MANAGERIAL ECONOMICS/II B.COM CA/NITHYA.J & NAGAVENI.

MANAGERIAL ECONOMICS

UNIT-I
Managerial Economics – Meaning and Definition – Nature and Scope –
Economic Theory –
Divisions – Goals of a firm.

UNIT-II
Demand Analysis – Meaning, Determinants of Demand – Law of Demand,
Elasticity of
Demand – Price, Income and Cross Demand – Demand Estimation and
Demand Forecasting –Demand Distinctions.

UNIT-III
Production Function – Meaning and Definition – Elasticity of Substitution and
Production –
Type of cost of Production – Long run and Short run cost.

UNIT-IV
Markets – Forms of Market – Characteristics - Pricing Methods – Objects of
pricing policies –Practices – Government intervention in Market.

UNIT-V
Price Theory – Perfect Competition, Monopoly, Monopolistic competition,
Monopsony,
Duopoly, Duopsony and Oligopoly.

Books for Reference:

1. R.L.Varshney and K.L.Maheshwari----Managerial Economics----Sulthan
Chand and
Sons
2.S.Sankaran---- Managerial Economics----Margham Publications
 Unit -1
Managerial Economics

MEANING:

Managerial Economics is economics applied in decision – making. It is that branch of

economics, which serves as a link between abstract theory and managerial practice. It is
based on economic analysis for identifying problems, organizing information and evaluating
alternatives. Economics as a science is concerned with the problem of allocation of scarce
resources among competing ends. Individuals, households, firms as well as economies
regularly confront these problems of allocation. Economics is able to provide a number of
sophisticated concepts and analytical tools to understand and analyze such problems.
Managerial economics, when seen in this light, may be taken as economics applied to
problems of choice of alternatives of economic nature and allocation of scarce resources by
the firms. In other words, managerial economics involves analysis of allocation of the
resources available to a firm or a unit of management among the activities of that unit.

NATURE OF MANAGERIAL ECONOMICS

DECISION MAKING AND FORWARD PLANNING

The prime function of a management executive in a business organization is decision-
making and forward planning. Decision-making means the process of selecting one action
from two or more alternative courses of action whereas forward planning means
establishing plans for the future. The question of choice arises because resources such as
capital, land, labour and management are limited and can be employed in alternative uses.
The decision making function thus becomes one on making choices or decisions that will
provide the most efficient means of attaining a desired end, say, profit maximization. Once
a decision is made about the particular goal to be achieve, plans as to production, pricing,
capital, raw materials, labour, etc. are prepared. Forward planning thus goes hand in hand
with decision-making.

DEFINITION
According to McNair and Meriam, Managerial Economics consists of the use of economic
modes of thought to analyze business situation. Spencer and sidgelman have defined
Managerial Economics as “the integration of economic theory with business practice for the
purpose of facilitating decision-making and forward planning by management”. We may,
therefore, define managerial economics as the discipline, which deals with the application of
economic theory to business management.
Economics Theory and Business
Methodology Management
Decision problems

Managerial
Economics

Application of Economics
To solving business problems

Optimal Solutions

To business problems

Aspects of Application
1. Reconciling traditional theoretical concepts of economics in relation to the actual
business behavior and conditions. In economic theory, the technique of analysis is one
of model building whereby certain assumptions are made and on that basis, conclusions
as to the behavior of the firms unrealistic drawn.
2. Estimating economic relationships, viz., measurement of various types of elasticity’s of
demand such as price elasticity, income elasticity, crosses elasticity, promotional
elasticity, cost-output relationships, etc. The estimates of these economic relationships
are to be used for purposes of forecasting.
3. Predicting relevant economic quantities, e.g., profit, demand, production, costs, pricing,
capital, etc., in numerical terms together with their probabilities. As the business
manager has to work in an environment of uncertainty. Future is to be predicted so that
in the light of the predicted estimates, decision-making and forward planning may be
possible.
4. Using economic quantities in decision-making and forward planning, that is, formulating
business policies and, on that basis, establishing business plans for the future pertaining
to profit, prices, costs, capital, etc.
5. Understanding significant external forces constituting the environment in which the
business is operating and to which it must adjust, e.g., business cycles, fluctuations in
national income and government policies pertaining to taxation, foreign trade, labour
relations, anti-monopoly measures, industrial licensing, price controls, etc. The business
manager has to appraise the relevance and impact of these external forces in relation to
the particular business unit and its business policies.
CHIEF CHARACTERISTICS
1. Managerial Economics is micro-economic in character. This is because the unit of study
is a firm.
2. Managerial Economics largely uses that body of economic concepts and principles which
is known as ‘Theory of the Firm’ or ‘Economics of the Firm’. In addition, it also seeks to
apply profit Theory that forms part of distribution Theories in Economics.
3. Managerial Economics is pragmatic. It avoids difficult abstract issues of economic theory
but involves compilations ignored in economic theory to face the overall situation in
which decisions are made.
4. Managerial Economics belongs to normative economic rather than positive economics
(also sometimes known descriptive economics). In other words, it is prescriptive rather
than descriptive.
5. Macro- economics is also useful to Managerial Economic since it provides an intelligent
understanding of the environment in which the business must operate. This
understanding enables a business executive to adjust in the best possible manner with
external forces over which he has no control but which play a crucial role in the well
being of his concern.

How does Managerial Economics differ from Economics?

1. Whereas Managerial Economics involves application of economic principles to the
problems of the firm. Economics deals with the body of the principles itself.
2. Whereas managerial Economics is microeconomics in character. Economics is both
macro- economic and micro-economic.
3. Managerial Economics, though micro in character, deals only with the firm and has
nothing to do with an individual’s economic problems. But Micro Economics as a branch
of Economics deals with both economics of the individual as well as economics of the
firm.
4. Under Micro-Economics as a branch of Economics, distribution theories, viz., wages,
interest and profit, are also dealt with but in Managerial Economics, mainly profit Theory
is used; other distribution theories have not much use in Managerial Economics. Thus,
the scope of Economics is wider than that of Managerial Economics.
5. Economics theory hypothesizes economic relationships and builds economic models but
managerial economics adopts, modifies and reformulates economic models to suit the
specific conditions and serves the specific problem saving process. Thus Economic gives
the simplified model, whereas Managerial Economics modifies and enlarges it.
6. Economic theory makes certain assumption whereas Managerial Economics introduces
certain feedbacks such as objectives of the firm.

