have to
make to minimize its costs and, therefore, maximizes profits?

ISOQUANT AND ISOCOST

An isoquant shows various combinations of two factors that will enable a producer to produce a same level of output. In
other words, each point of an isoquant will represent a technology and as we move from one point to another on an
isoquant we switch across technologies.

An isoquant, therefore, depicts all the technological possibilities graphically and show a substitution between two factors
while keeping the output same.

As such, an isoquant represents one specific level of output or for each level of output there will be an isoquant. Following
text provides a few definitions of an isoquant.

Definitions of Isoquant:
An isoquant shows alternative combinations of the two factors, each of which enables to produce a same quantity of
output. Defining differently, an isoquant is the contour of all the combination of two factors that give rise to a same level
of output.

In the words of Cohen and Cyert, an Iso-product curve is a curve along which the maximum achievable production is
constant.
According to Salvatore, isoquant shows the different combinations of two inputs that a firm can use to produce a specific
quantity of output.

Table represents an isoquant schedule which shows different possible combinations of labour and capital to product 50
kilograms of tea.
 87 | P a g e

One can observe from the table that 50 kilograms of tea can be produced by any combination ranging from A to E. The
table further shows that as the producer uses more of one factor input, labour in the table, it reduces the use of other
factor. For example, moving from combination A to B, labour increases by one unit while capital decline by 15 units or
substituting 15 units of capital by one additional unit of labour.

This will be further explained under the concept of marginal rate of technical substitution (MRTS).

All these combinations are plotted in Figure-8.1 by taking labour on X-axis and capital on Y-axis. It provides a curve, the
isoquant, which is downward sloping and convex to the origin. It shows all the technically efficient alternative methods of
production facilitating production of the same 50 kilograms of tea. The level of output being same, the producer will be
indifferent across all the combinations on the isoquant. Hence, it is also named as producer’s indifference curve.

Characteristics of an Isoquant:

Basic characteristics of an isoquant are same as that of indifference; hence, they are discussed briefly with regard to an
isoquant below.

A. Slopes Downwards from Left to the Right:

An isoquant slopes downward from left to right or is negatively sloped, as can be seen from Figure-8.1. Such a shape
implies that if a firm employs more of labour, it will employ less of capital or vice versa, in order to maintain the level of
output.
 88 | P a g e
Such a shape
of isoquant also means that the marginal factor productivities are positive, that is more of a factor will make a positive
contribution in production and less of other factor will make a negative contribution.

To remain on the same isoquant or to maintain the same level of output, the positive and negative factor contributions
should be equal.

When we move from point A to B in Figure-8.1, labour contribution increases while that of capital will fall. Hence —

Only a downward sloping isoquant will satisfy such behavior since it only shows substitution of one factor with other. No
other shape of an isoquant, whether positively slopped or parallel to X-axis or parallel to Y-axis, will show such a feature.
Thus, an isoquant, in general, should slope downward from left to right.

B. Convex to the Point of Origin:

This characteristic of isoquant means that the producer is willing to sacrifice fewer and fewer units of capital for every
additional unit of labour and vice versa. It is depicted in Figure-8.2.

As we move down on the curve from point A to point F his willingness to sacrifice capital for every additional unit of labour
comes down from 5 to 1. As such —

Such behaviour of an isoquant is based on the principle of diminishing MRTS. No other shape of isoquant, whether
concave or a straight line, will show such a feature. In case of a concave isoquant the MRTS will be increasing while in case
of a straight line isoquant, it will be constant.
Both of which are logically incorrect because no producer will be willing to sacrifice a larger or same quantities,
respectively, of a factor for successively more of other if the marginal factor productivities are diminishing. Thus, an
isoquant will be, in general, convex to the point of origin.

C. A Higher Isoquant Denotes a Higher Level of Output:

 89 | P a g e
Another basic characteristic of an isoquant is that greater its distance from the point of origin, higher output level it will
represent. This is shown in Figure-8.3 where combination B on isoquant Q2 (OL2 + OK2) shows more of both factors as
compared to point A on isoquant Q1 (OL1 + OK1).

Given that marginal factor productivities across the entire length of an isoquant is positive, the point B should indicate a
higher level of output than that of point A. This shows that a higher isoquant will represent a higher level of output vis-a-
vis a lower isoquant.

D. Two Isoquants Never Intersect Each Other:

Two isoquants representing different levels of output can never intersect. If they do so, it will produce an absurd result.
To show this, we have drawn two isoquants Q1 (= 100 units) and Q2 (= 200 units) intersecting each other at point A in
Figure-8.4.

It means that at the point of intersection the factor combination, OK + OL can produce 100 units as well as 200 units of
output. Such a situation makes no sense as one factor combination can produce only one level of output.

Even at other points, two intersecting isoquants will produce absurd results which will make it impossible to decide which
one of them represents a higher level of output – a higher isoquant will show a higher level of output at one point and
lower 90 | P a g e
output at
other point. Similar will be the case on a lower isoquant. Hence, it can be concluded that isoquants will never intersect
with each other.

Isoquant Map:

An isoquant map, as shown in Figure-8.6, is a cluster of isoquants, each one of which represents production of a specific
quantity of output. As we move on an isoquant map, away from the point of origin or on a higher isoquant, it will show a
higher level of output. In other words, an isoquant closer to the point of origin will indicate a lower level of output. In the
figure, isoquant Q1 represents a lower level of output as compared to isoquant Q2 and Q3.

Self-Test I (Conceptual Skill)

State any 3 characteristic of isoquant

TYPES OF ISOQUANTS:

The isoquant may assume various shapes depending upon the degree of substitutability of factors.
While a smooth and convex isoquant is its normal shape, there are a few exceptional shapes as well, two of which are
discussed below:

Linear Isoquant:
This type of isoquant are depicted by a straight line sloping downward from left to right, as shown in Figure-8.6 (a). It
indicated a perfect and unlimited substitutability between two factors implying that the product may be produced even
by using only capital or labour or by infinite combinations of the two factors.
 91 | P a g e

Input-Output Isoquant:

Input-output isoquants are L-shaped curve [Figure-8.6 (b)] and also known as Leontief isoquants. They assume a perfect
complementary nature between factors implying zero substitutability. Factors are jointly used in a fixed proportion. It
means that there is only one method of production to produce a commodity. Hence, to increase output, both factors are
to be increased holding the proportion constant.

Self-Test J (Observation Skill)

Give 2 real life examples of right-angle isoquant

ISO-COST LINE:
The iso- 92 | P a g e cost
line shows
various possible combinations of the two factors which a producer can have given the factor prices and producer’s total
outlay.
An iso-cost line is the locus of all the combinations of two factors that a producer can procure from the market at the given
factor prices from a given amount of outlay.
An iso-cost line shows various possible combinations of the two factors which a producer can procure from the market at
the given factor prices from a given amount of outlay.

The iso-cost function in a two factor modal can be written as —

Firm’s total outlay = Payment to labour + Payment to capital Or,
C = w.L + r.K
Where, C is the total outlay incurred by the firm on the two factors; the w and L are the price of labour (or wage rate) and
number of labour units and, r and K are the price of capital (or interest rate) and number of capital units, respectively.

If the firm spends its entire outlay on labour, then —

C = w.L + r.0 = w.L or, L = C/w
If the firm spends its entire outlay on Capital, then — C
= w.0 + r.K = r.k or, K = C/r

Based on it, an iso-cost line can be drawn, as shown in Figure-8.7.

In the figure, labour is taken on X-axis as OL (= C/w) and capital on Y-axis as OK (= C/r), the maximum quantity of labour
and capital the firm can have. Joining points K and L by a straight line we get the iso-cost line which shows the
combinations of labour and capital that the firm can purchase at given factor prices. The slope of this line can be estimated
as —
OK/OL = (C/r)/(C/w) = w/r
In other words, slope of iso-cost line will be ratio of two factor prices (PL/PK).

Shift in the Iso-Cost Line:

An iso-cost line is drawn on two assumptions – First, at given total outlay of the firm and, second, at given factor prices.
Thus, an iso-cost line will shift either because of a change in total outlay or a change in factor prices.
 93 | P a g e
A change in total outlay will cause a parallel shift in the iso-cost line, as there will be no change in its slope, factor prices
being constant. If the total outlay increases, the iso-cost line will shift upward, away from the point of origin, and if the
total outlay decreases, the line will shift downward or towards the origin.

Both the types of shift have been shown in Figure-8.8 (a). The iso-cost line shifts in a parallel fashion from AB to CD when
total outlay increases and from AB to EF if it declines.

Change in Slope Iso-Cost Line:

A change in price of labour (wage rate) or capital (interest) or both will result into a change in the slope of the iso-cost line
making it flatter or steeper depending upon the nature of change in factor prices.

If the wage rate declines, for example, without any change in the interest rate or in the total outlay, the firm can buy more
of labour and, hence the iso-cost line will become flatter. Similarly, if labour becomes expensive the line will become
steeper. In the Figure 8.8 (b), the iso-cost line (AB) becomes flatter (AB1) when wage rate falls and becomes steeper (AB2)
when it rises.

In the same manner, slop of iso-cost line will change when interest rate changes and it may become steeper or flatter.
In the Figure 8.8 (c), the iso-cost line (AB) becomes flatter (A2B) when interest rate increases and becomes steeper (A1B)
when the interest rate falls.
 94 | P a g e

Self-Test K (Problem Solving Skill and Interpretation Skill)

Assuming that the budget of a producer is 10000 Rs and price of labour is Rs. 100 and Price of capital is 200
Develop the Equation and Graphical representation of Different Combination Calculate the slope
Find out X intercept and Y intercept
Considering the above Problem, state the effect on Budget line, Slope and Change in equation and X intercept and Y
intercept in the following Cases
• If the price of Labour changes to Rs. 200
• If the price of Labour changes to Rs. 50
• If the Price of Capital changes to Rs. 250
• If the Price of Capital Changes to Rs.100
• If the budget of producer increases from Rs. 10000 to Rs. 20000
• If the budget of producer decreases from Rs. 10000 to Rs. 5000 State the inferences and Conclusion you got from the
above exercise (You can use word and Excel for developing the diagram and Table)

MARGINAL RATE OF TECHNICAL SUBSTITUTION:

The marginal rate of technical substitution (MRTS) is the rate at which one input can be substituted for another input
without changing the level of output. In other words, the marginal rate of technical substitution of Labor (L) for Capital (K)
is the slope of an isoquant multiplied by -1.
Since the slope of an isoquant is moving down, the isoquant is given by –ΔK/ΔL. MRTS
= –ΔK/ΔL = Slope of the isoquant.

MRTS
Labor
Combinations Capital (K) (L for Output
(L)
K)

A 5 9 -- 100

B 10 6 3:5 100

C 15 4 2:5 100

D 20 3 1:5 100
 95 | P a g e
In the
above table, all the four factor combinations A, B, C and D produce the same level of 100 units of output. They are all
iso-product combinations. As we move from combination A to combination B, it is clear that 3 units of capital can be
replaced by 5 units of labor. Hence, MRTSLK is 3:5. In the third combination, 2 units of capital are substituted by 5 more
units of labor. Therefore, MRTSLK is 2:5.

In figure 1,
MRTSLK at point B = AE/EB
MRTSLK at point C = BF/FC
MRTSLK at point D = CG/GD

Self-Test L (Application Skill)

Calculate MRTS and state its interpretation on the basis of slope and curve of Isoquant
Labor
Combinations Capital (K) MRTS (L for K) Output
(L)

A 15 1 100

B 14 2 100

C 12 3 100

D 9 4 100

E 5 5 100

PRODUCER EQUILIBRIUM

It may try to minimise its cost for producing a given level of output or it may try to maximise the output for a given cost or
outlay. Suppose the firm has already decided about the level of output to be produced. Then the question is with which
factor combination the firm should try to produce the pre-decided level of output. The firm will try to use the least-cost
combination of factors.
The 96 | P a g e least
cost
combination of factors can be found by super-imposing the isoquant that represents the pre decided level of output on
the isocost lines. This is shown in Figure 4

Suppose the firm has decided to produce 1,000 units (represented by iso-quant P). These units can be produced by any
factor combination lying on P such as A, B, C, D, E, etc. The cost of producing 1,000 units would be minimum at the factor
combination represented by point C where the iso-cost line MM1 is tangent to the given isoquant P.

At all other points such as A, B, D, E the cost is more as these points lie on higher isocost lines Compared to MM1. Thus,
the factor combination represented by point C is the optimum combination for the producer. It represents the leastcost
of producing 1,000 units of output. It is thus clear that the tangency point of the given isoquant with an isocost line
represents the least cost combination of factors for producing a given output Producer Equilibrium
MPL/MPK =PK/PK

Self-test M (Problem Solving Skill)

Given the price of labour 400 and price of capital 200 and producer budget 10000, what will be the producer equilibrium?
Given the isoquant details of 5000 Q of production
Combination Labour Capital
A 12 1
B 8 2
C 5 3
D 3 4
E 2 5

EXPANSION PATH THEORY OF PRODUCTION

So far 97 | P a g e we
have
assumed away the expansion of financial resources of the firm. As the producer becomes financially well-off, he has to
change the factor combinations with the expansion of his output, given the factor prices.

In Fig. 7.12, AB, CD, EF and GH are the four iso- cost lines representing different levels of total cost or outlay. All iso-cost
lines are parallel to one-another indicating that prices of the two factors remain the same”. E1, E2, E3 and E4 are the
points of producer’s equilibrium corresponding to the point of tangencies of the above four iso- cost lines with the highest
possible isoquant in each case.

The line joining the least cost combinations like E1, E2, E3 and E4 is called the expansion path. It is so called, because, it
shows how for the given relative prices of the two inputs (the slope of factor price line), the optimal factor combinations
with which the producer plans it output will alter as he expands the volume of output.

Expansion path may be defined as the locus of efficient combinations of the factors (the points of tangency between the
isoquants and the iso-cost lines). It is the curve along which output or expenditure changes, when factor prices remain
constant.

Hence, the optimal proportion of the inputs will remain unchanged. It is also known as scale-line, as it shows how the
producer will change the quantities of the two factors, when it raises the scale of production.

The expansion path may have different shapes and slopes depending upon the relative prices of the factors used and
shape of the isoquant. In case of constant returns to scale (homogenous production function), the expansion path will be
a straight line through the origin, indicating constancy of the optimal proportion of the inputs of the firm, even with
changes in the size of the firm’s input budget. In short-run, however, the expansion path will be parallel to X-axis

As expansion path depicts least cost combinations for different levels of output, it shows the cheapest way of producing
each output, given the relative prices of the factors. It is difficult to tell precisely the particular point of expansion path
at which the producer in fact be producing, unless one knows the output which he wants to produce or the size of the
cost or outlay it wants to incur.

But, this much is certain that though for a given isoquant map, there can be different expansion paths for different relative
prices of the factors. Yet, when prices of the variable factors are given, a rational producer will always try to produce at
one or the other point of the expansion path.
 Self- 98 | P a g e test N
(Conceptual Skill)
What is expansion path? Explain how expansion path can be used for planning

LAW OF RETURNS TO SCALE

In the long- run the dichotomy between fixed factor and variable factor ceases. In other words, in the long-run all factors
are variable. The law of returns to scale examines the relationship between output and the scale of inputs in the long-run
when all the inputs are increased in the same proportion.

Assumptions
This law is based on the following assumptions:
1. All the factors of production (such as land, labor and capital) but organization are variable
2. The law assumes constant technological state. It means that there is no change in technology during the time considered.
3. The market is perfectly competitive.
4. Outputs or returns are measured in physical terms.

Three phases of returns to scale

There are three phases of returns in the long-run which may be separately described as (1) the law of increasing returns (2)
the law of constant returns and (3) the law of decreasing returns.
Depending on whether the proportionate change in output equals, exceeds, or falls short of the proportionate change in
both the inputs, a production function is classified as showing constant, increasing or decreasing returns to scale. Let us
take a numerical example to explain the behavior of the law of returns to scale.

Total
Unit Scale of Production Marginal Returns
Returns

1 1 Labor + 2 Acres of Land 4 4 (Stage I - Increasing Returns)

2 2 Labor + 4 Acres of Land 10 6

3 3 Labor + 6 Acres of Land 18 8

4 4 Labor + 8 Acres of Land 28 10 (Stage II - Constant Returns)

5 5 Labor + 10 Acres of Land 38 10

6 6 Labor + 12 Acres of Land 48 10

7 7 Labor + 14 Acres of Land 56 8 (Stage III - Decreasing Returns)

8 8 Labor + 16 Acres of Land 62 6

The data of table 1 can be represented in the form of figure 1

 99 | P a g e

RS = Returns to scale curve

RP = Segment; increasing returns to scale
PQ = segment; constant returns to scale
QS = segment; decreasing returns to scale

Increasing Returns to Scale:

When the change in output is more than in proportion to the equi-proportional change in all the factors of production,
then the operating law is called the increasing returns to scale. Thus, the rate of increase in output is faster than the
increase in factors of production.

The distance between various iso-product curves decreases on the expansion path or scale line then the increasing returns
to scale will operate. It reveals that the increase in output in the same proportion requires fewer ratios of labour and
capital. Thus, output increases more than in proportion to the units of factors of production employed under this law. It
can be explained with the help of Diagram 9.

Capital and labour are shown on OY-axis and OX-axis respectively. IP, IP1, IP2 and IP3 are different iso-product curves
showing different levels of output, viz., 10 units, 20 units, 30 units and 40 units. The distance between successive
isoproduct curves diminishes as output is expanded by increasing the scale.

The distance OE>EE1>E1E2>E2E3 which reveals that for equal increase in output, firm has to employ less and less amount
of labour and capital.
 10 | P a g e
0

Causes of Operating the Law:

The increasing returns to scale operate on account of the following causes or reasons:

(i) Indivisibilities of Inputs: There are some factors of production which are indivisible. Indivisibility means that they are
available in a given shape or they cannot be divided into small pieces. Machine, managers, research, finance and
marketing are such examples of individualities. With the increase in the scale of production the efficiency increases and
the output increases more than in proportion to the change in inputs.

(ii) Division of Labour and Specialization: When the scale of production is increased the division of labour and
specialization is introduced. A process of production is divided into sub-processes and each process is completed by each
group of workers and at the same time the specialist are appointed for different departments, viz., finance manager,
marketing manager, personnel manager, purchasing manager and so on and so forth. Their services lead to increase in
the production and the increasing returns to scale operates.

(iii) Dimensional Efficiency: Increasing returns to scale is the result of operating dimensional efficiency in a business firm
which is on account of the large size. The size increases the efficiency of all inputs and the increasing returns operates.
Thus the investment in capital assets after a point will increase the output due to increased dimension of efficiency.

(iv) Economies of Large Scale: When the scale of production is increased the internal and external economies of scale
will operate and on account of it the increasing returns to scale will also operate.
Internal economies are on account of firm’s size and organization while external economies are caused by the
concentration and localization of industries. All these economies lead to increase in output more than in proportion to
the change in the ratio of two inputs.

2. Constant Returns to Scale: When the output of a firm increases in the same proportion in which the change in inputs
takes place the law is called constant returns to scale. The proportion of two inputs remains constant. When all isoproduct
curves showing the same level of output have the equal distance between them on the expansion path or scale line, the
law operating is called constant returns to scale. It is explained with the following diagram:
 10 | P a g e
1

Capital and labour are shown on OY-axis and OX-axis respectively. IP, IP1, IP2 and IP3 are different iso-product curves
showing different levels of output, viz., 10 units, 20 units, 30 units and 40 units.

The distance between iso-product curves is indicated by E, E1, E2 and E3. The distance on scale line (OP) are equal. OE =
EE1 = E1E2 = E2E3. The distance between all iso-product curves remains constant which reveal that the production
increases in the same proportion in which inputs are changed.
Hence, it is constant returns to scale. This law operates at the point where neither the internal and external economies nor
internal and external diseconomies are enjoyed by the firm during long period.

A production function showing constant returns to scale is often called ‘linear and homogeneous’ or ‘homogeneous of the
first degree.’ For example, the Cobb-Douglas production function is a linear and homogeneous production function.

3. Diminishing Returns to Scale:

When proportionate change in output is less than the proportionate change in all the factors of production their (inputs)
ratio being equal, the diminishing returns to scale will operate. The distance between various iso-product curves on the
scale line increases because for getting the same level of output we have to employ more of all inputs. It is explained with
the help of the following diagram:
 102 | P a g e

Labour and capital are employed on OX-axis an OY-axis. OP is the scale line on which E, E1, E2 and E3 different isoproduct
curves are showing different levels of output. The distance between these curves are increasing on the scale line which
show that we have to employ more of inputs and the resultant output is less than in proportion to the change in inputs.
OE<EE1<E1E2<E2E3 which show the diminishing returns to scale.

Causes of Operating the Law:

The diminishing returns to scale operate on account of the following reasons:

(i) Diseconomies of Large Scale: When the scale of production is increased the internal and external diseconomies of
scale operate. On account of these diseconomies the output increases less than in proportion to the change in the inputs
and the diminishing returns to scale operates.

(ii) Delay in Decision-Making and Its Implementation: With the size of scale of production the decisions are taken at
different levels of management. Delay in decision-making and its implementation lead to increase in output less than in
proportion to the change in all variable inputs. Pressure from top management, red-tapism and diseconomies of
managerial skill lead to diminishing returns to scale.

(iii) Managerial Inefficiency: With the increase in the size and scale of production in the long period the management
becomes a complicated process. It results into managerial inefficiency leading to operation of diminishing returns to scale.
 103 | P a g e

(iv) Industrial Unrest: With the increase in the size and scale of production the number of workers increases. There will
be political affiliation of trade unions leading to strikes, lockouts, go slow tactics, gheraos, etc. These labour problems are
not easily solved by the management. It adversely affects the production of individual firms or industries and diminishing
returns to scale operates.

(v) Entrepreneur not Variable: Entrepreneur is one of the factors of production. He is neither variable nor divisible input.
In practice he is fixed and indivisible input and on account of change in other variable inputs the ratio under the large
scale leads to imbalances and the law of diminishing returns to scale operates.

(vi) Over-Exploitation of Scarce Inputs: When the scale of production is increased and some of the scarce inputs are
exploited to unlimited extent the increase in output is less in proportion to change in all inputs during long period and
diminishing return to scale operates.

Variation in Returns to Scale: We have explained the various phases or stages of returns to scale when the long run
production function operates. It is revealed in practice that with the increase in the scale of production the firm gets the
operation of increasing returns to scale and thereafter constant returns to scale and ultimately the diminishing returns to
scale operates. These varying returns to scale or phases of returns to scale can be seen from Diagram 12.
 104 | P a g e

The above diagram shows varying returns to scale, namely, increasing returns to scale, constant returns to scale and
diminishing returns to scale. Capital and labour are shown on OY-axis and OX-axis respectively. IP to IP9 are different iso-
product curves showing different levels of output. E to E8 are different points on the scale line (OP) showing the different
distances among the product curves.
From OE to OE2 the increasing returns to scale is operating while from E3 to E5 the constant returns to scale operates and
the last phase of production is the diminishing returns to scale from E6 to E8 on the scale line

Self test O (Conceptual Skill)

Draw a diagrammatical representation and explain three returns to scale with the help of isoquant curve
 105 | P a g e

7: Cost Analysis
• Chapter Outline
• Concept of Cost
• Cost function
• Short Run Cost function
• Long run Cost function
• Economies and Diseconomies of Scale of Production
• Internal Economies and External Economies

CONCEPT OF COST
Real Cost: The term “real cost of production” refers to the physical quantities of various factors used in producing a
commodity. In other-words—Real cost signifies the aggregate of real productive resources absorbed in the production of
a commodity or a service.

Marshall has described “real cost” as the production of a commodity generally requires many different kinds of labour and
the use of capital in many forms.

The exertions of all the different kinds of labour that are directly or indirectly involved in making it, together with the
abstinences or rather the waiting’s required for saving the capital used in making it ; all these efforts and sacrifices
together will be called the real cost of production of a commodity. Further, he had said that the real cost of production
connotes the toil, trouble and sacrifice of factors in producing a commodity.
Thus, the Marshallian concept of real cost has only a philosophical significance. In practice, however it is difficult to
measure it. It has little significance in the analysis of price determination although more significance from the social point
of view.
The main difficulty with this concept is that the efforts and sacrifices implicit in the real cost of production and purely
subjective and cannot be subjective to accurate monetary measurement Prof. Handerson and Quant have observed that
“the real cost leads us into the quagmire of unreality and dubious hypothesis.”

Opportunity Cost: The opportunity cost is also known as ‘transfer cost’ or ‘alternate cost’.
Prof. Lipsey has defined it as “the opportunity cost of using any factor is what is currently forgone by using it.”
Whereas Mrs. Joan Robinson has defined opportunity cost in terms of transfer cost. According to her, ‘The price which is
necessary to retain a given unit of factor in a certain industry may be called its transfer earning or transfer price.” The
utility of the study of opportunity cost lies in the theory of production. The factor must be paid at least that price which
they are able to obtain in the alternate use. If the opportunity cost in another field is more the labour will shift from one
industry to those industries where transfer earning is more. But the main drawback of this concept is that it is not
applicable to a specific factor i.e., a factor which can be put to single use. Since the factor is a single use factor, it can have
no alternative or opportunity cost.

Money Cost: ‘Money Cost’ is the monetary expenditure on inputs of various kinds. It is that total money expenses incurred
by a firm in producing a commodity. They include wages and salaries of labour; cost of raw-material, expenditure on
machines and equipment, depreciation and obsolescence charges on machines building and other

capital goods; rent on building; interest on capital invested and borrowed ; normal profits of business, expenses on power,
light, fuel, advertisement and transportation, insurance charges and all types of taxes.
 106 | P a g e
The money cost includes both:
(a) Implicit Costs
(b) Explicit Costs
(a) Explicit Costs: This includes those payments which are made by the producer to those factors of production which
do not belong to the producer himself. These costs are mostly in the nature of contractual payment made by the producer
to the owner of those factors whose services were bought by him for the purpose of production, e.g., the payment made
for raw- materials, power, light, fuel the wages and salaries paid to the workers and other staff, the rent paid on the land
and the interest paid on the borrowed capital etc. Payments on all such accounts will be included in explicit cost.

(b) Implicit Costs: Implicit costs are also known as imputed costs. These costs arise in the case of those factors which are
possessed and supplied by the producer himself. Here we cannot assign exact money value but can term them in imputed
values, e.g., a producer may contribute his own building or premises for running the business, his own capital and working
also as Managing Director of the firm.
As such he is entitled to get rent on his own premises, interest on capital contributed by him and also salary for his work as
Managing Director. All these items will be included in the implicit costs.
Difference between the Explicit and Implicit Costs:
1. Difference between the two is that the former can be measured in terms of money value, whereas the latter is in terms
of imputed values.
2. The former is contractual payment whereas the second is the price paid to himself.

Accounting costs: It account only for the explicit costs incurred in conducting a business and not the implicit costs. The
explicit costs include the direct costs to the company, such as employee wages, utility bills (water, electricity, etc.), raw
material cost, premises cost, transportation and storage costs, etc. Since these are expenses for which bills or receipts are
available, such costs can be objectively verified. In fact, accountants only account for accounting costs in the financial
statement of the company. Since these expenses are already incurred, accounting costs are backward looking.

Economic cost: It account for both explicit and implicit costs. Implicit costs is the opportunity cost in terms of revenue
lost by forgoing the next best alternative, say renting out premises instead of conducting the business there. Implicit costs
do not appear on the financial statements and are not objectively verifiable, since there can be a number of alternative
to any given course of action. Implicit costs are forward looking, since they include what if (say, we rented out the premises
for next year instead of using it to conduct the business) scenario.

Self-Test A (Application and Problem Solving Skill)

Faris has been working for 22,000 Rs. /year. He saved Rs in a bank which pays him Rs dinars/year as interest. His manager
pays him 5,000 Rs. /year for his entrepreneurial abilities.
Faris decided to open a firm for his own in a store that he owns and have been renting for 5,000 Rs./year. After a year
his total revenues were 120,000 Rs. while he paid 40,000 Rs. for materials and 5,000 Rs. for utilities. Faris employed a
clerk to help him working in the store for 18,000 Rs. Determine Faris’s Accounting Profits and Economic Profits.

Self-Test B (Application and Problem Solving Skill)

Farmer McDonald gives banjo lessons for $20 an hour. One day, he spends 10 hours planting $100 worth of seeds on his
farm.
• What opportunity cost has he incurred?
• What cost would his accountant measure?
• If these seeds will yield $200 worth of crops, does McDonald earn an accounting profit?
• Does he earn an economic profit?
 107 | P a g e

Self-test C (Application and Problem Solving Skill)

Jack takes $300,000 of his savings out of the bank to buy a pizza restaurant. In
his first year:
Revenues = $200,000
Explicit Costs (wages and materials) = $150,000
Depreciation of equipment = $5,000
Lost interest (his money would otherwise stay in the bank and earn 2% interest) = $6,000 Lost income (he otherwise would
be working as a teacher) = $50,000
• Calculate Jack Accounting Cost and Accounting Profit, Economic cost and Economic profit.
• State what you infer by comparing accounting profit and economic profit

Production Costs: Production costs have been called as the total amount of money spent in the production of goods. They
include the cost of raw materials and freight thereon, the costs of manufacture, i.e., the wages of workers engaged in the
manufacture of the commodity and salaries of the manager and other office staff including those of peons etc.
They also include and cover other overheads expenses like—rent, interest on capital, taxes, insurance and other incidental
expenses like—cost of repairs and replacements. They include both prime costs and supplementary costs.

Selling Costs: Selling costs are the costs of marketing, advertisement and salesmanship. These costs are incurred to attract
customers, expand market and capture more business and retain the existing business. These costs are the essential costs
of the competitive economy.
They are especially important in the case of imperfect competition in which goods are not identical but substitutes. The
manufacturers resort to what is called product differentiation in order to change the demand curve of a particular seller
to his advantage.
Selling costs are an important aspect of an imperfect market and have no place in a fully competitive market where the
dealers are supposed to be fully aware of the quality of the goods and the conditions of the market.

Private Cost: Private cost refers to the cost of production incurred and provided for by an individual firm engaged in the
production of a commodity. It is found out to get private profits.
This cost has nothing to do with the society. It includes both explicit as well as implicit cost. A firm is interested in minimising
private cost.

Social Cost: Social cost refers to the cost of producing a commodity to the society as a whole. It takes into consideration
all those costs, which are borne by the society directly or indirectly. Social cost is not borne by the firm. It is rather passed
on to persons not involved in the activity in the direct way. Social cost is a much broader concept. It is found out to get
social profits rather than private profits. The production of a commodity by a firm generates advantages (benefits) as well
as disadvantages (cost) to other members of society, called external benefits and external costs respectively.
These benefits are available free of cost. For instance, to facilitate easier movement of raw materials and finished
products, a producer constructs a road, linking it with a highway. This road may be used by others, who will not pay for
the benefits derived. On the similar lines, no producer compensates others for the costs incurred to them as a result of
his production.
Water pollution caused by the disposal of wastes into a river (or sea) or air pollution and consequent health hazards by the
smoke generation by factories or buses plying in big cities are some other examples.
Noise pollution and accident proneness are some other social costs due to rising traffic in big cities. While computing social
costs, market prices of goods and factor of production are adjusted as social and shadow prices.
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Social cost is the sum of private cost and external cost. Alternatively, external cost is the difference between social cost
and private cost, which may be positive or negative. If social cost is more than private cost, there is an external cost (or.
negative externality). On the other hand, if social cost is less than private cost, there is an external benefit (or positive
externality).
Social cost is an important concept. Knowledge of social cost and social benefit is extremely important in the efficient
utilisation of limited resources. The concept of social cost can be linked with opportunity cost to which we now turn

Self-Test D (Observation Skill)

State what will the external cost, Private Cost and Social Cost attached to Manufacturing of Car

Self-Test C (Observation Skill)

Give any three real life example of external Cost attached to production of any Commodity

Fixed and Variable Costs: Cost refer to the prices paid to the factors of production, we find prices paid to fixed factors,
and the prices paid to the variable factors which are termed as the fixed costs and the variable costs respectively. Thus,
the cost of production of a commodity is composed of two types of costs, i.e., Variable Costs and Fixed Costs, also called
Prime and Supplementary Costs respectively.

Fixed Costs or Supplementary Costs: Fixed Costs or Supplementary Costs are the amount spent by the firm on fixed
inputs in the short-run. Fixed costs are those costs which remain constant, irrespective of the level of output. These costs
remain unchanged even if the output of the firm is nil. Fixed costs, therefore, are known as “Supplementary Costs” or
“Overhead Costs”. Fixed Costs, in the short-run, remain fixed because the firm does not change its size and the amount
of fixed factors employed.

Fixed or Supplementary Costs usually include:

1. Payments of rent for the building,
2. Interest paid on capital,
3. Insurance premiums,
4. Depreciation and maintenance allowances,
5. Administrative expenses—Salaries of managerial and office staff etc.,
6. Property and business taxes, licence fees etc.
These costs are overhead costs in the sense that they are to be incurred even if the firm is closed down temporarily and
the current production is nil. Further, they do not change as the output increases. Thus, fixed costs are also referred to as
“Unavoidable Contractual Costs” which occur even if there is no output. In brief, the costs incurred on the business plant
are called fixed costs.
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Variable cost: Variable costs are costs that are a function of output in the production period. For example, wages of casual
labourers and cost of raw materials and cost of all other inputs that vary with output are variable costs. Variable costs
vary directly and sometimes proportionately with output. Over certain ranges of production, they may vary less or more
than proportionately depending on the utilization of fixed facilities and resources during the production process

COST FUNCTION
Cost function refers to the mathematical relation between cost of a product and the various determinants of costs. Cost
Function expresses the relationship between costs and output. Cost functions are derived from actual cost data of the
firms and are presented through cost curves. The shape of the cost curves depends upon the cost function. Cost functions
are of two kinds: They are short-run cost functions and long-run cost functions.

COST-OUTPUT RELATION DURING SHORT RUN OR SHORT RUN COST CURVES

• Time element plays an important role in price determination of a firm. During short period two types of factors are
employed. One is fixed factor while others are variable factors of production.
• Fixed factor of production remains constant while with the increase in production, we can change variable inputs only
because time is short in which all the factors cannot be varied.
• Raw material, semi-finished material, unskilled labour, energy, etc., are variable inputs which can be changed during short
run. Machines, capital, infrastructure, salaries of managers and technical experts are included in fixed inputs. During short
period an individual firm can change variable factors of production according to requirements of production while fixed
factors of production cannot be changed.

The cost-output relation during short period can be studied with the help of short run cost curves based on short run costs
as given below:

A. SHORT RUN COSTS:

Short run total costs of a firm are of following types:

Total Fixed Cost (TFC): Those costs which remain constant when the output is zero as well as it is increasing are called
total fixed costs. Such costs are borne by the firm whether there is production or not. These costs are not concerned with
the production of a commodity. Plant, land and building, machinery, tools, equipment, implements, contractual rent,
insurance fee, maintenance cost, property tax, interest on the capital, manager’s salary, etc., are the items which are
included in total fixed costs.
These costs are borne even there is zero production during short period. The Table 1 show when production is zero the
total fixed cost is Rs. 100 and when it is 10 units even then it is Rs. 100. Hence, total fixed costs remain constant. These
costs are also known as supplementary costs, general costs, indirect costs and overhead costs.

Total Variable Costs (TVC): Those costs which vary with the production of a commodity during short period and they have
direct relation with the change in production. When production is zero these costs will be zero and when production
increases they will move in the same direction. These costs are incurred on raw material, direct wages and expenses on
energy or power. Variable costs are also called prune costs or direct costs. Total variable costs show an increasing trend
as shown in Diagram 1.
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Total Costs: Those costs which are incurred by a firm in the production of any commodity on the basis of total fixed cost and
total variable cost.
Total costs are calculated on the basis of the following formula:
Total cost (TC) = Total fixed cost (TFC) + Total variable cost (TVC)
Total costs change due to change in the total variable costs only during short period because total fixed costs (TFC) remain
constant.

Short run total costs can be seen from the following table:

The table reveals that total fixed cost remain constant when the production is zero while total variable cost is zero when
production is zero and it changes with the change in output and total cost is the aggregate of total fixed cost and total
variable cost.

Thus, total costs are the summation (aggregates) of total fixed costs and total variable costs. All these costs are related to
short run production.

The Diagram 2 shows TC, TFC and TVC. TFC is parallel to OX-axis and it remains constant whether production is zero or it
is 10 units. TVC starts from zero production where it is zero and goes on increasing with the increase in output. TC is the
total of TFC and TVC. When production is zero total cost is equal to TFC and it increases with increase in production. The
difference between TVC and TC is equivalent to TFC which remains constant.
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B. Average Costs or Per Unit Costs:

During short period average costs or per unit costs can be divided into following categories:
(1) Average fixed costs (AFC)
(2) Average variable costs (AVC)
(3) Average Costs (AC) (4) Marginal Cost (MC).

(1) Average Fixed Cost (AFC):

The average fixed cost is the total fixed cost divided by the volume of output. There is an inverse relation between output
and average fixed cost. With the increase in output average fixed cost decreases and with the decrease in output the
average fixed cost will increase. The shape of average fixed cost curve becomes rectangular hyperbola with the increase
in output.
It is calculated from the following formula:
AFC = TFC/Q
Q is volume of output AFC and TFC are average fixed cost and total fixed cost.