SCOPE OF MANAGERIAL ECONOMICS

1. Demand Analysis and Forecasting.
2. Cost and production analysis.
3. Pricing Decisions, policies and practices.
4. Profit Management.
5. Capital Management.
1.DEMAND ANALYSIS AND FORECASTING
A business firm is an economic organism, which transforms productive resources into goods
that are to be to sell in a market. A major part of managerial decision-making depends on
accurate estimates of demand. Before production schedules can be prepared and resources
employed, a forecast of future sales is essential. This forecast can also serve as a guide to
management for maintaining or strengthening market position and enlarging profits.
Demand analysis helps identify the various factors influencing the demand for a firm’’
product and thus provides guidelines to manipulating demand. Demand analysis and
forecasting, therefore, is essential for business planning and occupies a strategic place in
Managerial Economics.

2.COST AND PRODUCTION ANALYSIS

A study of economic costs, combined with the data drawn from the firm’s accounting
records, can yield significant cost estimates that are useful for management decisions. The
factors causing variations in costs must be recognized and allowed for if management is to
arrive at cost estimates, which are significant for planning purposes. An element of cost
uncertainty exists because all the factors determining costs are not always known or
controllable. Discovering economic costs and being able to measure them are necessary
steps for more effective profit planning, cost control and often for sound pricing practices.

3.PRICING DECISIONS, POLICIES AND PRACTICES

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

4.PROFIT MANAGEMENT
Business firms are generally organized for the purpose of making profits and, in the long
run, profits provide the chief measure of success. In this connection, an important point
worth considering is the element of uncertainty existing about profits because of variations
in costs and revenues which, in turn, are caused by factors both internal and external to the
firm. If knowledge about the future were perfect. Profit analysis would have been a very
easy task. The important aspects covered under this are
Nature and Measurement of profit, profit policies and Techniques of profit planning like
break-even analysis.

5.CAPITAL MANAGEMENT
Of the various types and classes of business problems, the most complex and troublesome
for the business manger are likely to be those relating to the firm’s capital investments.
Relatively not only requires considerable time and labour but is a matter for top-level
decision. Briefly, capital management implies planning and control of capital expenditure.
The main topics dealt with are: Cost of Capital, Rate of Return and Selection of Projects.
BASIC PRINCIPLES OF MANAGERIAL ECONOMICS:

1.OPPORTUNITY COST PRINCIPLE

The opportunity cost principle argues that a decision to accept an employment for any other
factor of production is good (profitable) if the total reward for the factor in that occupation
is greater or at least no less than the factor’s opportunity cost; the opportunity cost being
the loss of the reward in the next best use of that resource. It should be noted here that
the ‘reward’ includes both monetary as well as monetary and the true opportunity cost of a
factor may not be exactly known but may be possible to impute. Thus, for example, the
opportunity cost of a professor’s time when he launches a full-fledged consulting firm would
be the loss of his salary, perquisites in the form of residential accommodation, if any,
provident fund, etc. and the academic environment for carrying on research projects and
publications. According to the opportunity cost principle then, his profit-gross of his salary
alone should not be less than the sum of all the benefits he was deriving when he was a
professor.

2.DISCOUNTING AND COMPOUNDING PRINCIPLE

The discounting and compounding principle states that when a decision involves money
receipts or payments over a period of time, all the money transactions must be valued at a
common period to be meaningful for decision analysis. This is because money has time
value for three reasons: earning power, changing prices, and uncertainty. On this count, a
rupee to day is worth more than a rupee at a future date. Thus during inflation, a rupee
today is worth more than a rupee at a future date.
Only simple arithmetic is needed to apply this principle. Suppose an investment costs
Rs.100 lakhs this year and is expected to yield net returns of Rs.30 lakhs, Rs.40 lakhs and
Rs.60 lakhs, in the next three years, respectively. Assume further that the interest cost of
the money is 10 percent; there is no inflation/deflation and no uncertainty about these cash
flows. Then, whether the investment should be made or not depends upon whether the
following equation yields a positive or negative value:

The solution to this yields an amount of Rs.6.51 lakhs, and so the investment is desirable.
Incidentally, it should be noted here that interest is compounded once a year but any
frequency of compounding can easily be handled through this technique. Also, the method
can easily be extended to take account of inflation or deflation and uncertainty.

3.MARGINAL OR INCREMENTAL PRINCIPLE

The marginal or incremental principle states that given the objective of profit maximization,
a decision is sound if and only if it leads to increase in profit, which would arise in either of
the following cases
1) If it causes total revenue to increase more than the total cost.
2) If it causes total revenue to decline less than the total cost.

The MIP is significant; for some businessmen take an erroneous view that to make
maximum profit they must make a profit on every job. The result is that they refuse orders
that do no cover full cost plus some profit. This could be better explained through a
numerical example. Consider a firm whose output-cost relationship is as follows.
 OUTPUT TOTAL COST Rs. MARGINAL COST AVERAGE COST Rs.
0 20
1 28 8 28
2 37 9 18.50
3 47 10 15.70
4 58 11 14.50
5 68 10 13.60

Suppose firm A is producing three units and selling them at a price of Rs.25 per unit,
making a total profit of Rs.28. If the customer for its fourth unit of output is offering Rs.14
only, should the firm accept this offer? According to the full cost principle, the offer must be
rejected since the average cost of four units equals Rs.14.50, which exceeds the offered
price. However, the marginal or incremental principle would argue that the cost of the unit
(MC) equals Rs.11, which is less than the price offered, thereby his profit would increase,
and so the order must be accepted; profit would increase from Rs.28 to Rs.31. True, but
there is a catch in this argument.