(2) Average Variable Cost (AVC):

The average variable cost is total variable cost divided by the volume of output. Average variable cost falls with the
increase in output, reaches at its minimum and then starts rising. By the operation of law of increasing returns the AVC
decreases, and by the operation of constant returns leads to constancy in AVC and the law of diminishing returns leads to
increase in AVC. The shape of AVC is U-shaped because of the operation of the laws of returns during short period. The
AVC is calculated by the formula given below:
AVC = TVC/Q
AVC and TVC are average variable cost and total variable cost while Q is the volume of output.

(3) Average Cost (AC):

Average cost is also called average total cost (ATC) during short period because it is the aggregate of AFC and AVC. AC can
be calculated from total cost (TC) divided by the volume of output or by aggregating AVC and AFC. The following is the
formula of calculating AC:
AC = TC/Q
AC and TC are average cost and total cost while Q is the volume of output. Another
formula for the calculation of AC is as given under:
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AC = AFC + AVC
The AC curve decreases with the increase in output and remains constant up to a point and thereafter it increases with the
increase in output. Its shape is U-shaped because of the operation of the laws of return during short period.

(4) Marginal Cost (MC):

It is an addition to total cost by producing an additional unit of output. It can be calculated as the change in total cost divided
by an additional unit change in the output.
The formula for its calculation is as given below:
MC = ΔTC/ΔQ MC=
TCn -TCn-1
MC is marginal cost, ΔTC is change in TC and ΔQ is change in the volume of output while TCn is the last value while TCn-1 is
the last but one value.
For example, if the total cost (TC) of 5 units of a commodity is Rs. 550 and 6 units of a commodity is Rs. 600, then the marginal
cost of 6th units is Rs. 50.

It can be calculated on the basis of the above formula as given under:

MC = ΔTC/ΔQ = 50/1 = 50 or Rs. 50
The MC cost changes with the change in AVC and it is independent of fixed cost. In the beginning the MC falls, reaches at
its minimum and thereafter continuously rises. MC is also U- shaped. The MC curve cuts the AC and AVC curves at their
minimum points.

The cost-output relation during short period can be seen from Table 2.
The table reveals the trends in total costs (TFC and TVC), average cost (AFC and TVC) and MC. TFC remains constant and
TVC goes on increasing and consequently TC is also increasing. AFC is decreasing, but it is positive. AVC decreases, remains
constant and thereafter increases. AC also decreases, remains constant and shows an increasing trend. MC increases,
remains constant and thereafter shows an increasing trend.
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On the basis of the Table 2 we can show the costs and output relation during short period in the following diagram:

The diagram shows AC, AFC, AVC and MC on OY-axis and units of output on OX-axis. AC, MC and AVC are U-shaped curves.
The U-shaped curves are on account of the operation of the laws of return during short period. AFC curve shows a decreasing
trend. MC curve passes through the minimum points of AC and AVC curves.

There is a close relationship between AC and MC as given below:

(1) AC and MC fall in the beginning but MC falls more rapidly than AC and MC is below AC or AC is greater than MC (AC>MC).
(2) When AC rises, MC also rises but it rises more rapidly than the AC and MC is greater than AC (MC>AC).
(3) When AC is minimum it is equal to AC. The MC curve cuts the AC curve at its minimum point.

The relation between AC and MC can be seen from the following diagram during short period:
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The diagram shows AC and MC on OY-axis and volume of output on OX-axis.

Self-Test E (Problem Solving Skill and Interpretation Skill)

Solve the given Case study

Labour (no. of Output

worker) (Pens in units) ATC AFC AVC MC
0 0
10 100
20 210
30 330
40 400
50 450
60 460

This the data available of X company whose in to manufacturing of pens, in order to manufacture pens a machine was
required whose rental value was 1000 Rs and labour as input were required which were paid 500 Rs per worker

a. From the given information calculate AC, MC, AVC and ATC (fill the data up to 2 decimal)
b. What is the shape of Average fixed cost? Why (2)
c. What is the shape of Average total cost? Why (2)
d. What is shape of Average variable cost? Why (2)
e. What is the shape of marginal cost? Why (2)
f. State the relationship between Average Cost and Marginal Cost (4)
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Self-Test F (Problem Solving Skill)
Suppose Honda’s total cost of producing 4 cars is $225 000 and its total cost of producing 5 cars is $250 000.
• What is the average total cost of producing 5 cars?
• What is the marginal cost of the fifth car?
• Draw the marginal-cost curve and the average-total-cost curve for a typical firm.

ECONOMICS IN PRACTICE
The Cost Structure of a Rock Concert: Welcome to New York For
a rock concert, the output is the number of seats.
The fixed costs are considerable: the cost of publicity, booking a stadium, instruments on stage, etc.
The variable costs are not zero, but they are low relative to fixed costs: additional tickets sold, and increased security,
etc.

Self-Test G Thinking Practically

Can you think of other products or services that have low marginal costs and high fixed costs and conversely?

COST-OUTPUT RELATION DURING LONG RUN OR LONG RUN COST CURVES

Long period gives sufficient time to business managers to change even the scale of production. All the factors of
production are variable. All the costs are variable costs and there is no fixed cost. The supply of goods can be adjusted to
their demands because scale of production and factors of production can be changed. In the long run we can study the
long run average cost curve and long run marginal cost curve.

Long Run Average Cost (LAC): In the long run, all the factors of production are variable and the firm has a variety of
choices to select the size of the plants and the factors of production to be employed. Various short run average cost curves
represent the various sizes of the plants available to a firm. We can get the long run average cost curve with the help of
all the short run average cost curves. The long run average cost curve envelopes all the short run average cost curves in
it. It is also called an ‘Envelope Curve’ or ‘Planning Curve’.

The long run average cost curve is also a flat U-shaped curve as shown in the following diagram:
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The diagram shows long run cost on OY-axis and output on OX-axis. SAC, SAC1, SAC2, SAC3 and SAC4 are short run average
cost curves which represent the different size of plants. LAC has been drawn by combining all those points of least cost of
producing the corresponding output. The least per unit cost of production is OQ, OQ1, OQ2, OQ3, OQ4, and OQ5
respectively.

Long Run Marginal Cost (LMC): The long run marginal cost is an addition to the long run total cost when an additional
unit of a commodity is produced. It is calculated as the short run marginal cost is calculated. Long run marginal cost curve
is also U-shaped but the fall and rise in the marginal cost curve is not sharp but it is gradual.

The LAC and LMC can be seen from the following diagram:

The diagram shows that LAC and LMC are shown on OY- axis while output is shown on OX-axis. The shape of LAC and LMC
are U-shaped. The relation between LAC and LMC is the same as is between short run average cost (SAC) and short run
marginal cost (SMC) curves. The LMC curve cuts the LAC curve from its minimum point.

Why LAC Curve is U-Shaped?

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In the short run SAC curve is U-shaped because the laws of return operate but in the long run LAC is also U-shaped because
the laws of return of scale operate, namely, law of increasing returns to scale, law of constant returns to scale and the
law of diminishing returns to scale.
As the level of output is expanded or scale of operation is increased by the large firm they will enjoy economies of scale
but if these firms produce beyond their installed capacity then they might get diseconomies of scale. Economies of scale
bring down the fall in unit cost and diseconomies results into rise in it.

ECONOMICS IN PRACTICE
The Long-Run Average Cost Curve: Flat or U-Shaped?
A long-run average cost curve was first drawn as the “envelope” of a series of short-run curves in 1931.
Jacob Viner drew the long-run curve through the minimum points of all the short-run average cost curves.

In 1986, Professor Herbert Simon of Carnegie-Mellon University explained that studies show that a firm’s cost curves are
not U-shaped but instead slope down to the right and then level off.

Self-Test H Thinking practically

Some have argued that even if long-run AC curves do eventually slope up, we would not likely see many firms operating
at this size. Why not?

ECONOMIES AND DISECONOMIES OF SCALE OF PRODUCTION

Economies of Scale of Production:
The term scale of production refers to the size of a firm. A small-sized firm yields lower output compared to a largesized
firm. This is because in the small-sized firm smaller amount of resources are combined while in a large-sized firm’s larger
amount of resources, huge finance and modern technologies are employed to obtain larger output.

For example, if a typical firm increases employment of all inputs by 12 per cent while output increases by more than 12
per cent, then the firm experiences economics of scale. Thus, the scale of production is connected with the size of a firm.

Economies of Scale—Internal and External: A firm may experience economies of scale if costs per unit of output fall as the
scale of production increases. Thus, by economies of scale we mean advantages in large scale production.

It also refers to the factors which cause average cost of production to decline as output rises or scale of production increases.

A. Marshall classified these economies of scale into two groups: Internal economies and external economies.

INTERNAL ECONOMIES
• Internal economies of production arise when the benefits or advantages of a firm’s expansion are enjoyed by the firm itself.
• Thus, internal economies accrue only to the individual firm by its own organizational ability and effort.
• These internal advantages reaped by a firm enable it to lower its average cost of production as its scale of production
increases. These are called internal because the scale economies are within the control of the firm.

EXTERNAL ECONOMIES
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• On the other hand, external economies arise when an increase in a firm’s expansion produces favourable effects on other
firms. In other words, benefits of increased production spread on other firms in the industry or in the region.
• Such economies arise because the development of an industry leads to the development of ancillary services or benefit to
all firms.
• Thus, external economies are available to all firms in the industry irrespective of their sizes. These are called external because
the scale economies are outside the control of the firm.

These two economies of scale result in a falling average cost as output rises. But there are some adverse repercussions on a
firm or on other firms. Such adverse or unfavorable effects are termed diseconomies of large scale production.

Economies of scale enjoyed by a firm or other firms within the industry or in a particular locality will sooner or later be
replaced by diseconomies of large scale production when average cost of producing a commodity, instead of declining,
tends to rise. Likewise, there are internal and external diseconomies.

Note:
Diseconomies of scale are not to be confused with diminishing returns to a variable input.

A. INTERNAL ECONOMIES OF SCALE:

These economies arise from within the firm itself as a result of its own decision to become big. As a result of becoming
bigger the firm which experiences internal economies of scale is a situation where an average cost per unit of production
continues to fall as output increase.

Therefore, the firm of course more efficient. There are six main categories of internal economies — technical economies,
financial economies, marketing economies, managerial economies, risk-bearing economies and welfare economies.
These arise due to internal efficiency and are enjoyed by a particular firm and not by others belonging to an industry.
These are internal to a firm and external to the industry.
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1. Technical economies:

This involves such advantages as the following:

(i) Increased specialization: The large establishment gives greater opportunities for the specialisation of human and
non-human factors, i.e., men and machines. In a large firm the production process can be broken down into many more
separate operations, workers can be assigned more specific tasks and it becomes possible to make continuous use of
highly specialised machinery and equipment. Small firms employing a few staff have less scope for division of labour.

(ii) Indivisibility: The large firm can afford to employ large and specialized machinery. Moreover, the firm has the large
output to fully occupy the machine over a long period of time and, therefore, it can be operated efficiently.
Indeed, some machines are indivisible in that they are only efficient if they are large in size, e.g., blast furnace used in a
steel plant. Small firms cannot afford to purchase these large and indivisible machines and do not produce sufficient
output to keep them fully occupied over a long period.

(iii) Increased dimensions: Larger machines sometimes cut costs per unit of output. This is because a larger machine can
cater for a much larger output but this may involve only a slightly greater cost. If one doubles the length, breadth and
height of a cube, the surface area is four times as great, and the volume eight times as great as the original. This simple
arithmetic principle accounts for the remarkable increase in the dimensions of such capital equipment in recent years.

For instance, a double-decker bus can carry twice the amount of passengers as a single-decker; yet only one extra worker
is required. Likewise, there are tremendous economies in case of Jumbo-jet compared with the previous and much small
generation of jets.

A large oil tanker may carry twice as much oil as a small tanker but needs only a few more workers to operate it. A modern
oil tanker of 480,000 ton is just twice the size of a 60,000 ton tanker in terms of length, width and height, and only four
times as large in terms of surface area.

But few, if any, more people will be required to operate it and it will not certainly require eight times the power to propel it
through the water. This is called the economy of increased dimensions.

(iv) Economies of linked processes: Large firms can afford to link certain processes which reduce average cost. For
instance, a large steel firm like TISCO can afford to have a rolling mill next to a steel mill. Thus, the steel is immediately
rolled flat while still hot, thus avoiding the need to reheat the steel sheet. This is called the economy of linked processes.

(v) The principle of multiples: A related advantage to linked processes is the principle of multiples. Most large firms make
use of a variety of machines, each carrying out a different operation. Each of these machines is supposed to have a
different capacity. The machine which prints books will operate at a much slower speed than the machine which presses
the books or the machine which binds it.
Similarly, the machine which moulds the blocks of chocolate will operate at a much slower speed than the machine which
wraps the blocks in silver paper. This means that a large firm can afford to make use of a variety of different machines
each having a different capacity. If machine X produces 20 units per hour and machine Y produces 5 units per hour then
for every one machine X the firm needs 4 Y machines to operate efficiently and at full capacity.

The large firm can afford to purchase a wide variety of machines and in such numbers that each machine is working to a
full capacity. But, for a small firm producing a small output a problem arises — it is not possible to obtain a balanced team
(or an optimum mix) of machines such that each machine is being fully utilised.
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(vi) Research: The large firm can afford to organise a research laboratory and employ scientists to develop new and better
techniques of producing the good. This is the essence of indivisible or lumpy inputs which are a source of increasing
returns to scale.

2. Financial Economies:
• The large (and well-known) firm can easily get large bank loans. This is because they can offer more security for the loan
than could a small firm. Moreover, the risk of default is also less in case of a large reputed firm. They sometimes get these
loans at lower rates of interest owing to confidence of the bank and other financial institutions in their ability to repay.
This, in its turn, is attributable to their greater selling potential and larger assets.

• Large firms can issue shares and debentures in the capital market. Most of the larger financial institutions like the
Industrial Finance Corporation of India or the Industrial Development Bank of India and the new issue market are not
structured to meet the financial needs of the smaller firm. Again, investors are more likely to have confidence in buying
these securities in a large company like the Tata Chemicals than in a small company like the Usha Martin Black or India
Linoleums.

• Finally, we may note that the terms on which funds can be borrowed are more favourable to the large-scale borrower
because the borrowing of money in large amounts, like the bulk purchase of raw materials, yields economies of scale. The
cost of borrowing external funds does not increase proportionately with the volume of loans.

3. Marketing Economies:

(i) Advertising: The large firm can afford to advertise on television and in newspapers and magazines. Indeed the firm
may produce so many related products that the brand name helps to advertise all of these different products. Although
many large firm can spend huge sums on advertising, their advertising costs per unit sold may well be less than those of
the small firm. It is so because one product often advertises the other. Dettol, for example, is an advertise dettol soap
and dettol cream.

(ii) Bulk purchase: The large firm can afford to buy in bulk. The large firm usually purchases raw materials in bulk and
succeeds in paying lower prices and enjoying special privileges (e.g., discounts) from the supplier.
Bulk buying enables a firm to obtain goods at lower prices and be able to dictate its requirements with regard to duality and
delivery much more effectively than the smaller firm.
The larger firm can afford to employ the services of specialised buyers who have the necessary knowledge and skill to buy
‘the right materials at the right time, at the right place’. Just as expert buying can be a great economy (i.e., costsaving
device) unwise buying can be costly.

(iii) Selling skills: The large firm has many advantages on the selling side also. For instance, the large firm can afford to
employ specialist sellers (and buyers) whose specialised skills can give it great economic advantages. Moreover, packing
and distribution costs are likely to be lower per unit of output as are transport, clerical and administration costs. It is
usually cheaper per unit of output to package and distribute 1,000 units than 100 units.

4. Managerial Economies: Specialists can be employed in every department of the large firm. Specialist buyers and sellers
can be employed. There will be specialists on transport, personnel and administration. So, Adam Smith’s principle of
division of labour can be applied to management, too. Managers can specialise in their own departments rather than
attempting to perform several different roles.
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5. Risk-bearing Economies: Large firms are better equipped to cope with the risks of doing business. They often stand to
benefit from the laws of averages or the laws of large numbers, because variations in orders from individual customers
and unexpected changes in customers’ demands will tend to offset each other when total sales are very large.

They will produce a wide variety of different goods and can face the situation where demand for a particular product
declines. Risk-reduction is achieved through diversification (which is the opposite of specialisation). Diversification is of two
types — product and market. The large firm is also better able to sell products in different regions of India and even to export
to other countries.

6. Welfare economies: Large firms can afford, more than small firms, to spend money on providing good working
conditions, canteens, social and leisure facilities for employees. This makes workers happy and therefore more
productive.
B. EXTERNAL ECONOMIES OF SCALE:
These are the economies which apply to the industry as a whole and each particular firm can enjoy these economies as
the industry expands. These are cost advantages which a firm may enjoy due to the fact that a large number of firms
carrying out similar activities are situated in close proximity to one another.

External economies may be divided into two broad categories:

(i) Pecuniary economies: These refer to savings in money outlays, technological conditions remaining unchanged. For
example, an expansion of the whole industry may lead to a significant increase in demand for a particular component,
whose prices, in turn, may fall because of internal economies of scale in its manufacture.

(ii) Technological economies: These result from increased technological efficiency, improvement in quality of inputs, etc.
These external economies are especially evident where the industry has concentrated in a particular area, e.g., textiles in
Bombay and Maharashtra, jute in West Bengal, tea in West Bengal and Assam. Since external economies of scale are often
associated with industries concentrated in particular areas they are sometimes referred to as the economies of
concentration.

External economies include the following advantages:

1. Regional specialisation of labour: The concentration of similar firms in any one area leads to the creation of a local
labour force skilled in the various techniques used in the industry. Local colleges introduce special training programmes
geared to the specific needs of the industry. This is why labour in a particular area often become skilled at a specific
occupation.
A firm in the area should have less of a problem in finding supplies of labour with the skills required. Such skills are handed
down from generation to generation and the expectation is that the child will follow the parent into a particular trade.
For instance, in the West Midlands (U.K.) a high percentage of the labour force is involved in engineering, almost as a
matter of routine.

2. Education: The type of education offered reinforces the industry which dominates the region. Schools, technical
colleges, polytechnics and universities will reflect the region’s industries. For instance, coal mining is especially important
in Dhanbad and this is reflected in the type of educational facilities provided, e.g., the School of Mines is noted for its
engineering department.

3. Commercial facilities: External economies also arise from the fact that the service industries in the area develop a
special knowledge of the needs of the particular industry and this often leads to the provision of specialised facilities.
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Specialised banking, marketing, insurance services will have grown up in the area to deal with the particular requirements
of the industry.
Transport firms often find it economical to develop special equipment (e.g., containers and vehicles) to deal with the
industry’s requirements Again, each firm derives cost advantage from the fact that the industry as a whole provides a
large demand for these services.

4. Ancillary services: Ancillary firms provide components and parts for other firms. Such ancillary (or subsidiary) firms
will exist and cater for the needs of the industry of the region. For instance, in and around Calcutta there are many firms
producing components for the engineering industry.
5. Transport: A good system of road, rail, air and sea links will be important to all firms in the area and they all share the
advantages of the adequate provision of these links. For instance, Mumbai has an airport and is very well-served by
motorways, sea and rail links.