4.EQUI-MARGINAL PRINCIPLE
The equi-marginal principle states that a rational decision-maker would allocate or hire his
resources in such a way that the ratio of marginal returns and marginal costs of various
uses of a given resources or of various resources in a given use is the same. For example,
a consumer seeking maximum utility (satisfaction) from this consumption basket will
allocate his consumption budget on various goods and services such that

Where, MU1 = marginal utility from good 1, MU2 = marginal utility from good 2, MC1
marginal cost of good 1, and so on. Similarly, a producer seeking maximum profit would
use that technique of production (input-mix), which would ensure.
When MRP1 = marginal revenue product of input 1 (e.g. labour), M R P 2 marginal revenue
product of input 2 (e.g. capital), M C1 = marginal cost of input 1, and so on.
The principle involves new concepts and we are not able to explain it in detail at this stage.
Suffice it to say that it is easy to see that if the said equity were not true, the decision
maker could add to his utility/profit by reshuffling his resources/ inputs. For example, if,
The consumer would add to his utility by buying more of good 1 and less of good 2.

5.TIME PERSPECTIVE PRINCIPLE

The time perspective principle argues that the decision-maker must give due consideration
both to the short and long run consequences of his decision, giving appropriate weights to
the various time periods, before arriving at a decision. The principle can be well explained
through recalling the example cited under marginal or incremental principle. The order for
the fourth unit at Rs.14 inspite of an average cost of Rs.14.50 was worth accepting by the
producer on the short-run consideration for sure. But if that were to disturb the customers
(market) in the long run, it may have to be rejected. Similarly, we do come across many
new products, which are sold below cost or on relatively small margins in the beginning with
the hope of commanding a good market and thereby making profits in the long run.
MANAGERIAL ECONOMICS AND OTHER SUBJECTS:

1.MANAGERIAL ECONOMICS AND ECONOMICS

Managerial Economics has been described as economics applied to decision-making. It may
be viewed as a special branch of economics bridging the gulf between pure economic theory
and managerial practice.
Economics has two main divisions: microeconomics and macroeconomics. Microeconomics
has been defined as that branch where the unit of study is an individual or a firm.
Macroeconomics, on the other hand, is aggregate in character and has the entire economy
as a unit of study.
A survey in the U.K. has shown that business economists have found the following economic
concepts quite useful and of frequent application:
1. Price elasticity of demand.
2. Income elasticity of demand.
3. Opportunity cost.
4. The multiplier
5. Propensity to consume.
6. Marginal revenue product.
7. Speculative motive.
8. Production function.
9. Balanced Growth.
10. Liquidity preference.
Business economics have also found the following main areas of economics as useful in their
work:
1. Demand theory.
2. Theory of the firm-price, output and investment decisions.
3. Business financing.
4. Public finance and fiscal policy.
5. Money and banking.
6. National income and social accounting.
7. Theory of international trade.
8. Economics of developing countries.

2.MANAGERIAL ECONOMICS AND STATISTICS

1. Managerial economics calls for the marshalling of quantitative data and reaching
useful measure of appropriate function relationships involved in decision-making.
For instance, in order to base its pricing decisions on demand and cost
considerations, a firm should have statistically derived or calculated demand and
cost functions.
2. Managerial economics employs statistical methods for empirical testing of
economic generalization. This generalization can be accepted in practice only
when they are checked against the data from the world of reality and are found
valid.
3. Managers do not usually have exact information about the variables affecting
decisions and have got to deals with uncertainty of future events. Theory of
probability, upon which statistics is based, provides the logic for dealing with
such uncertainty.
3.MANAGERIAL ECONOMICS AND MATHEMATICS
Mathematics is yet another important tool-subject closely related to managerial
economics. This is because managerial economics is metrical in character, estimating
various economic relationships. Predicting relevant economic quantities and using them
in decision-making and forward planning. A knowledge of geometry, trigonometry and
algebra is not only essential but certain mathematical tools and concepts such as
Logarithms and Exponential, Vectors, Determinants and Matrix Algebra and, above all,
Calculus, differential as well as integral, are the handmaids.

4.MANAGERIAL ECONOMICS AND ACCOUNTING

Managerial Economics is also closely related to accounting, which is concerned with
recording the financial operations of a business fir. Indeed, accounting information is
one of the principal sources of data required by a managerial economist for his decision-
making purpose. For instance, the profit and loss statement of a firm tells how well the
firm has done and managerial economist to throw significant light on the future course
of action- whether it should improve or close down can use the information it contains.
Of course, accounting data call for careful interpretation, recasting and adjustments
before they can be used safely and effectively.

The main task of management accounting is now seen as being to provide the sort of
data which managers need of they are to apply the ideas of managerial economics to
solve business problems correctly: the accounting data are also to be provided in a form
so as to fit easily into the concepts and analysis of managerial economics.

5.MANAGERIAL ECONOMICS AND OPERATIONS RESEARCH

The significant relationship between managerial economics and operations research
can be highlighted with reference to certain important problems of managerial economics
which are solved with the help of OR techniques. The problems are: allocation problems,
competitive problems, waiting line problems and inventory problems. The essence of an
allocation problem is that men ‘machines and other resources are scarce, relatively to the
number and size of the jobs required to be done. The examples are production
programming and transportation problems.
To conclude, managerial economics is closely related to certain subjects, viz., Economics,
Statistics, Mathematics and Accounting. A trained managerial economist integrates
concepts and methods from all these subjects bringing them to bear on business problems
of a firm. In particular, operations research and management accounting are getting very
close to managerial Economics, and there appears to be a trend towards their integration

ROLE AND RESPONSIBILITIES OF MANAGERIAL ECONOMISTS:

One of the principal objectives of any management in its decision-making process is to
determine the key factors, which will influence the business over the period ahead. In
general, these factors can be divided into two categories: I) External. II) Internal. The
external factors lie outside the control of management because they are external to the firm
and are said to constitute business environment. The internal factors lie within the scope
and operation of a firm and hence within the control of management, and they are known
as business operations.