6. Disintegration: When there is a high degree of concentration of an industry in a particular locality, there is an
automatic tendency for individual firms to specialise in a single process or in the manufacture of a single component. This
simply means that industries in this area become ‘disintegrated’ in many specialised activities. This very fact enables each
individual firm to enjoy cost advantages by being able to obtain its components and other requirements at a relatively
low cost because they are being mass produced for the industry.

7. Cooperation: Regional specialisation creates another advantage to the firms located in a particular area. It encourages
various types of co-operation among firms. For example, research centres are often established by firms in heavily
localised industries on a cost-sharing (or, joint venture) basis.
In this context Stanlake has rightly commented that, “The opportunities for formal and informal contacts between
members of the firm are much greater where the firms themselves are all in one locality.” The formation of trade
associations, export promotion councils, chambers of commerce and other pressure groups as also publication of trade
journals or news bulletins are all examples of such cooperation. These cooperative ventures are normally stimulated in
highly localised industries.

Conclusion:
In practice we observe that in some highly capital-intensive industries, like automobiles, petro-chemicals, oil exploration
and steel, the optimum size of the firm is very large (notwithstanding the inefficiencies that are likely to arise as the size
of the firm increases). The proximate reason seems to be that in such industries the technical economies are so great that
they more than offset any managerial and administrative diseconomies. This is why firms in such industries are getting
larger.

DISECONOMIES OF SCALE OF PRODUCTION:

Because of increasing size, a firm enjoys certain advantages. But, growing size can also bring certain disadvantages. This
means that as the volume of production increases with an increase in firm size, economies of scale yield place to
diseconomies of size.
No doubt the present trend in industry is towards the growth of large firms. But the bigger is not necessarily the better.
Various statistical studies in the USA and other industrially advanced countries on the corporate private sector have shown
that, in a large number of cases, increases in the scale of production have not yielded the expected benefits in the form
of greater industrial and commercial efficiency.

In fact, for each particular industry there will be some optimum size of the firm for which cost per unit (or average cost)
is minimum. If any firm grows beyond this optimum size, its efficiency will decline and cost per unit will rise. Like
economies of scale, diseconomies are of two types – internal and external.
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A. INTERNAL DISECONOMIES:
Internal diseconomies are unlikely to arise from purely technical reasons Greater division of labour and increased
specialisation, increased dimensions the principle of multiples, indivisibilities and so on should continue to offer certain
advantages which, individually or conjointly, should continue to offer potential reductions in per unit cost as the scale of
production increases.

A close look reveals that the major cause of diseconomies is management problems. It may be noted at the outset that
while the usage of land, labour and capital can be increased proportionately in the long run this may not be possible in
case of the fourth factor, viz., management ability’ even in the long run.
As Stanlake has rightly commented, “The entrepreneurial skills required to manage large enterprises are, it seems,
limited in supply so that it is often difficult to match the increase in the supply of other factors with a corresponding
increase in the supply of management ability.”
Another cause of diseconomies of large-scale of production is rise in the price of inputs.

Diseconomies of scale are usually classified into two categories:

(a) Pecuniary (which arise due to increase in prices of inputs caused by expansion in demand of firms which use them), and
(b) Technological (which arise out of higher input requirements per unit of output) these two causes may now be discussed.

1. Management Problems: There is no denying the fact that as the size of the firm increases, management problems (the
problem of co-ordination and control inside the factory) become more complex and assume serious proportions. It
becomes more and more difficult to perform the usual management functions of co-ordination, control, communication
and the maintenance of morale of the labour force (which conduces to higher factor productivity).

(i) Co-ordination: With an increase in the size of an organisation it becomes necessary to set up many specialised
departments (such as production planning, sales, purchasing, personnel, accounts, etc.) Over time these departments not
only multiply in numbers but grow in size as well. And it becomes increasingly difficult to coordinate the activities of these
departments.

(ii) Control: Management basically consists of two major functions- decision-making and carrying out (implementing) the
decisions. With an increase in the size of firm and in the work force it becomes more and more difficult to exercise control
over the subordinates, and to ensure that everyone is doing what he (she) is supposed to do and do it well. There is an
optimum span of control in every organisation (which indicates the maximum number of subordinates a superior can
control). If the actual number exceeds the optimum number there is likely to be a loss of control in the chain of command,
(i.e., in the organisation hierarchy). Even the adoption of Taylor’s scientific management principles cannot solve the
problem.

(iii) Communication: With an increase in the size of the firm there is breakdown of the two-way communication process
(i.e., passing orders from subordinates and receiving feedback from them). The reason is easy to find out. With an increase
in the number of employees it becomes really difficult, in practice, to keep everyone informed of what is required of him
(her) and on what is actually happening in the firm.

(iv) Morale: Perhaps the thorniest problem for organizations with large numbers of employees is the maintenance of
morale. With an increase in the size of the firm it becomes more and more difficult to develop in each worker in a labor
force of thousands a sense of involvement and belonging.
The workers fail to identify themselves with the organization and there is lack of harmony between their interest and the
overall organizational goal. Workers feel that they are alien to the organization. Since workers often regard the firm (or
the organization) with apathy and sometimes with hostility, the large organization often becomes a loose organization.
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2. Factor (Input) Prices: Rising factor prices also explain why growth in the size of the firm may lead to increasing cost per
unit as the size of the firm increases. As has been commented by Stanlake, “As the scale of production increases, the firm
will increase its demand for materials, labour, energy, transport and so on. It may, however, be difficult to obtain
increased supplies of some of these factors for example, skilled labour, or minerals from mines which are also working at
full capacity. In such cases a firm attempting to increase the scale of its production may find itself bidding up the prices of
some of its inputs”. The problem becomes more serious when all firms expand at the same time.

B. EXTERNAL DISECONOMIES:
Another cause of rising costs per unit with an increase in the size of the firm is rising price of factors of production. This is
an example of external diseconomy. This point may now be discussed.

Rising prices of inputs: When all firms attempt to expand at the same time factor prices like wages, cost of raw materials,
interest on loans, etc., tend to rise. In a highly localised industry, land for expansion will become increasingly scarce and
costly. Transport charges may also rise due to increased congestion created by increased deliveries, shipments, etc.
Similarly, expansion of a group of chemical firms located along a river bank may lead to increased discharge of affluent
into the river, thus increasing costs of cleaning and using water to firms located downstream. These are all reflected in
the cost of production of each firm belonging to the industry under consideration. So, what apparently seems good for
individual firm (i.e., output expansion) is not so in the ultimate analysis.

Conclusion:

The truth is that no clear-cut demarcation can be drawn between internal economies and external economies. It may be
noted that economies that are internal to a firm is external to other firms. An external economy, by definition, is a function
of the growth of an industry.
But, some of the external economies may be enjoyed by the smaller firms. The growth of a large industry may pave the
way for the growth of allied industries supplying spare parts and raw-materials to the large industry Thus laree industries
may benefit the small firm equally with the large one.
A given external economy may require internal reorganization of a farm which in its turn may lead to further internal
economies. D. Robertson has called them internal-external economies’. As they depend upon the size of Je firm they are
internal economies and they are external economies as they depend upon the size of the industry.

Self-test J (observation skill)

If Bombardier produces 9 jets per month, its long-run total cost is $9.0 million per month. If
it produces 10 jets per month, its long-run total cost is $9.5 million per month.
• Does Bombardier exhibit economies or diseconomies of scale?

ECONOMICS IN PRACTICE
Economies of Scale in the Search Business
Online search is a scale-driven business: The search behavior of one user can be used to improve the search of future
users.
Google—the top search engine—has more than three times the searches of Microsoft’s Bing but employs only about twice
as many engineers and spends less per search on its data centers.

Self-test J THINKING PRACTICALLY

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Google was an early pioneer in the search business. How did that early lead interact with the fact of scale economies in
Google’s favor?

Bibliography

For Detail study and further Reference

3. Gregory Mankiw principle of Economics
4. Bruce Flynn – Economics
5. Karl E. Case Ray C. Fair Sharon Oster

B.COM ENTREPRENEURSHIP

Semester I

Unit 4
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Table of Contents

CHAPTER 8 REVENUE ANALYSIS ...................................................................................................................... 3

CHAPTER 9 MARKET STRUCTURE ANALYSIS ........................................................................................................ 9
CHAPTER 10 ENTREPREUER INNOVATION THEORY .......................................................................................... 23
CHAPTER 11 TOOLS FOR ORGANIZATIONAL AND INVESTMENT ANALYSIS .............................. ... 28
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Chapter 8: Revenue Analysis

Chapter Outline

• Revenue Analysis
• Concept of revenue
• Relationship between TR,AR,MR and elasticity
• Objectives of Firm
• Profit Maximization

CONCEPTS OF TOTAL REVENUE, AVERAGE REVENUE AND MARGINAL REVENUE

Total Revenue:

If a firm sells 100 units for 10 each. It realizes ` 1,000 (100 x 10), which is nothing but the total revenue for the firm. Thus,
we may state that total revenue or the total expenditure incurred by the purchasers of the firm’s product refers to the
amount of money which a firm realizes by selling certain units of a commodity.

Symbolically, total revenue may be expressed as TR = P x Q.

Where, TR is total revenue
P is price
Q is quantity of a commodity sold.

This may be represented by the following diagrams. In figure A, when the product of the price is ` 30, the quantity sold is
40 units. The total revenue is P x Q = ` 1200.

Panel B shows the total revenue curve of a competitive firm having a perfectly elastic demand curve.

Since the firm can sell any quantity at market determined prices, the TR curve is linear and starts from the origin. The TR
curve of a firm which has a downward sloping demand curve is shown in figure

Average Revenue:
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Average revenue is the revenue earned per unit of output. It is nothing but price of one unit of output because price is always
per unit of a commodity. For this reason, average revenue curve is also the firms demand curve.

Symbolically, average revenue is:

AR = TR/Q
Where AR is average revenue
TR is the total revenue
Q is quantity of a commodity sold
Or AR = P ×QQ
Or AR = P

If, for example, a firm realizes total revenue of ` 1,000 by the sale of 100 units, it implies that the average revenue is ` 10
(1,000/100) or the firm has sold the commodity at a price of ` 10 per unit.

Marginal Revenue: Marginal revenue (MR) is the change in total revenue resulting from the sale of an additional unit of the
commodity.

Thus, if a seller realizes ` 1,000 while selling 100 units and ` 1,200 while selling 101 units, we say that the marginal revenue
is ` 200. We can say that MR is the rate of change in total revenue resulting from the sale of an additional unit of output.
MR = ∆TR/∆Q

Where MR is marginal revenue

TR is total revenue
Q is quantity of a commodity sold stands for a small change

For one unit change in output

MRn = TRn – TR n-1
Where TR is the total revenue when sales are at the rate of n units per period.
TR n-1 is the total revenue when sales are at the rate of (n – 1) units per period.

RELATIONSHIP BETWEEN AR, MR, TR AND PRICE ELASTICITY OF DEMAND

It is to be noted that marginal revenue, average revenue and price elasticity of demand are uniquely related to one another
through the formula:
MR = AR × e/e−1, Where e = price elasticity of demand
• Thus if e = 1, MR = AR × 1 −1/1 = 0
• if e >1, MR will be positive
• if e <1, MR will be negative
•
In a straight line downward falling demand curve, we know that the coefficient of price elasticity at the middle point is
equal to one. It follows that the marginal revenue corresponding to the middle point of the demand curve (or AR curve)
will be zero. On the upper portion of the demand curve, where the elasticity is more than one, marginal revenue will be
positive and on the lower portion of the demand curve where elasticity is less than one, marginal revenue will be negative.
These can be shown in diagram next page:
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In fig., DD is the AR or demand curve. At point C, elasticity is equal to one. Corresponding to C on the AR curve, the
marginal revenue is zero. Thus, MR curve is touching X-axis at N (corresponding to C on the AR curve). At a greater quantity
than ON, the elasticity of the AR curve is less than one and the marginal revenue is negative. Negative marginal revenue
means MR curve goes below the X-axis to the fourth quadrant. Marginal revenue being negative means that total revenue
will diminish if a quantity greater than ON is sold. Total revenue will be rising up to ON output since up to this the marginal
revenue remains positive. It follows that total revenue will be maximum where elasticity is equal to one. Thus, TR is shown
to be at its highest level at ON level of output (corresponding to the point C on AR curve). Beyond ON Level of output, the
TR curve has a negative slope.

Self-Test A
Calculate All Revenue
Price Quantity TR AR MR
10 100
8 200
6 300
4 400
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2 500

BEHAVIOURAL PRINCIPLES
Principle 1- A firm should not produce at all if its total variable costs are not met.
It is a matter of common sense that a firm should produce only if it will do better by producing than by not producing. The
firm always has the option of not producing at all. If a firm’s total revenues are not enough to make good even the total
variable costs, it is better for the firm to shut down.

In other words, a competitive firm should shut down if the price is below AVC. In that case, it will minimise loss because
then its total cost will be equal to its fixed costs and it will have an operating loss equal to its fixed cost. The sunk fixed
cost is irrelevant to the shutdown decision because fixed costs are already incurred. This means that the minimum average
variable cost is equal to the shut-down price, the price at which the firm ceases production in the short run.

Shutting down is temporary and does not necessarily mean going out of business If price (AR) is greater than minimum
AVC, but less than minimum ATC, the firm covers its variable cost and some but not all of fixed cost. If price is equal to
minimum ATC, the firm covers both fixed and variable costs and earns normal pro t or zero economic pro t. If price is
greater than minimum ATC the firm not only covers its full cost, but also earns positive economic pro t or super normal
profit

Principle 2 - The firm will be making maximum profits by expanding output to the level where marginal revenue is equal to
marginal cost.

In other words, it will pay the firm to go on producing additional units of output so long as the marginal revenue exceeds
marginal cost i.e., additional units add more to revenues than to cost. At the point of equality between marginal revenue
and marginal cost, it will earn maximum pro ts.

The above principle can be better understood with the help of figure 5 which shows a set of hypothetical marginal revenue
and marginal cost curves.

Marginal revenue curve slopes downwards and marginal cost curve slopes upwards. They intersect each other at point E
(MC= MR) which corresponds to output Q.* Up to Q* level of output, marginal revenue is greater than marginal cost and
at output level *Q they are equal. The firm will be maximizing profits at E (or at Q* level of output). For all levels of output
less than Q*, additional units of output add more to revenue than to cost (as their MR is more than MC) and thus it will
be pro table for the firm to produce them. The firm will be foregoing pro t equal to the area EFG if it stops at A. Similarly
profits will fall, if a greater output than OQ is produced as they will add more to cost than to revenues. On the units from
Qth to Bth, the firm will be incurring a loss equal to the area EHI.
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Fig: 5: Equilibrium of the Firm: Maximization of Profits

To conclude, the firm will maximize profits at the point at which marginal revenue is equal to marginal cost

PROFIT MAXIMIZATION
The traditional objective of the business firm is profit-maximization. The theories based on the objective of profit
maximization are derived from the neo-classical marginalist theory of the firm
The common concern of such theories is to predict optimal price and output decisions which will maximize profit of the
firm. We have already discussed these decisions in relation to the different forms of competitive structure from pure
(perfect) competition at one end of the spectrum to monopoly at the other.
In essence the theories based on the profit- maximization goal suggests that firm seeks to make the difference between
total revenue (or sales re-ceipt) and total cost (outgo) as large as possible.

Rationale for Maximising Profit

From the above hypothesis we may provide two important rationale for maximizing profit.
Firstly, in a single owner firm, where the entre-preneur is both owner and manager, maximizing profit will maximize his
own income. For a given amount of effort this is considered to be rational be-haviour, irrespective of the structure of the
market (or nature of competition).
Secondly the impact of competition from rival firms forces the entrepreneur to maximize profits. Profit maximization
therefore is not an aspect of discretionary behaviour (choice) but rather a compelled necessity. The entrepreneur is forced
to maximize profit for his long-term survival.
Thus, the justification for profit maximization depends upon the nature of competition. If competition is absent (as in
monopoly) there is no such pressure, although the previous argument still holds. Under highly competitive conditions the
entrepreneur has to maximize profit just for survival.
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Criticisms of Marginalist Theory of the Firm:

The profit maximization hypothesis developed during 1874-1890 by Leon Walras, W. S. Jevons and Alfred Marshall has
formed the basis of the neo-classical (marginalist) theory of the firm. It has not been challenged up to the 1920’s. But
from early 1930s it has been subject to various criticisms.

Critics have argued that profit maximization is not the only objective of a firm. Modern business firms and their managers
pursue certain other goals, too. Thus profit-maximization as the only goal of a firm is no longer a tenable hypothesis.

Being dissatisfied with both of the justifica-tions, modern economists and management special-ists have suggested various
alternatives to profit- maximization

The following arguments bear relevance in this context:

Separation of ownership from management:
In 1932, Berle and Means challenged, through their pioneering work, the argument that the firm would seek to maximize
profits (even though it was necessary due to competitive pres-sure).

They discarded profit-maximization as a ra-tional behaviour because of an alleged break in the identity of purpose of the
manager and his firm. They discovered that in most large U.S. companies there was separation of ownership from control.

Most of such corporations were essentially in the control of the managers rather than the owners (shareholders), due to
fragmentation and disper-sion of ownership of shares.

Thus, in a handful of cases could a small group of shareholders’ directly affect the decisions of the corporation. In such a
situation, with managers acquiring only new shares, the identity of purpose of maximizing prof-its and maximizing
entrepreneurial satisfaction was largely shattered.

In truth, the notion of the entrepreneur has lost relevancy with management becoming an executive function performed
by a com-mittee, rather than a simple individual taking all decisions unilaterally (as has been postulated — explicitly and
implicitly — by the traditional marginalist approach).

The inevitable consequence of such divorce of ownership from control was that managers may wish to pursue goals other
than profit maximization, and would be forced to take into consideration the matter of profits to the ex-tent that sufficient
cash had to be generated to pay satisfactory dividends to the shareholders (so that they did not withdraw funds from the
compa-ny).

Self-Test (Observation Skill)

What are the other objectives the organisation in modern world tries to achieve?
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Chapter 9 : Market Structure Analysis

Chapter Outline
• Market Structure
• Perfect Competition
• Imperfect Competition
• Monopoly
• Monopolistic Competition
• Oligopoly

A market structure comprises a number of interrelated features or characteristics of a market.

These features include number of buyers and sellers in the market, level and type of competition, degree of differentiation
in products, and entry and exit of organizations from the market.

Among all these features, competition is the main characteristic of a market. It acts as a guide for organizations to react
and take decisions in a particular situation. Therefore, market structures can be classified on the basis of degree of
competition in a market.