Environmental Studies:
An analysis and forecast of external factors constituting general business conditions. E.g.,
prices, national income and output, volume of trade, etc., are of great significance, since
they affect every business firm. Certain important relevant questions in this connection are
as follows;
1. What is the outlook for the national economy? What are the most important local,
regional or worldwide economic trends? What phase of the business cycle lies
immediately ahead?
2. What about population shifts and the resultant ups and downs in regional
purchasing power?
3. What are the demand prospects in new as well as established markets? Will
changes in social behavior and fashions tend to expand or limit the sales of a
company’s products, or possibly make the products obsolete?
4. Where are the market and customer opportunities likely to expand or contract
most rapidly?
5. Will overseas markets expand or contract, and how will new foreign government
legislations affect operation of the overseas plants?
6. Will the availability and cost of credit tend to increase or decrease buying? Are
money or credit conditions ahead likely to be easy or tight?
7. What the prices of raw materials and finished products are likely to be?
8. Is competition likely to increase or decease?
9. What are the main components of the five-year plan? What are the areas where
outlays have been increased? What are the segments, which have suffered a cut
in their outlays?
10. What is the outlook regarding government’s economic policies and regulations?
What about changes in defense expenditure, tax rates, tariffs and import
restrictions?
11. Will Reserve Bank’s decisions stimulate or depress industrial production and
consumer spending? How will these decisions affect the company’s cost, credit,
sales and profits?

BUSINESS OPERATIONS:
A managerial economist can also be helpful to the management in making decisions
relating to the internal operations of a firm in respect of such problems as price, rate of
operations, investment, expansion or contraction. Certain relevant questions in this
context would be as follows:

1. What will be a reasonable sales and profit budget for the next year?
2. What will be the most appropriate production schedules and inventory
policies for the next six months?
3. What changes in wage and price policies should be made now?
4. How much cash will be available next month and how should it be
invested?
 SPECIFIC FUNCTIONS:
1. Sales forecasting.
2. Industrial market research.
3. Economic analysis of competing companies.
4. Pricing problems of industry.
5. Capital projects.
6. Production programmers.
7. Security/investment analysis and forecasts.
8. Advice on trade and public relations.
9. Advice on primary commodities.
10. Advice on foreign exchange.
11. Economic analysis of agriculture.
12. Analysis of underdeveloped economies.
13. Environmental forecasting.

Having examined the significant opportunities before a managerial economist to

contribute to managerial decision-making, let us next examine how can he best
serve the management. For this, he must thoroughly recognize his responsibilities
obligations. A managerial economist can serve management best only if he always
keeps in mind the main objective of his business, viz., to make a profit on its
invested capital. His academic training and the critical comments from people
outside the business

OBJECTIVES OF THE FIRM

1. Profit maximization.
2. Firm’s value maximization.
3. Sales (revenue) maximization subject to some predetermined profit.
4. Size maximization.
5. Long-run survival.
6. Management utility maximization.
7. Satisfying.
8. Other (non-profit) objectives.

PROFIT MAXIMIZATION
The traditional theory of firm’s behavior assumes that the objective of firm owners is to
maximize the amount of short-run profits. Before we dwell on the pros and cons of this
theory, it is imperative that we understand the meaning of profits. Profit is defined
differently in business and economics. The public and business community define profit
as an accounting concept, where it is the difference between total receipt and the
explicit and the explicit (accounting) costs of carrying out the business; explicit cost is
the payments made to the hired factors of production. This profit concept is gross of the
implicit cost, which stands for the imputed cost of the self-owned factors production
employed in the business. The economic of profit is the residual after both the explicit
and implicit costs are deducted from the total receipts. To illustrate this important
distinction, let us consider an example.

A carpenter makes 100 chairs per month and sells them at Rs.150 per piece. His
expenses on rent of the shop, cost of wood and other material are worth Rs.5000. He
employs two workers whose monthly wage bills stand at Rs.2, 400 and pays electricity
bill of about Rs.500 per month. He has invested Rs.50, 000 in the form of machines,
tool and inventories in the business, of which Rs.25, 000 is from his own fund and the
remaining Rs.25, 000 is a loan from a bank at the interest rate of 18% per annum.
Further, assuming imputed costs of his own time, his own shop and his own savings of
Rs.25, 000 for the month are Rs.3, 000, Rs.1, 000 and Rs.250, respectively. The
various calculations would then be:

Total receipts = Rs.150 X 100 = Rs.15, 000.

2,500
Total explicit costs = Rs.5000 + 2400 + 500 + ---------(0.18)
12
= Rs.8, 275
Total implicit costs = Rs.3000 + 1000 + 250.
= Rs. 4,250
Business (Accounting) profit = Rs. 15,000 – 8,275
= Rs 6,725.
Economic Profit = Rs. 15,000 – 8,275 – 4,250
= Rs.2, 475

Thus, business and economic concepts of profit are different. Economic profits are a
powerful guiding force in the free enterprise system, particularly for a proprietorship
firm. However, the present day world has both the private and public sector firms
operating simultaneously, and most firms are either on a partnership basis or are
corporations.

Innovation Theory: Firms make innovations in new products, new production

techniques, new marketing strategies, etc. These innovations are costly and must be
rewarding for them to flow continuously.

Risk – Bearing Theory: Invest large sums in the production system, expecting to
produce goods and make profits on it. However, the production may run into difficulties,
be delayed and there may not be an adequate market when production is ready. The
firms take these risks and must be adequately rewarded.

Monopoly Theory: Some firms are able to enjoy certain monopoly powers in view
of being in possession of a huge capital, economies of scale, patent protection or socio-
political powers. As a result, there is a lack of perfect competition and such firms are
able to reap economic profits.