These different types of market structures

Perfect Competition
Perfectly Competitive Market:
In a purely competitive market, there are a large number of buyers and sellers dealing in homogenous products. A
perfectly competitive market is a wider term than a purely competitive market. A perfectly competitive market is
characterized by a situation when there is perfect competition in the market.
Some of the definitions of perfect competition given by different economists are as follows:

According to Robinson perfect competition can be defined as, “When the number of firms being large, so that a change
in the output of any of them has a negligible effect upon the total output of the commodity, the commodity is perfectly
homogeneous in the sense that the buyers are alike in respect of their preferences (or indifference) between one firm
and its rivals, then competition is perfect, and its rivals, then competition is perfect, and the elasticity of demand for the
individual firm is infinite.”

In perfect competition, there are a large number of buyers and sellers in the market. However, these buyers and sellers
cannot influence the market price by increasing or decreasing their purchases or output, respectively.

FEATURES OF PERFECT COMPETITION

In general, a perfectly competitive market has the following characteristics:
1. There are large number of buyers and sellers who compete among themselves. The number is so large that the share of
each seller in the total supply and the share of each buyer in the total demand is too small that no buyer or seller is in a
position to influence the price, demand or supply in the market.
2. The products supplied by all firms are identical or are homogeneous in all respects so that they are perfect substitutes.
Thus, all goods must sell at a single market price. No firm can raise the price of its product above the price charged by
other firms without losing most or all of its business. Buyers have no preference as between different sellers and as
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between different units of commodity offered for sale; also sellers are quite indifferent as to whom they sell. For example,
most agricultural products, cooking gas, and raw materials such as copper, iron, cotton, and sheet steel etc. are fairly
homogeneous. In addition, all consumers have perfect information about competing prices.
3. Every firm is free to enter the market or to go out of it. There are no legal or market related barriers to entry and also no
special costs that make it di cult for a new firm either to enter an industry and produce, if it sees pro t opportunity or to
exit if it cannot make a profit.

If the above three conditions alone are fulfilled, such a market is called pure competition. The essential feature of pure
competition is the absence of the element of monopoly. Consequently, business combinations of monopolistic nature are
not possible. In addition to the above stated three features of ‘pure competition’; a few more conditions are attached to
perfect competition. They are:
1. There is perfect knowledge of the market conditions on the part of buyers and sellers. Both buyers and sellers have all
information relevant to their decision to buy or sell such as the quantities of stock of goods in the market, the nature of
products and the prices at which transactions of purchase and sale are being entered into.
2. Perfectly competitive markets have very low transaction costs. Buyers and sellers do not have to spend much time and
money ending each other and entering into transactions.
3. Under prefect competition, all firms individually are price takers. The firms have to accept the price determined by the
market forces of total demand and total supply. The assumption of price taking applies to consumers as well. When there
is perfect knowledge and perfect mobility, if any seller tries to raise his price above that charged by others, he would lose
his customers
While there are few examples of perfect competition which is regarded as a myth by many, the agricultural products,
financial instruments (stock, bonds, foreign exchange), precious metals (gold, silver, platinum) approach the condition of
perfect competition

Equilibrium of the Industry: An industry in economic terminology consists of a large number of independent rms. Each
such unit in the industry produces a homogeneous product so that there is competition amongst goods produced by
different units. When the total output of the industry is equal to the total demand, we say that the industry is in
equilibrium; the price then prevailing is equilibrium price. A firm is said to be in equilibrium when it is maximising its
profits and has no incentive to expand or contract production.
As stated above, under competitive conditions, the equilibrium price for a given product is determined by the interaction of
the forces of demand and supply for it as is shown in figure 14.

In Fig. , OP is the equilibrium price and OQ is the equilibrium quantity which will be sold at that price. The equilibrium
price is the price at which both demand and supply are equal and therefore, no buyer who wanted to buy at that price
goes dissatisfied and none of the sellers is dissatisfied that he could not sell his goods at that price. It may be noticed that
if the price were to be fixed at any other level, higher or lower, demand remaining the same, there would not be
equilibrium in the market. Likewise, if the quantities of goods were greater or smaller than the demand, there would not
be equilibrium in the market.

Equilibrium of the Firm: The firm is said to be in equilibrium when it maximizes its profit. The output which gives maximum
profit to the firm is called equilibrium output. In the equilibrium state, the firm has no incentive either to increase or
decrease its output.
Firms in a competitive market are price-takers. This is because there is a large number of firms in the market who are
producing identical or homogeneous products. As such these firms cannot influence the price in their individual capacities.
They have to accept the price determined through the interaction of total demand and total supply of the commodity
which they produce.
This is illustrated in the following figure:
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The firm’s demand curve under perfect competition

The market price OP is fixed through the interaction of total demand and total supply of the industry. Firms have to accept
this price as given and as such they are price-takers rather than price-makers. They cannot increase the price above OP
individually because of the fear of losing its customers to other rms. They do not try to sell the product below OP because
they do not have any incentive for lowering it. They will try to sell as much as they can at price OP.

As such, P-line acts as demand curve for the firm. Because it is a price taker, the demand curve D facing an individual
competitive firm is given by a horizontal line at the level of market price set by the industry. In other words, the demand
curve of each firm is perfectly (or infinitely) elastic. The firm can sell as much or as little output as it likes along the
horizontal price line. Since price is given, a competitive firm has to adjust its output to the market price so that it earns
maximum profit.

Conditions for equilibrium of a firm: As discussed earlier, a firm, in order to attain equilibrium position, has to satisfy two
conditions as below: (Note that because competitive firms take price as fixed, this is a rule for setting output, not price).
• The marginal revenue should be equal to the marginal cost. i.e. MR = MC. If MR is greater than MC, there is always an
incentive for the firm to expand its production further and gain by selling additional units. If MR is less than MC, the firm
will have to reduce output since an additional unit adds more to cost than to revenue. Profits are maximum only at the
point where MR = MC.
• The MC curve should cut MR curve from below. In other words, MC should have a positive slope.

Short run
In the short run, a firm will attain equilibrium position and at the same time, it may earn supernormal profits, normal profits
or losses depending upon its cost conditions. Following are the three possibilities:

SUPERNORMAL PROFITS:
There is a difference between normal profits and supernormal profits.
When the average revenue of a firm is just equal to its average total cost, a firm earns normal profits or zero economic
profits. It is to be noted that here a normal percentage of profits for the entrepreneur for his managerial services is already
included in the cost of production.

When a firm earns supernormal profits, its average revenues are more than its average total cost. Thus, in addition to normal
rate of profit, the firm earns some additional profits.

NORMAL PROFITS:
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When a firm just meets its average total cost, it earns normal profits. Here AR = ATC.

LOSSES:
The firm can be in an equilibrium position and still makes losses. This is the situation when the firm is minimising losses.
For all prices above the minimum point on the AVC curve, the firm will stay open and will produce the level of output at
which MR = MC. When the firm is able to meet its variable cost and a part of fixed cost, it will try to continue production
in the short run. If it recovers a part of the fixed costs, it will be beneficial for it to continue production because fixed costs
(such as costs towards plant and machinery, building etc.) are already incurred and in such case it will be able to recover
a part of them. But, if a firm is unable to meet its average variable cost, it will be better for it to shut down. This shutdown
may be temporary. When the market price rises, the firm resumes production.

Long Run Equilibrium of the Industry

A long-run competitive equilibrium of a perfectly competitive industry occurs when three conditions hold:
• All firms in the industry are in equilibrium i.e. all firms are maximizing profit.
• No firm has an incentive either to enter or exit the industry because all firms are earning zero economic profit or normal
profit.
• The price of the product is such that the quantity supplied by the industry is equal to the quantity demanded by consumers.

A firm producing output at optimum cost is called an optimum firm. In the long run, all firms under perfect competition are
optimum firms having optimum size and these firms charge minimum possible price which just covers their marginal cost.

Thus, in the long run, under perfect competition, the market mechanism leads to optimal allocation of resources. The
optimality is shown by the following outcomes associated with the long run equilibrium of the industry:
• The output is produced at the minimum feasible cost.
• Consumers pay the minimum possible price which just covers the marginal cost i.e. MC = AR. (P = MC)
• Plants are used to full capacity in the long run, so that there is no wastage of resources i.e. MC = AC.
• Firms earn only normal profits i.e. AC = AR.
• Firms maximize profits (i.e. MC = MR), but the level of pro ts will be just normal.
• There is optimum number of firms in the industry.
In other words, in the long run,
LAR = LMR = P = LMC = LAC and there will be optimum allocation of resources.

It should be remembered that the perfectly competitive market system is a myth. This is because the assumptions on which
this system is based are never found in the real world market conditions.

Case studies
Let us try to solve each of these questions.
Since the total cost when zero product is produced is Rs. 100, the total fixed cost of “Tasty Burgers” will be 100/-.
Quantity Total Cost Fixed Cost Variable Cost Average Average Marginal Marginal
Variable Fixed Cost Cost
Cost Cost (Per unit)
0 100
10 210
20 300
30 400
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40 540
50 790
60 1060

Q1. If burgers sell for Rs. 14 each, what is Tasty Burgers’ profit maximizing level of output?
Q2. What is the total variable cost when 60 burgers are produced?
Q3. What is average fixed cost when 20 burgers are produced? Q4.
Between 10 to 20 burgers, what is the marginal cost?

Monopoly

The word ‘Monopoly’ means “alone to sell”. Monopoly is a situation in which there is a single seller of a product which
has no close substitute. Pure monopoly is never found in practice. However, in public utilities such as transport, water
and electricity, we generally find a monopoly form of market.

FEATURES OF MONOPOLY MARKET

The following are the major features of the monopoly market:
1. Single seller of the product: In a monopoly market, there is only one firm producing or supplying a product. This single
firm constitutes the industry and as such there is no distinction between firm and industry in a monopolistic market.
Monopoly is characterized by an absence of competition.
2. Barriers to Entry: In a monopolistic market, there are strong barriers to entry. The barriers to entry could be economic,
institutional, legal or artificial.
3. No close-substitutes: A monopoly firm has full control over the market supply of a product or service. A monopolist is a
price maker and not a price taker. The monopolist generally sells a product which has no close substitutes. In such a case,
the cross elasticity of demand for the monopolist’s product and any other product is zero or very small. The price elasticity
of demand for monopolist’s product is also less than one. As a result, the monopolist faces a steep downward sloping
demand curve.
4. Market power: A monopoly firm has market power i.e. it has the ability to charge a price above marginal cost and earn a
positive profit.
While to some extent all goods are substitutes for one other, there may be essential characteristics in a good or group of
goods which give rise to gaps in the chain of substitution. If one producer can so exclude competition that he controls the
supply of a good, he can be said to be ‘monopolist’ – a single seller

Short run Equilibrium

Conditions for equilibrium:

• The marginal revenue should be equal to the marginal cost. i.e. MR = MC.
• The MC curve should cut MR curve from below. In other words, MC should have a positive slope

SHORT RUN
SUPERNORMAL PROFIT
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In order to know whether the monopolist is making profits or losses in the short run, we need to introduce the average total
cost curve. The following figure shows two possibilities for a monopolist firm in the short run.
LOSS
One of the misconceptions about a monopoly firm is that it makes profits at all times. It is to be noted that there is no
certainty that a monopolist will always earn an economic or supernormal pro t. It all depends upon his demand and cost
conditions. If a monopolist faces a very low demand for his product and the cost conditions are such that ATC >AR, he will
not be making profits, rather, he will incur losses. Figure 26 depicts this position.

Long Run Equilibrium:

Long run is a period long enough to allow the monopolist to adjust his plant size or to use his existing plant at any level
that maximizes his profit. In the absence of competition, the monopolist need not produce at the optimal level. He can
produce at a sub-optimal scale also. In other words, he need not reach the minimum of LAC curve; he can stop at any
point on the LAC where his profits are maximum. However, one thing is certain; the monopolist will not continue if he
makes losses in the long run. He will continue to make super normal profits even in the long run as entry of outside firms is
blocked

MONOPOLISTIC COMPETITION
This type of market contains features of both the markets discussed earlier – monopoly and perfect competition. In fact,
this type of market is more common than pure competition or pure monopoly. The industries in monopolistic competition
include clothing, manufacturing and retail trade in large cities. There are many hundreds of grocery shops, shoe stores,
stationery shops, restaurants, repair shops, laundries, manufacturers of women’s dresses and beauty parlours in a
medium sized or large city.

FEATURES OF MONOPOLISTIC COMPETITION

1. Large number of sellers: In a monopolistically competitive market, there are large number of independent firms who
individually have a small share in the market.
2. Product differentiation: In a monopolistic competitive market, the products of different sellers are differentiated on the
basis of brands. Because competing products are close substitutes, demand is relatively elastic, but not perfectly elastic
as in perfect competition. Firms use size, design, colour, shape, performance, features and distinctive packaging and
promotional techniques to make their products different. Such differentiation may be true or fancied. Brands are
generally so much advertised that a consumer starts associating the brand with a particular manufacturer and a type of
brand loyalty is developed. Product differentiation gives rise to an element of monopoly to the producer over the
competing products. Because of absence of perfect substitutability, the producer of an individual brand can raise the
price of his product knowing that he will not lose all the customers to other brands. However, since all brands are close
substitutes of one another; the seller who increases the price of the product will lose some of his customers to his
competitors. Thus, this market is a blend of monopoly and perfect competition.
3. Freedom of entry and exit: Barriers to entry are comparatively low and new firms are free to enter the market if they find
pro t prospects and existing firms are free to quit.
4. Non-price competition: In a monopolistically competitive market, firms are often in fierce competition with other firms
offering a similar product or service, and therefore try to compete on bases other than price, for example: they indulge
in aggressive advertising, product development, better distribution arrangements, and efficient after-sales service and so
on. A key base of non-price competition is a deliberate policy of product differentiation. Sellers attempt to promote their
products not by cutting prices but by incurring high expenditure on publicity and advertisement and other sales promoting
techniques. This is because price competition may result in price – wars which may throw a few firms out of market or
reduce the profit margins
Price-output determination under monopolistic competition:

Equilibrium of a firm
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In a monopolistically competitive market, since the product is differentiated, each firm does not face a perfectly elastic
demand for its products. Each firm makes independent decisions about price and output. Each firm is a price maker and
is in a position to determine the price of its own product. As such, the firm is faced with a downward sloping demand
curve for its product. Generally, the less differentiated the product is from its competitors, the more elastic this curve will
be.

Conditions for the Equilibrium of an individual firm:

The conditions for price-output determination and equilibrium of an individual firm may be stated as follows:
• MC=MR
• MC curve must cut MR curve from below

Short Run Equilibrium

SUPER NORMAL PROFIT

LOSS

Long equilibrium
If the firms in a monopolistically competitive industry earn supernormal profits in the short run, there will be an incentive
for new firms to enter the industry. As more firms enter, profits per firm will go on decreasing as the total demand for the
product will be shared among a larger number of firms. This will happen till all supernormal profits are wiped away and
all firms earn only normal profits. Thus, in the long run all firms under monopolistic competition will earn only normal
profits.

All firms are earning zero economic profits or just normal profits.
In case of persisting losses, in the long run, the loss making firms will exit from the market and this will go on till the remaining
firms make normal profits only.

It is to be noted that an individual firm which is in equilibrium in the long run, will be operating at levels at which it does
not fully realize economies of large scale production. In other words, the plants are not used to optimum capacity.
However, any attempt to produce more to secure the advantage of least cost production will be irrational since the price
reduction to sell the larger output will exceed the cost reduction made possible.
Thus, a monopolistically competitive firm which is in equilibrium in the long run is at a position where it has excess capacity.
That is, it is producing a lower quantity than its full capacity level.
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Oligopoly
We have studied price and output determination under three market forms, namely, perfect competition, monopoly and
monopolistic competition. However, in the real world economies we find that many of the industries are oligopolistic.
Oligopoly is an important form of imperfect competition.

Oligopoly is often described as ‘competition among the few’. Prof. Stigler defines oligopoly as that “situation in which a
firm bases its market policy, in part, on the expected behaviour of a few close rivals”. In other words, when there are few
(two to ten) sellers in a market selling homogeneous or differentiated products, oligopoly is said to exist. Oligopolies
mostly arise due to those factors which are responsible for the emergence of monopolies. Unlike monopoly where a single
firm enjoys absolute market power, under oligopoly a few firms exercise their power to keep possible competitors out.

Consider the example of cold drinks industry or automobile industry. There are a handful firms manufacturing cold drinks
in India. Similarly, there are a few firms in the automobile industry in India. Airlines industry, petroleum refining, power
generation and supply in most of the parts of the country, mobile telephony and Internet service providers are other
examples of oligopolistic market. These industries exhibit some special features which are discussed in the following
paragraphs.

CHARACTERISTICS OF OLIGOPOLY MARKET

The oligopolistic industry is dominated by a small number of large firms, each of which is comparatively large relative to
the total size of the market. These large firms exercise considerable control over the market. An oligopoly market may
have a large number of firms along with very large firms, but most of the market share will be enjoyed by the few large
firms and therefore they conquer and retain market control. There are strong barriers to entry (refer barriers to entry
discussed under monopoly).

1. Strategic Interdependence: The most important feature of oligopoly is interdependence in decision-making of the few
firms which comprise the industry. Since there are only few sellers, there will be intense competition among them. Under
oligopoly, each seller is big enough to influence the market. A firm has to necessarily respond to its rivals’ actions, and
simultaneously the rivals also respond to the firm’s actions. This is because when the number of competitors is few, any
change in price, output or product by a firm will have direct effect on the fortunes of the rivals who will then retaliate by
changing their own prices, output or advertising technique as the case may be. It is, therefore, clear that an oligopolistic
firm must consider not only the market demand for its product, but also the reactions of other firms in the industry to
any major decision it takes. An oligopoly firm that does not consider its rivals’ behaviour or incorrectly assumes them is
likely to suffer a setback in its profits.

2. Importance of advertising and selling costs: A direct effect of interdependence of oligopolists is that the firms have to
employ various aggressive and defensive marketing weapons to gain greater share in the market or to maintain their
share. For this, firms have to incur a good deal of costs on advertising and other measures of sales promotion. Therefore,
there is great importance for advertising and selling costs in an oligopoly market. It is to be noted that firms in such type
of market avoid price cutting and try to compete on non-price basis because if they start undercutting one another, a
type of price-war will emerge which will drive a few of them out of the market as customers will try to buy from the seller
selling at the cheapest price.

3. Group behaviour: The theory of oligopoly is a theory of group behaviour, not of mass or individual behaviour and to
assume profit maximizing behavior on the oligopolists’ part may not be very valid. There is no generally accepted theory
of group behaviour. The firms may agree to pull together as a group in promotion of their common interest. The group
may or may not have a leader. If there is a firm which acts as a leader, it has to get others to follow it. These are some of
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the concerns of the theory of group behaviour. But one thing is certain. Each oligopolist closely watches the business
behaviour of the other oligopolists in the industry and designs his moves on the basis of some assumptions of how they
behave or are likely to behave.