Friction Theory: According to this theory, there is a long-run equilibrium of

economic profit, which is zero (adjusted for risk). However, markets are seldom in
equilibrium and that gives rise to economic profits or losses. For example, if winter is
too severe or too prolonged, firms dealing in woolen garments would reap large
economic profits while those dealing in items like ice cream, or fans may run into losses.
Managerial efficiency Theory: This theory argues that economic profits can arise
because of exceptional managerial skills of well-managed firms. For example, if firms that
operate at an average level of efficiency can avoid losses, then those, which operate at
above that level must reap economic profits. Thus, existence of profit is essential to ensure
good performance.

FIRM’S VALUE MAXIMIZATION

Since most firms are expected to operate for a long period, they are postulated to
aim for maximum long-term profits instead of maximum short-term profit. Thus, if 
denotes expected profit in period 1, expected profit in period 2, and so on, what the firm
aims at is not to seek the maximum value of any one of these profits but the maximum
value of their sum, adjusted properly for the time value of money, Thus, The parameter
denotes the appropriate interest rate and the number of years the firm is expected to last.
If are interpreted as dividend per share. Is inclusive of capital gains, if any, and the
cost equity capital, then the value of the firm just equals the present value of a share of the
firm. The above equation assumes that the readers familiar with the concept of discounting
and preset value, which is discussed later in these chapter.
The goal of values or wealth maximization is recognized today as the primary objective of a
business firm. However, most firms have multiple objectives in the modern world and
business firms are no exception to this rule. Further, non-business firms do pursue non-
value maximization objectives.

SALES MAXIMIZATION SUBJECT TO SOME PRE-DETERMINED PROFIT:

Wilson J. Baumol had advanced a theory of firm behavior in which he argues that a firm
seeks a certain level of profit and within that constraint aims at maximum sales. The
‘certain level of profit’ presumably means the level of profit considered satisfactory by the
shareholders. The constrained variable for maximization, viz., sales, is in terms of revenue
(rupees) and not in terms of physical units of goods and services. This is because, many
firms are engaged in multiple products, and these products may not be additive in physical
terms or/and may have different values per unit. For example, Godrej manufactures
refrigerators and cupboards of different sizes, among other things, and it is impossible to
add these products in physical units. Also, just as in the short-term profit maximization and
long run profit (or value) maximization theories, one could postulate the constrained short-
run sales or constrained long-run maximization theories, and choose the long-run
alternatives only.

SIZE MAXIMIZATION
Some experts have suggested growth or size maximization as an alternative goal for firms.
By growth they mean, an increase in sales, assets and/or the number of employees. Edith
penrose argues that managers have a vital interest in growth because “individuals gain
prestige, personal satisfaction in the successful growth of the firm with which they are
connected, more responsible and better paid positions, and wider scope for their ambitions
and abilities:”

LONG – RUN SURVIVAL

K.W.Rothschild (1947) has suggested yet another alternative goal for the firm to pursue,
that is, of assuring long-run survival for the firm. Under these objectives, the firm seeks to
maximize the probability of its survival into the future. Such an objective would
commensurate with the interest of the share – holders and the management. Through this
objective, the owners of today would be able to provide security and business to their next
generations.

MANAGEMENT UTILITY MAXIMIZATION

O.E.Williamson’s model of firm behavior (1963) “ focuses on the self-interest seeking
behavior of corporate managers”. The theory basically ignores the owner’s interest
whenever there is a dichotomy between owners and managers. To this extent it goes even
beyond Baumol’s hypothesis, where managers at least ensure some minimum profit for the
owners.
There are many variables in an organization, which affect the management utility. Among
these, the prominent ones are the salary including bonus, if any, perquisites, number of
subordinates and the management’s role in investment decisions. Again, the theory is
somewhat vague since the numerous dimensions of management’s utility may not always
be in harmony and there is no perfect method of developing a combined yardstick, which
merge all these into a single variable.

SATISFYING
Herbert Simon, a noble prizewinner, had proposed an alternate theory of firm behavior.
According to his theory, firms do not aim at maximizing anything due to imperfections in
data and incompatibility of interests of various constituent of an organization. Instead, they
set up for themselves some minimum standards of achievement, which they hope will
assure the firm’s viability over a long period of time. This would require satisfying all the
constituents of the firs, including the stockholders, management, employees, customers,
suppliers and government.
The satisfying objective, in fact, is multiple goals and it is very difficult to practice and
achieve. This is because; human beings by nature want satisfaction not only in an absolute
sense but in a relative sense as well.

OTHER (NON- PROFIT) OBJECTIVES

The none profit objectives include goals such as, maximization of quantity and quality of
output subject to a break-even budget constraint, administrators’ utility maximization,
maximization of factor productivity, and maximization of each flows. The rationale for these
objectives is inherent in the nature of the public sector firms and not-for-profit organization.
These units are engaged in the production of essential goods (such as gas, electricity,
transport and electricity) and public goods (such as national parks, museums, national
defense and flood control), and render services to a group of clients (such as patients of a
hospital) and to their members/contributors (such as the members of a trade union, of a
cooperative firm or of a country club).

FIRMS CONSTRAINTS
Decision making by firms is often subject to certain restrictions or constraints, which may be
internal or external. The internal constraints refer to the one’s imposed by the organization
itself. For example, while deciding on what to produce, a firm might not like to explore each
and every and every alternative goods or service it could produce. If the promoter, for
example, is a fresh engineer with a little money of his own and is a risk factors, he might
consider only a handful of small manufacturing firms to choose just one amongst them.
Among the external constraints, the important ones are resources constraints, output
quantity or quality constraints, legal constraints, and environmental constraints.

RESOURCES CONSTRAINTS
Certain resources might be available in a fixed or limited quantity and the firm has to take
the most appropriate decision. For example, for a small entrepreneur, capital would be a
constraint, Similarly, a raw material have to be imported and there may be an import
restriction or it might be locally available, but only in a limited quantity, in which case, the
firm has to decide within this constraint.

OUTPUT QUANTITY AND QUALITY CONSTRAINTS

Production of many goods requires a license from a competent authority. Since the,
licenses are issued for installing a certain unit of maximum capacity, they become a
constraint to the firm and, such constraints are sometimes dictated by the availability of the
market. Similarly, the licensing authority might prescribe certain quality norms, which the
organization must adhere to.

LEGAL CONSTRAINTS
The legal constraints of firms’ behavior take the form of laws that define minimum wages
and bonus, health and safety standards, pollution emission standards, fuel efficiency
requirements, price controls including taxes and subsidies, import-export quotas and tariffs,
fair marketing practices, priority lending and differential interest rates on loans, backward
area subsides, differential tax rates, and so on. All these constraints impose restrictions on
managerial flexibility.

ENVIRONMENTAL CONSTRAINTS
No firm can afford to ignore the economic, social and political environment within which it
has to function. It needs to understand these spheres not only within the economy but also
in the world outside since most economies are open economies in the present day context.

DECISION PROCESS
1. Establish objectives
2. Specify the decision problem
3. Identify alternatives
4. Evaluate alternatives
5. Select the best alternative
6. Implement the decision
7. Monitor the performance.

Unit II
 DEMAND ANALYSIS
Meaning of Demand
Demand in economics means effective demand, that is one, which meets with all its three
crucial characteristics; desire to have a good, willingness to pay for that good, and ability to
pay for that good. In the absence of any of these three characteristics, there is no demand.
Fox example, a teetotaler professor may possess both the willingness to pay as well as the
ability to pay for a bottle of liquor, yet he does not have a demand for it. This is because he
does not desire to have an alcoholic drink. Similarly, a businessman might have the desire
to have a television, he might be rich enough to be able to pay for it, but if he is not willing
to pay for the television, he does not have a demand for this product.
Demand is usually defined as a schedule, which shows various quantities of a product which
one, or more consumers are willing and able to purchase at each specific price in a set of
possible prices during a specific period of time. For example, demand for milk by a
household per month may be as follows:
Milk price Milk Demand
(Rs. Per litre) (litres)
8 5
7 8
6 12
5 20
4 30
3 45

QTY DD

TYPES OF DEMAND
There are a large number of goods and services available in every economy. Their
classification is important in order to carry out a meaningful demand analysis for managerial
decisions. Also, an understanding of demand at various levels of aggregation is inevitable
for policy decisions. The significant classification in these two respects is the following;

1. Demand for consumer’s goods and producer’s goods.

2. Demand for perishable and durable goods.
3. Autonomous (direct) and derived (indirect) demand.
4. Individual buyer’s demand and all buyers’.
5. Firm and industry demand.
6. Demand by market segments and by total market.

Consumers’ goods and producers’ goods:

Goods and services used for final consumption are called consumers goods. E.g., food
items, clothes, kitchen utensils, residential houses, medicines, and services of teachers,
doctors, lawyers etc.,
Producers’ goods refer to the ones used for production of other goods. Thus, producers
goods consist of plant and machines, factory buildings, services of business employees, raw
materials etc,

Perishable and Durable goods:

Perishable goods are those, which perish or become unusable after sometime, the rest are
durable goods. Thus, the former would include items like milk, fish, eggs, and paper cups
and plates: and the latter would include furniture, cars, refrigerators, clothes and shoes.
Perishable goods refer to those goods, which can be consumed only once. In other words,
these goods are themselves consumed while in the case of durable goods; their services
alone are consumed. E.g., plant and machinery, buildings, furniture, automobiles,
refrigerators and fans.

Autonomous and Derived Demand:

The goods whose demand is not tied with demand for some other goods are said to have
autonomous demand, while the rest have derived demand. Thus, the demands for all
producers’ goods are derived demands, for they are needed in order to obtain consumers or
producers goods. The distinction between autonomous and derived demand is one of a
degree than of a kind. Some times a distinction is also drawn between direct and indirect
demand, and that distinction is close to the difference between autonomous and derived
demand, respectively. Goods that are demanded for their own sake have direct demand
while goods that are needed in order to obtain some other goods posse’s indirect demand.

INDIVIDUALS’ DEMAND AND MARKET DEMAND

The demand for a good by an individual buyer is called individual’s demand while the
demand for a good by all buyers in a market is called market demand.
Milk price Buyer 1 Buyer 2 Buyer 3 All buyers
(Rs./litre) market
demand
8 5 10 0 15
7 8 12 4 24
6 12 15 7 34
5 20 19 12 51
4 30 25 20 75
3 45 30 30 105
FIRM AND INDUSTRY DEMAND
More than one firm today produces most goods and so there is a difference between the
demand facing an individual firm and that facing an industry (all firms producing a particular
goods constitute an industry engaged in the production of that good). For example, Maruti
Udyog, Hindustan motors, premier Automobiles, and standard motor products of India
manufacture cars in India. Demand for Maruti car alone is a firm’s (company) demand
where as demand for all kinds of cars is industry’s demand.

DEMAND BY MARKET SEGMENTS AND BY TOTAL MARKET

If the market is large in terms of geographical spread, product uses, distribution channels,
customer sizes or product varieties, and if any one or more of these differences were
significant in terms of product price, profit margins, competition, seasonal patterns or
cyclical sensitivity, then it may be worthwhile to distinguish the market by specific segments
for a meaningful analysis. In that case, the total market demand would mean the total
demand for the product from all market segments while a particular market segment
demand would refer to demand for the product in that specific market segment.

DETERMINANTS OF DEMAND
Demand analysis is needed basically for three purposes:

1. To provide the basis for analyzing market influences on the demand.

2. To provide the guidance for manipulating the demand.
3. To guide in production on planning through forecasting the demand.