MEANING OF MONOPOLY POWER:

The monopolist is the only seller in the market of his product. As the only seller, he possesses a monopolistic dominance
or monopoly power in the market. But the degree of monopoly power is not the same in the case of all monopolies.
Generally speaking, the less elastic is the demand for a monopolist’s product, the more would be his degree of monopoly
power, and vice versa.

That is, the degree of monopoly power depends upon the numerical coefficient (e) of the price-elasticity of demand for
the monopolist’s product—a higher degree of monopoly power would be obtained at a smaller value of e and a lower
degree of monopoly power at a larger value of e.
This idea is supported by the formula given by Prof. A. P. Lerner (1903-82) for measuring the degree of monopoly power.

According to Prof. Lerner, degree of monopoly power in perfect competition is zero.

• At the equilibrium point of a competitive firm, we have p = AR = MR = MC, or p = MC, or p – MC = 0.
• On the other hand, at the equilibrium point of a monopolistic firm, we have p = AR > MR = MC, or, p > MC, or, p – MC =
positive.

Prof. Lerner thinks that the larger the positive value of p – MC as a proportion of p, the larger would be the degree of
monopoly power. Therefore, his formula for the degree of monopoly power is Lerner’s Index of monopoly power = p –
MC/p

It is obvious from (11.48) that under perfect competition, the value of this index is zero (p – MC = 0), and in the case of
monopoly, this index would be positive (p > MC).

We may now easily obtain the relation between the Lerner’s Index and the price-elasticity of demand for the product:
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That is, the Lerner’s Index of monopoly power is nothing but the reciprocal of the numerical coefficient of priceelasticity
of demand for the product, which supports our idea that the less elastic is the demand for the product, the more would
be the degree of monopoly power, and vice versa.

We may easily understand the economic meaning of this idea. The smaller the price-elasticity of demand, i.e., the value
of e, the smaller would be the response of demand for the product in response to a change in its price and the larger
would be the power of the monopolist to charge a price in excess of MC, i.e., the larger would be value of p – MC and,
therefore, of the Lerner’s Index.
Sources of Monopoly Power:

Monopoly power of a firm, is its ability to set the price of its product above the marginal cost. We have also seen that, in
equilibrium, p – MC/p is equal to 1/e. This gives us that the smaller the price-elasticity of demand for the product the
larger would be the monopoly power of the firm.
The main source of monopoly power, therefore, is the elasticity of demand for the product concerned.

Now, the elasticity of demand for a firm’s product is determined by three factors. These
are:

(i) Elasticity of market demand,

(ii) The number of firms in the market, and (iii)
The nature of interaction among the firms.

(i) The Elasticity of Market Demand:

In the case of pure monopoly, there is only one firm that produces the product. Here, there is no difference between the
elasticity of the firm’s demand and the elasticity of market demand. Therefore, in this case, the firm’s degree of monopoly
power is determined directly by the elasticity of market demand for his product.

However, pure monopoly is rare in the real world. Because, barring exceptions, every product has at least a few close
substitutes. In other words, in the real world we often find that a close substitute product-group is produced by a number
of firms.

These firms compete over selling their respective products. In the case of each such firm, the elasticity of market demand
for the product-group, hereafter called the ‘product’, provides the bottom line for the elasticity of its demand curve.

For example, if at any particular price, the e of the market demand for the ‘product’ be e* = 1.5 (say), then the e for the
product of every firm would be at least 1.5. That is, if a firm decreases (or increases) the price of its product by 1 per cent,
then the demand for its product would increase (or decrease) by at least 1.5 per cent.

(ii) The Number of Firms:

However, e for the product of a firm belonging to the group of firms that produce the ‘product’, may very well be more
than the e* (here 1.5)—how much more would, of course, depend on the number of firms that produce the ‘product’. Let
us see why.

If one among several firms producing the ‘product’, say, firm A, reduces its price by 1 per cent, say, the prices of the other
firms remaining unchanged, then the product of A would become relatively cheaper and some of the customers of the
other firms would switch over to A.
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In this case, demand for the product of A would not only increase, in the first instance, by 1.5 per cent as given by the e*
for the market demand for the product, but it would also increase somewhat more because of the ‘switch-over’ factor.

Similarly, if the price of the product of A increases by 1 per cent, then its demand would decrease not only by 1.5 per cent
as given by e*, but it would also decrease somewhat more because of the ‘switch-over’ factor. For, now, the product of
A would become relatively dearer and some of the customers of A would switch over to the close-substitute products of
the group.

It is easy to understand from what we have said above that the larger the number of firms in the group, the more would
be the strength of the ‘switch-over’ factor. That is, the larger the number of firms, the more would be the e for the product
of A.

We may conclude then that the number of firms producing the ‘product’ is a determinant of the elasticity of demand for a
firm’s product and the latter, in its turn, is a determinant of the degree of its monopoly power.

We may say then that the smaller (larger) the number of firms producing the close-substitute products, the smaller (larger)
would be elasticity of demand for the product of a particular firm and the larger (smaller) would be the degree of its
monopoly power (which is equal to 1/e)

We therefore have come, to an interesting conclusion that since in the case of pure mo¬nopoly, the number of firms is
only one, and since the e of the pure monopolist is equal to the bottom line e which is e*, the degree of monopoly power
of a pure monopolist is the largest, i.e., it is larger than the monopoly power of a firm in a ‘non-pure’ monopolistic
situation.

(iii) The Interaction among Firms:

If there are several firms producing the close-substitute products, called the ‘product’, then the monopoly power enjoyed
by each of them would depend upon the interactions among them. If the firms compete aggressively, then they would
undercut one another’s prices in order to increase their respective market shares.

Such aggressive competition among the firms may drive the prices of the products down nearly to the level of competitive
price. In this case, p – MC would also be driven down and the degree of monopoly power of the firms would be relatively
small.

On the other hand, the firms might decide not to compete among themselves, rather they might collude. In this case,
collusion among the firms would restrict their outputs and increase their prices. So here they would have relatively high
p – MC and the degree of their monopoly power would also be high.

Collusion may go to such a length that the firms may behave almost like one firm (giving rise to a multi-plant monopoly). In
such a case, the degree of monopoly power would be the highest possible (approaching 1/e*).
We may conclude then that the monopoly power of a firm may arise from three sources. These
are:
(i) Elasticity of market demand for the product,
(ii) The number of firms, and
(iii) The nature of interaction among firms.
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CONCENTRATION RATIOS AS MEASURES OF MONOPOLY POWER:

In an industry, usually there exist some smaller firms and some larger firms in the sense that smaller firms have relatively
smaller shares in total industry sales (or profits or assets), and the larger firms have relatively larger shares.

That is, sales (or profits or assets) may be more concentrated in a few firms of the industry, or such concentration may be
less. Now, the size of the largest firms’ share in total industry sales, etc. is known as the concentration ratio.

For example, if we consider sales as the criterion, then the n largest firms’ share in total industry sales is called an nfirm
concentration ratio which is denoted by CRn. Usually, the four firm and eight firm concentration ratios denoted by CR4
and CR8, are used as a measure of monopoly power.

The concentration ratio may act as a measure of monopoly power because in a competi¬tive industry, sales are more
evenly distributed among firms—concentration of sales is more or less absent. On the other hand, in a monopolistic
industry, sales tend to concentrate in a few large firms—in the limiting case, sales are concentrated in only one firm when
we have the case of a pure monopoly.

Let us suppose that there are five firms in an industry, and the shares of the firms arranged in a descending order are as
follows:

We can compute the cumulative shares for the n largest firms for n = 1, 2, 3, 4, 5.

These cumulative shares are:

We have obtained above that the cumulative share of the first two largest firms (CR2) is 0.80. Similarly, CR3 = 0.90, CR4 =
0.96 and CR5 = 1.00.
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If we plot the cumulative percentage of sales against the cumulative number of firms from largest to smallest, we would
obtain a curve called the concentration curve. The concentration curves of three typical industries have been shown in
Fig. 11.28.

The figure shows us that concentration is larger in industry A than in the industries B and C. But whether concentration is
larger in B or C depends on whether we are comparing the concentrations in the largest four firms (CR4) or in the largest
eight firms (CR8).

If we look at CR4, concentration is larger in industry B, but if we look at CR8, concentration is larger in industry C. This is the
basic defect of concentration ratios as measures of monopoly power.

There may be another problem also with the concentration ratios. From the point of view of sales, one industry may be
more concentrated than another and, from the point of view of profits or assets the latter may be more concentrated
than the former.

A third problem with the concentration ratio is that it does not take into account the number of firms. For example, in the
example of five firms we have obtained CR4 = 0.96. In another industry with 100 firms the CR4 may also be obtained to
be 0.96. We cannot really compare the monopoly power or the competitiveness in these two industries, since the
numbers of firms in the two cases are different.

A fourth problem with the concentration ratios is that they are usually based on the distribution of firms in the domestic
industry and they completely ignore the picture in the foreign sector. Yet the existence of foreign competition might
considerably affect the behaviour of the domestic firms.

THE HERFINDAHL INDEX FOR MEASURING MONOPOLY POWER:

The Herfindahl Index (named after Orris C. Herfindahl) avoids some of the major problems involving the use of concentration
ratios (CRs).
This index is denoted by HI and defined as:
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where n is the number of firms in the industry and S; is the market share of the ith firm (i = 1,2, …, n). As is evident, this
index reflects both the number of firms and their relative sizes. For, the example we have already considered, HI to be
obtained would be

HI = (0.50)2 + (0.30)2 + (0.10)2 + (0.06)2 + (0.04)2 = 0.3552.

In case all the firms had equal market shares of 0.2, the Herfindahl Index would be HI
= 5 (0.2)2 = 1/5

That is, if there are n firms in an industry all having equal shares, the share of each firm would be 1/n and we would have

Thus, HI depends solely on two things, viz., the variance of the market shares and the number of firms. If the market share
is equally distributed among the firms, i.e., if σ2 = 0, the measure of monopoly power which is given by the HI, would
assume the value 1/n, and this is also the minimum value of the HI (... σ2 ≥ 0) for a given n.

Therefore, if there are many firms in the industry that are more or less of equal size, the value of HI would be small, since
n is large and σ2 is close to zero. On the other hand, if n = 1, then we would have σ2 = 0, and in that case the HI would be
equal to 1.

In other words, in the case of pure monopoly, the HI would be equal to 1, and it is the maximum value of HI. That is, we
have obtained that the HI would lie between and 1, both ends inclusive (1/n ≤ HI ≤ 1), and a larger HI indicates a greater
monopoly power
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Chapter 10: Entrepreuer – Innovation Theory

Chapter outline
• Entrepreneur
• Schumpeter theory of innovation

ENTREPRENEUR
‘Entrepreneur’ is a French word which means to undertake, to pursue opportunities, to fulfill needs and wants of the people
through innovation and starting business.

An entrepreneur undertakes a venture, organizes it, raises capital to finance it, and assumes the whole or major part of the
risk of business. In other words, entrepreneurship is the process of giving birth to a new business.

An entrepreneur is one of the most important inputs and segments of economic growth. He/she is one of the responsible
people who can set up a business or an enterprise. In reality, he/she is the one who has the initiative, innovative skills and
who aims for high achievements. The entrepreneur is a person who brings overall change through innovation. The
entrepreneur is a visionary and integrated man with outstanding leadership qualities.

The definitions of Entrepreneur may be divided into three parts:

1. Based on Traditional Approach
2. Based on Modern Approach 3.
Based on Synthesized Approach.

1. Based on Traditional Approaches:

Alfred Marshall, “Entrepreneur is an individual who brings together the capital and labour required for the work, who
adventures or undertakes risks, who arrange or engineers its general plan.”

J.B. Say, “The entrepreneur is a person who shifts economic resources out of the area of lower yield and into an area of
higher and greater yield.”

Frank H. Knight, “The Entrepreneur is a specialised person or group of persons who bear risks and meet the uncertainty.”

2. Based on Modern Approaches:

Peter F. Drucker, “Entrepreneurs create something new, something different, they change and transmute value.”

Arthur dewing, “Entrepreneur is one who transforms ideas into a profitable business.”
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3. Based on Synthesised Approaches:
Joseph A. Schumpeter, “Entrepreneur is a person who foresees the opportunity and tries to exploit it by introducing a new
product, a new method of production, new market, new source of raw material or new combination of factors of
production.”

Frantz, “Entrepreneur is an innovator and promoter as well as generally he is more than a manager.”

An entrepreneur may be defined as an individual who intends to add value to the economy by creating a new business
venture through the able utilisation of his knowledge, passion, dream, and desire.An entrepreneur is thought to be a
person who intends and evaluates the new situation in the environment and directs the making of such adjustments or
alteration in the economic or manufacturing system as he thinks necessary for achieving desired results.

He conceives the industrial enterprises as the purpose of new creation, display consideration, initiates courage and
determination in bringing his new project into existence perform one or more of the following- (i) Perceiving opportunities
for profitable investments.
(ii) Exploring the prospects of a manufacturing concern.
(iii) Obtains necessary industrial licenses.
(iv) Arranges initial capital.
(v) Providing personal guarantees.
(vi) Supplies technical know-how.

This definition highlights risk-taking, innovation and resource organising aspects of entrepreneurship. In other words of
Kao, “Entrepreneurship is the attempt to create value through recognition of business opportunity, the management of
risk-taking appropriate to the opportunity and through the communicative and management skills to mobilize human,
financial and material resources necessary to bring a project to fruition.”

This definition recognises that entrepreneurship involves the fusion of capital, technology and human talent to complete a
project successfully and with reasonable degree of risk.
Therefore, the main characteristic features of entrepreneurship can be summed up as under:
(a) It relates to economic activity.
(b) It involves creativity or innovation.
(c) It involves dynamism or flexibility.
(d) It means taking decision under uncertainty.
(e) It involves bringing together the difference means of production.
(f) It involves risks.
(g) It involves ability to organised and administer.

FUNCTIONS OF AN ENTREPRENEUR:
In general, an entrepreneur performs the following functions:
INITIATING BUSINESS ENTERPRISE AND RESOURCE CO-ORDINATION:

An entrepreneur senses business opportunities, conceives project ideas, decides on scale of operation, products and
processes and builds up, owns and manages his own enterprise. The first and the foremost function of an entrepreneur
is to initiate a business enterprise. An entrepreneur perceives opportunity, organizes resources needed for exploiting that
opportunity and exploits it. He undertakes the dynamic process of obtaining different factors of production such as land,
labour and capital, bringing about co-ordination among them and using these economic resources to secure higher
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productivity and greater yield. An entrepreneur hires the services of various other factors of production and pays those
fixed contractual rewards: labour is hired at predetermined rate of wages, land or factory building at a fixed rent for its
use and capital at a fixed rate of interest. The surplus, if any, after paying for all factors of production hired by him, accrues
to the entrepreneur as his reward for his e orts and risk-taking. Thus, the reward for an entrepreneur, that is a profit, is
not certain or fixed. He may earn profits, or incur losses. Other factors get the payments agreed upon, irrespective of
whether the entrepreneur makes profits or losses.

RISK BEARING OR UNCERTAINTY BEARING:

The ultimate responsibility for the success and survival of business lies with the entrepreneur. What is planned and
anticipated by the entrepreneur may not come true and the actual course of events may differ from what was anticipated
and planned. The economy is dynamic and changes occur every day. The demand for a commodity, the cost structure,
fashions and tastes of the people and government’s policy regarding taxation, credit, interest rate etc. may change. All
these changes bring about changes in the cost and/or demand conditions of a business rm. It may happen that as a result
of certain broad changes which were not anticipated by the entrepreneur, the firm has to incur losses. Thus, the
entrepreneur has to bear these financial risks. Apart from financial risks, the entrepreneur also faces technological risks
which arise due to the inventions and improvement in techniques of production, making the existing techniques and
machines obsolete. The entrepreneur has to assess and bear the risks. However, Frank Knight is of the opinion that pro t
is the reward for bearing uncertainties. An entrepreneur need not bear the foreseeable risks such as of re, theft, burglary
etc. as these can be insured against. Uncertainties are different from risks in the sense that these cannot be insured
against and therefore, the entrepreneur has to bear them. For example genuine business uncertainties such as change in
tastes, emergence of competition etc. cannot be foreseen or insured against. Thus, an entrepreneur earns profits because
he bears uncertainty in a dynamic economy where changes occur every day. While nearly all functions of an entrepreneur
can be delegated or entrusted with paid managers, risk bearing cannot be delegated to anyone. Therefore, risk bearing is
the most important function of an entrepreneur

INNOVATIONS:

According to Schumpeter, the true function of an entrepreneur is to introduce innovations. Innovation refers to
commercial application of a new idea or invention to better fulfillment of business requirements. Innovations, in a very
broad sense, include the introduction of new or improved products, devices and production processes, utilisation of new
or improved source of raw-materials, adoption of new or improved technology, novel business models, extending sales
to unexplored markets etc.
According to Schumpeter, the task of the entrepreneur is to continuously introduce new innovations. These innovations
may bring in greater efficiency and competitiveness in business and bring in pro ts to the innovator. A successful
innovation will be imitated by others in due course of time. Therefore, an innovation may yield profits for the
entrepreneur for a short time but when it is widely adopted by others, the profits tend to disappear. The entrepreneurs
promote economic growth of the country by introducing new innovations from time to time and contributing to
technological progress. But innovations involve risks and only a few individuals in the society are capable of introducing
new innovations. The greater the innovating ability, the greater the supply of entrepreneurs in the economy, and greater
will be the rate of technological progress.

Self test A (Conceptual Skill)

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State the difference between innovation and invention

Self-Test B (Conceptual Skill)

State the Difference between Organizer and Entrepreneur

Schumpeter theory of innovation

Innovation refers to all those changes, in the production process with an objective of reducing the cost of commodity so as
to create gap between the existing price of the commodity and its new cost.

Innovation may take any shape like introduction of a new technique or a new plant, a change in the internal structure or
organizational set up of the firm or change in the quality of raw material, a new form of energy, better method of
salesmanship, etc.

Schumpeter makes a distinction between invention and innovation. Innovation is brought about mainly for reducing the cost
of production and it is cost reducing agent. Profit is the reward for this strategic role. Innovations are not possible by all
entrepreneurs. Only exceptional entrepreneurs can innovate. They are capable of tapping new resources, technical
knowledge and reduce the cost of production. Thus, the main motive for introducing innovation is the desire to earn profit.
Profit is therefore the causes of innovation. Profits are of temporary nature.

Thus, innovation can be classified into two categories;

a. The first category includes all those activities which reduce the overall cost of production such as the introduction of a
new method or technique of production, the introduction of new machinery, innovative methods of organizing the
industry, etc.
b. The second category of innovation includes all such activities which increase the demand for a product. Such as the
introduction of a new commodity or new quality goods, the emergence or opening of a new market, finding new sources
of raw material, a new variety or a design of the product, etc.