DEMAND DETERMINANTS

For all demands for durable and/or for aggregate demand

Expensive goods

Consumers own consumers Numbers Distribution

Income price taste and of consumers of consumers
Preference

Prices of related Consumers expectations

Goods about

Substitutes Complementary
Goods price goods prices

Future Future
Incomes Prices
CONSUMERS’ INCOME AND DEMAND
Demand presupposes the existence of the ability to pay for the product. The ability to pay
is in turn determined by the income, wealth or / and the credit worthiness of the consumer.
Economists Classify Goods into normal or superior goods and inferior goods. By definition,
the former are those whose demand varies directly with income while the latter are those
whose demand varies inversely with income. The relationship between demand and income
is of this type because as the consumer’s income increases, his purchasing power goes up
and therefore he increases his consumption of superior goods, and if he was consuming
some inferior items earlier, he would give then up either totally or partially in favor of
superior items.

Engel Schedules

For superior Goods For inferior Goods

Income Demand Income Demand

100 5 100 10
150 8 150 9
200 10 200 7
250 11 250 4

PRICE AND DEMAND

The demand for a good varies inversely with its own price, ceteris paribus. (Other remain
constant) Thus, as the price of the maruthi car goes up, other things remaining same, the
demand for Maruthi car goes down, and vice versa. This is known as the law of demand. It
must be noted here that the law, which describes the inverse relationship between quantity
demanded and price, includes a rider, that is, other things remaining the same. The ‘other
things’ here refer to all the factors which affect the demand barring its own price.
The price effect (PE) refers to the effect of a change in the price of a commodity, cteris
paribus, on the demand for that commodity. This effect is divided into income effect (IE)
and substitution effect (SE):

PE = IE + SE

The income effect refers to the effect of a price change on its demand, ceteris paribus,
which arises due to the corresponding change in the (real) income of the consumer.

PRICE OF RELATED GOODS AND DEMAND

The two goods X and Y are said to be complementary goods if consumer needs good X when
he has good Y. For example, tea and sugar, cart and petrol, cigarettes and matchboxes are
pairs of complementary items. If the two goods A and B are substitutes, an increase in the
price of good B, price of good a remaining constant, would happen when the price of
substitute items falls. In the case of complementary goods, the relationship is the other
way round. If the price of a complementary item (petrol) goes up, the demand for the
parent good (car) goes down.
CONSUMERS’ TASTES AND PREFERENCES, AND DEMAND
Consumers’ tastes and preferences are an important determinant of the demands for all
consumers’ good. If a person is a pure vegetarian, either because of religion, tradition or
taste, his demand for meat is Zero no matter what his income and the price of meat are.
Similarly, if a product goes out of fashion, or taste, its demand goes down. On the
other hand, if an item becomes popular (due to improved taste for it), its demand goes up.
Television, car and most luxury items fall in the category of popular items.

CONSUMERS’S EXPECTATIONS AND DEMAND

Consumer’s expectations with regard to their future income, and future prices of the goods
in question in relation to its substitutes and complementary products exert influence on the
demand for many goods. For example, graduate students are often observed to spend
beyond their means, for their future incomes are high, while the service people in their late
fifties try to cut on non-essentials, for their future incomes are low. Thus, an increase in
expected future income leads to an increase in the demand for consumers’ goods and vice
versa. Similarly, an increase in the expected future price of a product leads to an increase in
the demand for that product in the current period. Also, when consumers fear shortage of a
commodity, they are often found to buy and stock under panic. Quite the opposite holds
good when there are rumors of bumper crops. The expectations’ variables are often left out
from the list of demand determinants for non-durable and cheap goods.

NUMBER OF CONSUMERS, THEIR DISTRIBUTION AND DEMAND

The aggregate demand for a good obviously depends also on the number of consumers.
Other factors remaining the same, the larger the number of consumer of consumers, the
greater is the demand, and vice versa. Thus, the demand for almost all the products in
India as we all as in the world as a whole is increasing over time, partly because the
population is increasing over time.
If the proportion of rich households to the total number of households increases, demand
for cars would increase and vice-versa. Similarly, demand for cosmetics would increase if
the proportion of women in the total population increases, and demand for baby food would
fall if the proportion of babies in the total population fall, and so on.

DEMAND FUNCTION
A function of that which describes the relationship between variable and its determinants.
Thus, the demand function for a good relates the quantities of goods which consumers
demand during some specific period to the factors, which influence that demand. To put it
mathematically, the demand function for a good X can be expressed as follows:
Dx = f (Y,Px,Ps,Pc,T; Ep,Ey: N, D, D, u)

Where,
Dx = demand for good x
Y = consumers’ income
Px = price of good x
Ps = Prices of substitutes of x
Pc = Prices complements of x
T = measures of consumers’ tastes and preferences
Ep = consumer’s expectations about future prices
Ey = Consumers’ expected future incomes
N = number of consumers
D = distribution of consumers
u = ‘other’ determinants of the demand for x
f = unspecified function to be read as “function of “ or “depends on”
fi = partial derivative of f with respect to the ith variable.
It would suffice to point out here f1 is positive if X happens to be a superior good and
negative if it were an inferior good: f5 is positive if consumers develop taste and
preferences in favor of X and negative if against it, and the sign of f9 depends on the way
an appropriate distribution of consumers undergo a change. Incidentally, it may also be
recalled here that the first five determinants (Y,Px,Ps,Pc and T) affect the demand for all
goods, the next two (Ep and Ey) exert an influence mainly on the demand for durable and
expensive goods, and the next two (N and D) are arguments only in the demand functions
for a group of consumers.

DEMAND ELASTICITIES
The foregoing section delineated the forces, which impinge on demand as well as the
directions of their effects. For managerial decisions, one also needs the extent or
magnitude of these effects. One way to measure the magnitude is provided by the concept
of elasticity. Elasticity is a general measurement concept and therefore, in what follows, we
shall first discuss its general meaning and then go oven to demand elasticity’s.

ELASTICITY CONCEPT
Elasticity is a measure of the sensitiveness of one variable to changes in some other
variable. It is expressed in terms of a percentage and is devoid of any unit of
measurement. For example, elasticity of a variable X with respect to variable Y (ex, y) is
expressed as
Percentage change in X
Exy =-----------------------------------------------.