The pioneer who innovates earns abnormal profit for a short period. Soon other entrepreneurs, “swarm in clusters”,
compete for profit in the same manner. The pioneer will make another innovation. In a dynamic world innovation in one
field may induce other innovations in related fields. The emergence of motor car industry may in turn stimulate new
investments in the construction of highways, rubber tyres and petroleum products.

Profits are thus causes and effects of innovation. The interest of profit leads entrepreneur to innovate and innovation
leads to profit. Thus, profit has a tendency to appear, disappear and reappear. Profits are caused by innovation and
disappear by imitation. Innovational profit is thus, never permanent, in the opinion of Schumpeter. Therefore it is different
from other incomes, such as rent, wages and interest. These are regular and permanent incomes arising under all
circumstances. Profit on the other hand is a temporary surplus resulting from innovation.

Prof. Schumpeter also explained his views on the functions of the entrepreneur. The entrepreneur organizes the business
and combines the various factors of production. But this is not his real function and this will not yield him profit. The real
function of the entrepreneur is to introduce innovations in business. It is innovations which yield him profit.

Self Test (Conceptual Skill)

State the crux of Schumpeter theory of Innovation
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Criticisms:
This theory has been criticized on the following grounds:
1. This theory concentrates only on innovation, which is only one of the many functions of the entrepreneur and not the
only factor.
2. This theory does not consider profit as the reward for risk-taking. According to Schumpeter it is the capitalist not the
entrepreneur who undertakes risk.
3. This theory has ignored the importance of uncertainty bearing which is one of the factors that determines profit.
4. This theory attributes profit only to innovation ignoring other functions of entrepreneur.
5. Monopoly profits are permanent in nature while Schumpeter says that profits (resulting due to innovation) occur
temporarily.
6. This theory has presented a very narrow view of the functions of the entrepreneur. He not only introduces innovation but
he is equally responsible for proper organisation of the business. As such profit is not merely due to innovation. It is also
due to organizational work performed by the entrepreneur. As it is well known, every entrepreneur does not innovate
and yet he must earn profit, if he is to stay in business.
7. It is an incomplete theory because it has failed to explain all the factors that influence profit. We can conclude by saying
that undoubtedly, ‘Innovation’ is an important element and determinant of profit.

But Prof. Schumpeter’s theory, like the other theories of profit, does not provide a comprehensive explanation of emergence
of profit and hence it is also an inadequate theory of profit.

Self Test
State any two grounds on which Schumpeter theory of innovation was criticize

Chapter 11: Tools for organizational and Investment Analysis

Chapter Outline
• Break Even Analysis
• Time value of Money
• Capital Budgeting
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• Risk and uncertainty Analysis

BREAK EVEN ANALYSIS

Break-even analysis occupies an important place in economic theory. It analyses the relationship between cost of
production, revenue and profit. It is very useful to business firms in decision making related to investment policies,
production planning etc. and also to the government in formulating its various policies.
Break-even point is that point at a particular level of output at which total revenue is equal to total cost. It implies a
noprofit-no loss zone. At this point the firm neither makes profit nor loss. Here total revenue is exactly equal to total cost.
This analysis can be explained through a graphic method and an algebraic method.

The break-even analysis is based on the following assumptions:

(1) The cost function and the revenue function are linear.
(2) The total cost consists of fixed cost and variable cost.
(3) The selling price of the commodity is constant.
(4) The quantity of output produced is equal to the total quantity of output sold
(5) The productivity of factors, both average and marginal productivity remain the same.
(6) The price of factors of production is constant.
(7) If the firm produces a number of goods the product mix remains the same.

Graphic method:
This method explains the relationship between revenue, cost and profit at various levels of output. This method considers
both linear function and non-linear function.
Linear function and break-even analysis:
Linear function implies that the price remains constant and the total revenue and total cost curves are straight lines. When
the price remains the same, every increase in production and sales will lead to increase in total revenue in a constant
proportion. The total revenue curve starts from the origin indicating that it varies with the level of output. The total cost
curve is also a straight line starting at a point on the y axis above the origin. This indicates that there is an element of fixed
cost in the total cost of production. The point at which total revenue is equal to total cost is said to be the break-even
point. The break-even point in the case of linear cost and revenue curves can be shown as follows:

In the above diagram TR represents the total revenue curve. TC refers to the total cost curve while TFC stands for total
fixed cost. TR curve starts from the origin and it is a linear curve indicating that TR increases in a constant proportion. TFC
is a straight line indicating that it remains the same whatever be the level of output. The vertical distance between TC and
TFC represents total variable cost. TVC increases with the increase in output. The total revenue curve and the total cost
curve intersect each other at point E and this point is the break-even point.
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At this point total revenue is equal to total cost. The firm neither makes profit nor loss at this point. Before the breakeven
point total revenue is less than total cost, whereas after the break-even point total revenue is more than the total cost.
Break-even point shows the minimum level of output required to be produced and sold by the firm to break-even. Any
rational firm would like to produce the quantity output which is more than the output at the break-even point at least,
the quantity of output at the break-even point.
No firm would like to produce the output which is less than the break- even output as it clearly indicates loss. If the firm
aims at attaining a fixed amount profit in its operation then break-even point indicates the required level of output to be
produced. For e.g. in the figurer let us suppose the firm aims at a profit of It then the new cost curve TC + π intersects the
TR curve at point R1 while the break-even output is OQ, the output required to achieve the targeted profit is OQ1.

Nonlinear function
While linear total revenue and total cost functions exists in perfect competition, in reality the market structure is
monopoly, monopolistic competition or oligopoly. In such a case the cost and revenue functions are non-linear. The
determination of breakeven point in this case can be explained with the help of the following diagram:

In the above diagram the TR curve slopes upwards up to a particular point and then it starts declining, TR increases at a
diminishing rate when more output is sold. The total cost curve starts from point F on the y axis indicating the fixed cost
component. Initially it increases at a diminishing rate and then it rises at an increasing rate. The vertical distance between
TR and TC represents the total profits earned by the firm.

The TR and TC curves intersect each other at point B1 and B2. At B1 the total revenue is equal to total cost and the
corresponding level of output is OQ1. B1 is the break-even output. After this point TR curve lies above the TC curve. When
the firm produces OQ level of output the distance between TR and TC is the maximum.

Beyond this point the distance between TR and TC starts narrowing down and again at point B2 the total revenue curve
intersects the total cost curve. While B1 is called the lower breakeven point, B2 is called the upper break-even point. B2
lies beyond the profit maximizing level of output of the firm and hence it does not have much relevance. B1 or the lower
break-even point is more relevant to a business firm as it indicates how much output has to be produced and sold to
break-even and maximize profits.

Its method is very useful to business firms in decision making. Algebraically the break-even output is determined by using
the following concepts and symbols:
(1) Price of the commodity per unit = P.
(2) Quantity of output produced and sold = Q.
(3) Total fixed cost = TFC
(4) Average variable cost per unit of output = AVC.
(5) Profits = π.
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Generally, profit is the difference between total revenue and total cost.
Symbolically it can be expressed as π =TR-TC
=P x Q - TC........... (TR=P x Q) …………. (1)
The total cost incurred by the firm is the summation of fixed and variable cost. TC
= TFC + TVC,
= TFC + AVC × Q ……….. (2)
At the break-even point TR = TC. Let us assume the break-even point level of output = QB. At
the break-even point
TR = TC
P x QB = TFC + AVC x QB
P x QB - AVC x QB = TFC
QB (P - AVC) = TFC
QB = TFC / P - AVC
This equation implies that the break-even quantity depends upon total fixed cost, price of the commodity and total
variable cost. Break-even quantity will change when there is a change in any one of these variables. The denominator P
— AVC is known as contribution ratio i.e. the profit contribution per unit. The formula quoted above can be modified to
determine a particular level of output to achieve the targeted profit. The formula to be used is as follows:
Qr = TFC – π / P – AVC
Where Qr refers to the output to be produced to achieve the targeted profit π refers to the target profit

Criticism
This analysis has been criticised by many economists on a number of grounds. They are:
(1) The assumptions of the theory are unrealistic. Constancy of productivity of factors, constancy of prices of factors of
production is difficult to realise.
(2) Modern economies are dynamic economies. This analysis is not suitable as it is a static one.
(3) This analysis assumes a linear function. It is not possible to have this in practice as linear function exists in perfect
competition which is not a realistic market structure.
(4) According to this analysis, profit, is a function of output produced but in reality it depends upon the state of technology
used, managerial efficiency and productivity of factors of production.
(5) Under monopolistic competition and oligopoly, a huge expenditure is incurred on advertisement, sales promotion, etc.
This type of expenditure known as selling cost exerts a greater influence on sales, production, etc. This aspect has not
been analysed by the break-even analysis. Hence it is an incomplete theory.
(6) The effect of taxation on prices cost of production and sales are not analysed by break-even analysis.
Despite all the criticisms, this analysis is widely used by business firms. It gives them an idea about the profit structure
and helps them to control the cost function. It is also useful to decide about future expansion, modernization and
diversification.

Self Test

TIME VALUE OF MONEY

Time value of money is defined as “the value derived from the use of money over time as a result of investment and
reinvestment”. Time value of money means that “worth of a rupee received today is different from the worth of rupee to
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be received in future”. The preference for money now, as compared to future money is known as time preference of
money.

The whole set of financial decisions (whether financing decision or investment decision) hinges on the fact that the value
of one rupee today is not equal to the value of one rupee at the end of one year or at the end of second year. In other
words, we cannot assume that the value of rupee remains the same. This is known as ‘Time Value of Money’.

Time value of money is singularly important amongst all the concepts and principles used in the field of financial
management. Crux of time value concept is that money has a time value. A rupee to be received a year from now is not
worth as much today as a rupee to be received immediately. At Least three factors contribute to the time value of money.

• First, there is the simple bird-in-the-hand notion that uncertainty increases with die futurity of an event so that the
promise of one rupee in 10 years is usually worth less than a similar promise in one year. This bird-in-the-hand principle
is extremely significant in making investment decisions.

• Second, under inflationary conditions, purchasing power of the rupee over time declines. So if inflation is expected to
continue, future rupees will have a depreciated value compared to current value.

• Third, there is opportunity costs associated with any expenditure, which again makes future rupees less valuable than the
current ones. Opportunity costs arise because a rupee today can be profitably invested and as a result will be worth more
than a rupee in the future. Opportunity costs are not losses in the absolute sense but they are relative to what could have
been, had the decision maker made the best use of available resources. By opting for use of resources over another, a
decision maker always incurs an opportunity cost equal to the income that could have been earned on the next best
alternative.

Time value of money is based on the premise that cash flows occur at different points of time. As such, Time Lines constitute
an important ingredient of time value of money.

The concept of time value of money is very fundamental to financial decision making. Any decision which ignores this
basic concept is sure to lead to wrong decisions. This concept is often known as the ‘Discounting Principle’ also. This is of
great significance in any decision where the operations are stretched over a period of time, or where we have to make
intertemporal choices.

Illustration 1
Suppose the rate of interest is 10 percent per annum.
If we receive a sum of Rs. 500 now, it will earn an interest of Rs. 50 in one year and will become equal to Rs. 550 after 1
year. The same sum will earn an interest of Rs. 55 in the second year and will become equal to Rs. 605 after two years.
How this money grows at different points of time can be calculated by the following compound interest formula?
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In the above figure, different values are given at different time periods. These are all values of the same Rs. 500 at different
points of time, assuming the rate of interest to be 10 percent per annum. The amount of Rs. 500 becomes Rs. 550 after
one year, 605 after two years and 805.26 after 5 years. In terms of valuation all sums have equal value.

All these values have been calculated by the above mentioned compound interest formula. This, well known compound
interest formula, can be modified a little to make our working more convenient. Instead of using ‘r’ as rate percent, we
use the symbol ‘i’ to indicate rate per rupee.

Accordingly, the modified formula would be:

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Suppose, a sum of Rs. 500 is to be received after 4 years and we have to find its present worth or present value, we can find
it as follows (assuming the same rate of interest).

Hence, we can say that the discounted value of Rs 500 payable/receivable after 4 years is Rs 341.50. In this manner, we can
find the discounted value of any sum of money payable/ receivable at some future date.

Illustration 2

For example, in the above example if the interest or the discount rate is taken as 12 percent, then the present value of Rs
500 payable/ receivable after 4 years would be
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This value is lower than what we get when it is discounted for 4 years only.
In this manner, discounted values can be found for different rates and time periods.

Compounding and discounting are the two sides of the same coin. If present values are carried into the future, it is called
‘compounding’ and if future values are transferred into present, it is called ‘discounting’. Obviously, compounding
increases the value, while discounting decreases the same. Both are the consequences of the same concept i.e. ‘time
value of money’.
It would now be obvious to the readers, that the compounding or discounting impact is dependent on time period and the
interest rate or the discount rate. If the discount rate is high, there is a greater reduction in value and vice versa.

Time Value of Money -Importance

In the financial decisions, the time value of money holds great importance. It is now the most significant principle in finance
and economics. There are certain valid reasons for this state of affairs.

Inflation
Because of inflationary conditions, the rupee today has a higher purchasing power than rupee in future. As a result, those
who have to receive the money prefer to receive the same as early as possible, while those who have to pay the money
try to delay the payment.

Uncertainty
Since the future is characterised by uncertainty, individuals/business concerns prefer to have current income rather than
having the same payment at a later date. They have an apprehension that the party making the payment may default due
to insolvency or other reasons.

Preference for Present Consumption

Both due to uncertainty and inflationary conditions, individuals prefer the consumption to future consumption. They do not
wish to save for the future by curtailing current consumption.

Opportunities for reinvestment

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Money can be employed to generate real returns. Individual’s business concerns reinvest the money at a certain rate so as
to have some yield on it.
As such a financial manager of any business concern cannot ignore the concept of time value of money while making any
financial decisions; otherwise his decisions will be invalid and incorrect also.

Self test
Time Value of Money – Multiple Choice Questions and Answers
Time value of money indicates that
(a) A unit of money obtained today is worth more than a unit of money obtained future
(b) A unit of money obtained today is worth more less than a unit of money obtained future
(c) There is no difference in the value of money obtained today and future (d) None of
the above

Process of calculating future value of money from present value is classified as (a)
Compounding
(b) Discounting
(c) Money value
(d) Stock value

Ans (a)

An interest rate is 5%, number of period are 3 and present value is Rs. 100 and then future value will be (a)
115.76
(b) 105.00
(c) 110.25
(d) 113.56

If security pays Rs.5,000 in 20 years with 7% annual interest rate, PV of security by using formula is (a)
Rs.1290.10
(b) Rs.1292.10
(c) Rs.1,295.10
(d) Rs.1297.10

Security present value is Rs.100 and future value is Rs.150 after 10 years and value if 1 = interest rate will be (a)
4.14%
(b) 0.59%
(c) 0.69%
(d) 0.79%

If deposited money is Rs. 10,000 in bank pays interest 10% annually, an amount after 5 years will be (a)
Rs. 16,105.14
(b) Rs. 16,110.14
(c) Rs. 16,115.14
(d) Rs. 16,505.14
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INTRODUCTION TO CAPITAL BUDGETING

Every business entity has to continuously incur expenses on certain resources or assets which help it not only to produce
but also grow. This expenditure has to be made on raw materials, labour, fuel and power, spares and stores as well as
certain essential maintenance expenses. These expenses are the routine and recurring expenses which help an enterprise
to continuously produce at the current level of output.

However, enterprises also want to expand their productive capacities or to set up new ventures for which also they have
to incur expenses which are not routine or regular. These expenses are occasional and are made when an enterprise sees
a new opportunity and wants to exploit it in the foreseeable future. These expenses are on fixed assets like land, building,
machinery, equipment etc. They are called ‘capital expenditure’.

Expenditure on fixed assets is entirely different from expenditure on current or variable assets. The implications of
expenditure on fixed assets like plant, machinery, equipment, land, building or any such expenditure like research, brand
building etc. extend into the future, whereas expenditure on variable inputs like raw material, labour, power or other
current outlays belong to the same time period.
In this way, expenditure on fixed assets has inter temporal implications, i.e., expenditures are being done now but benefits
will be received in future. That is why, they are treated as investment or capital expenditure decisions and the process of
this decision making is called ‘capital budgeting’.

Meaning of Capital Budgeting

The investment decisions are commonly known as capital budgeting or capital expenditure decisions. Capital budgeting
means planning for capital expenditure in acquisition of capital assets such as new building, new machinery or a new
project as a whole. It refers to long term planning for proposed capital outlays and their financing.
It includes mechanization of a process replacing and modernizing a process introduction of a new product and expansion
of the business. It includes both raising of long-term funds as well as their utilization. It contains the preparation of
Detailed Project Reports (DPR) and cost and revenue statements indicating the profitability.

Need for Capital Budgeting

The need for Capital budgeting arises due to the following reasons:
1. Capital budgeting is necessary because large sums of money are involved for acquiring fixed assets.
2. Large sums of money involved on capital assets are permanently blocked. Capital investment decisions once taken cannot
be reversed easily without heavy loss. This necessitates capital budgeting.
3. Funds invested in capital projects or fixed assets are recovered over a long period. Therefore, there is risk and uncertainty
in the recovery of funds. So it necessitates capital budgeting.
4. Capital investment decisions require an assessment of future events, which are uncertain. This necessitates capital
budgeting.
5. Excessive capital investment would increase the operating cost of the firm. So, careful planning of the capital budgeting
is quite necessary.

Features of Capital Budgeting Decisions

Basic Features of Capital Budgeting decisions are:
(1) Current funds are exchanged for future benefits
(2) There is an investment in long-term activities; and
(3) The future benefits will occur to the firm over a series of years.
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Significance of Capital Budgeting

Capital budgeting decisions are of paramount importance in the financial decision-making process of an organization. It
provides the following benefits:
1. Capital budgeting decisions affect the profitability of a firm.
2. Capital budgeting decisions determine the destiny of the company. A few wrong decisions affect the survival of firms.
3. Capital budgeting decisions affect a company’s future cost structures.
4. Capital budgeting decisions provide a basis for long term financial planning.
5. Capital budgeting is helpful for taking proper decisions on Capital expenditure.
6. Majority of the firms have scarce capital resources. Therefore, proper Capital budgeting decisions are helpful in allocating
such scarce means in an economical way, keeping in mind the objective of the company.

Project Classification
Capital budgeting decisions involve more time and cost. The costs incurred in this process must be justifiable by the
benefits from it. The capital budgeting process may be less or more, it depends on the type of the project. So firms
normally classify the projects into different categories.
The categorisation may differ from one firm to another firm, but the following are the most important classification of
projects:

1. New Projects:
New manufacturing concerns require investing in fixed assets, without which there is no manufacturing process. For
example – establishment of a paper manufacturing company requires machinery to produce paper, which may require
investment of some crores of rupees. Purchase of long-term assets requires efficient decision-making.

2. Expansion Projects:
Expansion projects generally increase existing capacity, or addition of new features to the existing product or widen the
distribution network. These types of investments call for an explicit forecast of growth.

Project expansion generally requires more careful analysis than the other types of projects. For example – a paper
manufacturing company which is currently producing 20,000 tonnes of paper per year may increase its plant capacity by
10,000 tonnes per year.
A Home Appliance Product Company that is producing semi-automatic washing machines now is planning to produce fully
automatic washing machines.

3. Diversification Projects:
Diversification is the spread of risk across a number of assets of investments. Here it is necessary to recollect the proverb,
“don’t put all eggs in one basket”. Diversification may be concentric or conglomerate. For example – a company producing
toilet soaps is planning to enter into detergent soaps, is known as concentric diversification.

Conglomerate diversification is entering into a new business area. For example -Reliance, marketer of textiles, entering
into petroleum business. Often diversification projects entail substantial risks, involve large initial cash outflows, and
require considerable managerial effort and attention. They require more analysis not only in the form of quantitative but
also in qualitative aspects.
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4. Replacement and Modernization Projects:
In the competitive world, companies have to improve their operating efficiency and reduce costs, for which they are
required to go for either modernization of the existing machines or replacement of the obsolete and inefficient machinery,
even though they may be in good condition. In other words, replacing or modernization is to reduce costs, increase yield
and improve quality of the product.

For example – a cement manufacturing concern is planning to go for modernization where it is changing its drying process
from semi-automatic to fully automatic drying equipment or replacement of manually operated machinery by fully
automatic machinery.

5. Research and Development (R&D) Projects:

Nowadays, the majority of the large firms are setting up their own R&D departments. Organisations require more funds
to set up R&D departments. R&D projects are characterized by numerous uncertainties and typically involve sequential
decision-making. For this type of projects, discounted cash flow analysis is not applicable, but these projects are decided
on the basis of managerial judgment.

6. Miscellaneous Projects:
Apart from the above-discussed types of projects, there are some other projects like interior decoration, recreational
facilities, executive aircrafts, and landscaped gardens and so on. For evaluation of these projects there is no standard
approach and the decisions with regard to such projects are based on the top management’s preferences and their
judgement.

Self-Test
Give any two real life example where Capital Budgeting technique can be used

Capital Budgeting Techniques

The ultimate objective of the capital budgeting process is to achieve maximum benefit from the project. For
this purpose, there are various techniques of capital budgeting which are as follows:

Technique # 1. Payback Period Method:

When one invests an amount in any type of investment, he/she always worries about the length of time for getting
invested money back, same happens in a firm too. When a firm goes to invest an amount in purchasing any fixed asset, it
explores the alternatives available which may provide cash back soon.
The payback period is the duration to recover the initial cost of the project. In this process, the payback period is the
most identified and popular method of capital budgeting to evaluate the proposals for the purpose of capital expenditure.
Payback period is that time period in which net cash inflow from investment recovers the cost of investment.

Under this method, the proposal is to be selected which is time conscious i.e. the project which will take least time to
pay back the amount invested will be preferred. If numbers of proposals are available then these will be ranked on the
basis of their estimated time consumption and selected accordingly.

Advantages or Merits of Payback Method:

i. It is simple to calculate and easy to understand, apply and interpret.
ii. It is realistic in approach as businessmen want speedy recovery of their money in capital assets. iii. It weights early
returns heavily and ignores distant returns and thus a short payback period acts as a hedge against a boon decision. iv.
It is safe since it avoids incalculable risk and uncertainty in the long run. Limitations or Demerits of Payback Method:
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Major shortcomings of this method are as follows:
i. This method is a ‘crude rule of thumb’ and over-emphasizes early recovery of invested funds of course, liquidity in itself
is an important factor but ignoring ‘profitability of investment’ and concentrating, only on ‘liquidity of investment’ can in
no way be justified in most of the situation.
ii. It concentrates only on the ‘recovery of the cost of investment’ and does not consider the earnings after the payback
period.
iii. It considers only the payback period of the project and not its whole life. It doesn’t include the cash inflows which occur
after the payback period.
iv.This method ignores the risk factor in investments. Hence, projects with higher risk but lower payback period will be
accepted as compared to a project with lower risk and higher payback period.
v. This method does not consider the ‘cost of capital’ which is an important base of sound investment decisions.
vi.This method ignores the time value of money. It fails to consider varying cash flow patterns. All cash flows are treated and
weighted equally, regardless of the time period of their occurrence.
vii. It focuses on recovery of capital only rather than measuring the profitability of a firm. viii. This method ignores the
salvage value of the asset. ix. It is not possible to calculate the rate of return by this method.

Accept/Reject Criteria:
If the actual pay-back period is less than the predetermined pay-back period, the project would be accepted. If not, it would
be rejected.

The payback period is calculated as follows: i.

In the Case of Even Cash Inflows:
If cash inflows from investment are uniform throughout the life of investment, payback period is calculated by dividing the
cost of investment with the amount of annual cash inflow.
As per formula:

’ ii.
In the Case of Uneven Cash Inflows:
If cash inflows from investment are not uniform each year, payback period will be calculated by taking cumulative total
of each year’s cash inflows and the exact payback period will be calculated by interpolation. Payback period will be
calculated as:
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Note – The Answer will be in years. If we will multiply B/C with 12 or 365 then this part will be converted into months or
days respectively.

Technique # 2. Accounting Rate of Return Method (ARR Method):

This method is also known as the unadjusted rate of return method or Financial Statement Method because the main
figures used in the calculation are derived from accounting statements. Under this method, the percentage rate of return
of the annual net profit on investment is calculated.
If it is calculated on initial investment, it is called Return on Investment (ROI) and if it is calculated on average investment,
it is called as Average Rate of Return. Usually, it is calculated on average investment in the project. If annual net income
fluctuates then average annual net income is used into the calculation.
Thus, the formula for calculating this return is as follows:

Note:
1. Average investment we can say average value of investment (opening value + closing value)/2
2. Average investment refers to the average funds that remain invested or blocked over its economic life. Average
investment = 1/2(Initial cost +installation exps. – salvage value) + salvage value.

Evaluation of Project under ARR Method:

Rate of return calculated as above is compared with the cutoff or the pre-specified rate of return. If the return is more than
the cut-off rate, the project would be accepted, if not, it would be rejected.
In the evaluation of mutually exclusive projects, only such projects are considered, whose accounting rates of returns are
more than the cut-off rate and the project with the highest rate is selected. The larger is the rate, better is the project.

Advantages or Merits of Unadjusted Rate of Return Method:

a. It is simple to compute and easy to understand and interpret.
b. It takes into consideration the total earnings from the project during the entire economic life.
c. This method gives due weight to the profitability of the project.
d. This method duly recognizes the concept of net earnings, i.e., earnings after providing for depreciation on capital assets.
In fact, this is the correct way of income determination.
e. This method ignores the life of the project for determining the cost of investment. Hence, the amount of initial investment
and average investment remain the same.

Limitations or Demerits of Unadjusted Rate of Return Method:

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a. It is simply an averaging technique, which does not take into account the impact of various external factors on overall
profits of the firm.
b. It ignores the life of the project and differentiates against the projects of lower economic life. Two projects can have the
same ARR, A proposal with a longer life may have the same ARR with a shorter life proposal. On the basis of ARR both the
projects are equally good, but the proposal with longer life would be preferred.
c. It ignores the time value of earnings. In other words, this method does not discount the future earnings to present value.
d. The method does not determine the fair rate of return on investments. It is left at the discretion of management.
e. This method does not give consideration to the risk factor in respect of each project. Risk analysis should be the integral
part of a project evaluation technique.
f. This method is based on accounting profits rather than cash flows. We know that accounting profits are affected by
different accounting policies.

Technique # 3. Present Value Method:

This is the method which follows the concept of real time factor. It involves the value of time in transactions. This method
is popularly known as ‘discounted cash flow method’ because in this method all future cash flows (inflows and outflows
both) of an investment project which occur at different times are discounted at a given rate to bring them at a common
denominator and make them comparable.
Discounting is a procedure of bringing future inflows and outflows of cash to their present values. In general, money
received today is valued more than money receivable tomorrow. “A bird in hand is worth more than the two in the bush”
is rightly applicable to the management of capital.
Therefore, in this technique, all future inflows and outflows of cash of an investment project are brought to technique, all
future inflows and outflows of cash of an investment project are brought to their present values by applying a discounting
rate (i.e., cost of capital or interest rate).
What you have today is more worthy than what you will have in future.

Calculating Present Value:

The present value of future cash flows is found out with the help of the following algebraic formula:

Net Present Value Method (NPV Method):

This is also known as Excess Present Value Method or Net Gain Method. This method is used when the management has
prescribed a minimum (or target) rate of return or cut-off rate.
Following steps are involved in this method:
(i) Determine the present value of all cash inflows from investments at different periods at required earnings rate. The
formula is:
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Note:
It should be remembered that salvage value and working capital released at the end of the project’s life are considered as
cash inflows of the last year and are duly discounted to present values.
(ii) Determine the present value of all cash outflows at different periods at the same earnings rate. Cash outflows at zero
period of time (initial investment including working capital needed, if any) are not discounted.
For this amount, the present value factor is taken as 1. However, cash outflows at subsequent periods are discounted by the
relevant present value factor.
(iii) Find out the present value. For this, the total of present values of all cash inflows is compared with the total of present
values of all cash outflows.

As per formula:

Accept/Reject Criteria:
(a) If NPV is positive, the project is accepted.
(b) If NPV is zero, the project is accepted or rejected on non-economic considerations.
(c) If NPV is negative, the project is rejected.
Higher the NPV, more attractive will be the project. Hence, in mutually exclusive projects, (if cost of investment is similar),
the project which gives the higher positive NPV will be preferred.

Merits of NPV Method:

a. The NPV method recognizes the time value of money and takes into consideration the cost of capital.
b. It is very easy to calculate and simple to understand and interpret.
c. It takes care of the entire life of the project and its entire earnings including salvage of asset.
d. It can be applied to both types of cash inflow patterns – even and uneven cash inflows.
e. The economists generally prefer this method as it is consistent with the objective of maximizing owners’ wealth.

Limitations or Demerits of NPV Method:

a. Compared to the payback or accounting rate of return methods, NPV methods are difficult and complicated.
b. The greatest problem of this method is determination of desired rate of return. Due to the difference in the state of risk
and uncertainty of different business, no uniform rate can be used.
c. Keeping in view the time-span of different projects and the difference of risk inherent in them, use of a common
discounting rate is not correct.
d. It may also not give satisfactory results where the projects under competition have different lives. NPV method favors
long-lived projects.
e. It assumes that intermediate cash inflows are reinvested at the firm’s cost of capital, which is always not true.
f. The results from this method may contradict those under the internal rate of return method, even in the case of
alternative proposals, which are mutually exclusive.
g. Net present value is sensitive to discount rates. With a change in rate, a desirable project may turn into an undesirable
one and vice-versa.
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Profitability Index Method or Present Value Index Method:

The Profitability index method is a variant of NPV method and is called benefit-cost ratio. It is preferable to the NPV
method where capital costs of mutually exclusive projects differ substantially. It expresses the relationship between
present values of cash inflows and the present value of cash outflows (i.e., cost of investment).

The formula is:

The main object of the use of present value index is to provide ready comparability between investment proposals of
different magnitude. A proposal can be accepted only if the profitability index is greater than or at least equal to unity.
Higher the index, more desirable is the investment.
The proposal is rejected if its profitability index is less than one. But, it is to be noted that a profitability index of less than
one does not indicate loss. It simply means that the firm’s cost of capital exceeds the rate of return making it imperative
for the proposal to be rejected.

Technique # 5. Time Adjusted Rate of Return Method (TAR Method) or Internal Rate of Return Method (IRR Method):
This rate is also known as ‘Marginal Efficiency of Investment’, ‘Internal Rate of Project’ and ‘Breakeven Rate’. It follows
the discounted cash flow technique, which takes into account the time value of money. This is why this rate is called a
time adjusted rate. This method is used when the management does not prescribe a desirable rate of return.

Under this method, such a rate of return (or discounting rate) is derived at which the aggregate of the present values of
all future cash inflows from investment equals the present value of cash outflows for the proposal (i.e., initial investment
outlay). In other words, IRR is the maximum rate of interest that could be paid for the capital employed over the life of an
investment without loss on the project.

It is the rate of discount at which net present value is zero. Higher the IRR, more attractive is the proposal. A proposal is
accepted only when IRR is higher than the required rate of return (cut-off rate). If it is lower, the proposal is rejected; if it
is just an equal decision is taken on the basis of other considerations. In case of mutually exclusive projects, the project
with the highest IRR is selected.
Computation of IRR:

Criteria for Acceptance:

(1) Accept the project of IRR>k,
(2) Reject the project of IRR<k
(3) k is the cost of capital

Merits of TAR or IRR Method:

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(a) Like NPV, IRR method takes into consideration time value of money and also the total cash inflows and outflows over the
entire life of the project.
(b) The pre-determination of earnings rate is not a precondition for the use of this method.
(c) For a manager, it is easier to understand and interpret the ‘rate’ than an absolute amount.

Demerits of TAR or IRR Method:

(a) Its computation is difficult. IRR requires tedious calculations based on trial and error procedure or interpolation. (b)
The assumption that cash flows are reinvested for the remaining life of the project at the IRR is unrealistic. In some cases,
it remains idle in the business.
(c) This method requires the determination of minimum required rate of return to know the acceptability of IRR, which is a
difficult task.
(d) If cash inflows in any years are negative then it may give more than one solution.
(e) This method does not differentiate satisfactorily between projects of different lives.

RISK AND UNCERTAINTY ANALYSIS

Risk Meaning:
Risk is inevitable, more so in the field of Business. Risk is factored in from the trial stage of investment evaluation of a
business right until the winding up of the business entity. Business in these days allocate large amounts of money from
time to time in developing strategies to help manage risks associated with their business and investment dealings. Their
major role in the risk management process is assessing risk, which involves the determination of the risks both internal
and external to their business or investment.
Risk occurs when the probability of future outcomes is unknown but there exists some basic information of past
experience which helps predict future course of action like consumer’s preference, level of competition & so on. Emmett
J Vaughan, “Risk is a condition in which there is a possibility of adverse deviation from a desired outcome that is expected
or hoped so far”.
Irving Fisher, “risk may be defined as a combination of hazards measured by probability”. Warren
Buffett, “Risk comes from not knowing what you’re doing.”

Uncertainty Meaning:
Uncertainty refers to those future events whose probability of occurrence cannot be accurately predicted. Uncertainty
arises due to lack of information to accurately make future predictions. The lack of complete certainty like political factors,
government policies, natural calamities & terrorists attack.

The following points highlight the four popular techniques for measuring risk and uncertainty in different projects.

Technique # 1. Risk Adjusted Discount Rate Method:

This method calls for adjusting the discount rate to reflect the degree of the risk and uncertainty of the project. The risk
adjusted discount rate is based on the assumption that investors expect a higher rate of return on risky projects as
compared to less risky projects.

The rate requires determination of:

(i) Risk free rate, and
(ii) Risk premium rate.
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Risk-free rate is the rate at which the future cash inflows should be discounted. It is the borrowing rate of the investor.
Risk premium rate is the extra return expected by the investor over the normal rate. The adjusted discount rate is a
composite discount rate.

It takes into account both time and risk factors. In this technique, the discount rate is raised by adding a risk margin in it
while calculating the NPV of a project. For example, if the rate of discount is 10% for the project, it may be raised to 11%
by adding 1% to take account of risks and uncertainties.

The increased discount rate will reduce the discount factor, thereby lowering the NPV. Thus the project would be judged
as undesirable. This method is used for ranking of risky projects. But the problem with this method is that there is no
‘specified margin’ which should be added to the free risk rate.

Technique # 2. The Certainty Equivalent Method:

According to this method, the estimated cash flows are reduced to a conservative level by applying a correction factor
termed as certainty equivalent coefficient. The correction factor is the ratio of riskless cash flow to risky cash flow.

The certainty equivalent coefficient which reflects the management’s attitude towards risk is Certainty
Equivalent Coefficient = Riskless Cash Flow/Risky Cash Flow.

If a project is expected to generate a cash of Rs. 40,000, the project is risky. But the management feels that it will get at
least a cash flow of Rs. 24,000. It means that the certainty equivalent coefficient is 0.6. Under the certainty equivalent
method, the net present value is calculated as:

Where αt = Certainty Equivalent Coefficient

At = Expected Cash Flow for year t
I = Initial outlay on the project i =
Discount rate

Technique # 3. Sensitivity Analysis:

The future is not certain and involves uncertainties and risks. The cost and benefits projected over the lifetime of the project
may turn out to be different. This deviation has an important bearing on the selection of a project.

If the project can stand the test of changes in the future, affecting costs and benefits, the project will be selected. The
technique to find out this strength of the project is covered under the sensitivity analysis of the project. This analysis tries
to avoid overestimation or underestimation of the costs and benefits of the project.

In sensitive analysis, a range of possible values of uncertain costs and benefits are given to find out whether the projects
desirability is sensitive to these different values. In this analysis, we try to find out the critical elements which have a vital
bearing on the costs or benefits of the project.

In investment decision, one has to consider as many elements of uncertainty as possible on costs or benefits side and
then arrive at critical elements which affect the expected costs or benefits of the project. How many variables should be
tested to carry out the sensitivity analysis in order to find out its impact on costs or benefits of the projects? It is a matter
of judgement.

In sensitivity analysis, one has to consider the changes in the various factors correlated with changes in the other. In order
to arrive at the degree of uncertainty, the decision maker has to make alternative calculation of costs or benefits of the
project.
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When there are several uncertain outcomes, three cost-benefit calculations are made in this analysis:
(i) The most pessimistic where all the worst possible outcomes are estimated.
(ii) The most likely where all the middle of the range outcomes are estimated.
(iii) The most optimistic where all the best possible outcomes are estimated.

It explains how sensitive the cash flows are under these three different situations. If the difference is larger between the
optimistic and pessimistic cash flows, the more risky is the project. The most likely outcome can give a good guide to how
‘borderline’ is the project.

Technique # 4. Probability Method:

Another method for dealing with risks and uncertainties is to estimate the probable value for a result. Here one has to
see a range of possible cash flows from the most optimistic to the most pessimistic for each pertinent year. Probability
means the likelihood of happening of an event. It is the proportion of times an event occurs i.e. its frequency. It is the
ratio of favourable number of events to the total number of events.
In a particular situation, if all possible outcomes of an event are listed and the probability of occurrence is assigned to
each outcome, it is called a probability distribution. For any probability distribution there is an expected value. The
expected value is the weighted average of the values associated with the various outcomes, using the probabilities of
outcome as weights.

If NPV1 NPV2 and NPV3 are three possible estimates of the net present value of a project under uncertainty, and’ the
probability of each outcome of NPV is P1 P2 and P3 then the expected net present value is Ev (NPV) = P1 (NPV1) + P2
(NPV2) + P3 (NPV3).

This method is conceptually sound. But it lacks objectivity as it is not possible to find out the probabilities of different
outcomes.