Percentage change in Y

This is the formula if the data is discrete. For continuous functions, it is given as
In this expression, please note that X is a dependent (effect) variable and Y is an
independent (cause) variable. The term stands for derivative of X with respect to Y.
Elasticity could be measured at a point or on an arc (line). To explain this, consider a
hypothetical schedule, describing a relationship between X and Y:
X Y
5 50
3 100
The elasticity at point A = 5, Y = 50 equal.The elasticity at point B, where X =3, Y = 100
equals Thus, if the set of values of the two variables at point A are used, then it is the point
elasticity at point A, and so on. In contrast, there is a concept, which computes the
elasticity on the arc. The formula for that is given by Where subscripts 1 and 2 refer to
the first and second values of the corresponding variables. Thus, the arc elasticity in the
above example would be.It would be seen that the arc elasticity lies between the
corresponding two-point elasticity’s and this is always true.

DEMAND ELASTICITIES
Demand elasticity’s refer to elasticity’s of demand for a good with respect to the
determinants of its demand.
1. Price elasticity of demand.
2. Income elasticity of demand
3. Cross elasticity of demand
4. Promotional (advertisement) elasticity of demand.

PRICE ELASTICITY OF DEMAND:

Price elasticity of demand refers to elasticity of demand for a good (Dx) with respect to its
own price (Px). If the law of demand holds good, the price elasticity of demand would be
negative. Thus, if the two points on the demand curve were:
Then the price elasticity at the original point (first) would be –2.5
And at the new point would equal –1.33
There are five critical values for this elasticity: Zero, less than one, one, more than one, and
infinity. The price elasticity is Zero ( or demand is perfectly price inelastic) when demand is
invariant to all changes in price. There is hardly any commodity in the world for which this
is true. The closest example would be for salt. Salt is an inexpensive and yet an essential
consumption item and its consumption can vary only within a small range. For this reason
alone, its consumption hardly varies with variations in its price.
Price elasticity is less than unity (or demand is relatively price inelastic) when changes in
price leads to a less than proportionate change in demand. A large number of goods and
services, which include all the essential items, have inelastic demand. On the other hand, if
percentage change in demand exceeds that in price, price elasticity’s greater than unity (or
demand is relatively price elastic).

INCOME ELASTICITY OF DEMAND:

The income elasticity of demand measures the sensitiveness of demand to change in
consumer’s income (y). Symbolically, it can be expressed as it is positive for superior goods
and negative for inferior goods. When income elasticity is positive and greater than unity,
the good is called a luxury good. For necessary but superior goods, the elasticity is positive
but less than unity. For semi-luxury products, the elasticity is around unity. An
understanding of the income elasticity of demand is of great significance for both firms and
the government. Firms whose demand functions have high-income elasticity’s will have
good growth opportunities in an expanding economy. Such firms therefore must take a
close look at the aggregate economic activities and its likely growth rate in the future. In
contrast, companies whose products have low-income elasticity’s would neither gain much if
the economy expands nor lose significantly if the economy retards.
CROSS ELASTICITY OF DEMAND:
The cross (price) elasticity of demand refers to the responsiveness of demand for product x
to changes in the price of product Y. It can be computed as follows:
It is positive if goods x and y are substitutes in the consumption basket, negative if they are
complements, and zero if they are unrelated. The greater the magnitude of this elasticity,
the stronger is the relationship between two goods. Thus, the cross elasticity of demand
between the demand for a Maruti car and the price of a Fiat car would be positive, and that
this elasticity would be greater than the cross elasticity of demand between the demand for
a Maruti car and the price of a Bajaj scooter.
The cross-price elasticity concept is used for two main reasons. One, to assess the
significance of changes in related products’ prices on its own market, and thereby to
formulate ones ’ own pricing strategy. Two, cross elasticity is used in industrial
organizations to measure the inter-relationships between industries and sector. For
instance, in an agriculture dominant economy like India, knowledge of the cross elasticity of
demand for industrial products with respect to agricultural price would indicate the extent
by which farmers prosperity is the cause of industrial growth.

PROMOTIONAL ELASTICITY OF DEMAND

Promotional elasticity stands for the sensitiveness of demand for goods x to changes in
advertisement budget of its producers(A). Its formula would be the following:
This must obviously be positive, for advertisement expenditures are supposed to boost up
the market. The higher this elasticity, the greater would be the incentive for the firm to go
in for advertising its product.
Besides these four demand elasticity’s, as hitherto pointed out, there are other demand
elasticity’s which are with respect to ‘other’ (other than the four corresponding demand
determinants) arguments in the demand function. For example, the interest rate may be an
important determinant in the demand for some expensive goods like housing, and if so, one
might like to compute the interest elasticity of demand for housing. In the western world,
where the climate is so cold, public utilities like electricity would like to know the weather
elasticity of demand for their products, and so on.
Before we end this section, it is pertinent to explain the calculations of various demand
elasticity’s through a hypothetical example. Let the demand function for coffee of a typical
consumer be the following:

Coffee Quantity of Real income Tea price

(Rs./kg) coffee bought (Rs) (Rs./Kg)
(Kgs)
Year
1 95 20 1000 35
2 98 18 1000 35
3 98 21 1050 35
4 95 21 1000 40
DEMAND FORECASING
Demand results in sales, which constitute the primary source of revenue for business. On
the other hand, the production to meet the demand gives rise to most of the costs in a firm.
The importance of demand or sales forecasting to business planning can hardly be over –
emphasized. Good production and sales planning require forecasts of the business
conditions and of their relationship to demand. Any forecasting requires managers to
predict for future, which, by its nature, is unknown. In fact, it is to minimize the
‘uncertainties’ of the unknown future that these forecasts are needed. The more realistic
the forecasts, more effective decisions can be taken for tomorrow. Actually, the most
important factor, which goes into making an effective manger, is his sense of predicting
future events influencing the firm. Usually, as a first step the firm needs to make a demand
or sales forecast and later on to move into other areas of corporate forecasting and
planning.

PURPOSE OF FORECASTING DEMAND

PURPOSE OF SHORT-TERM FORECASTING
Forecasting is done both for the long run as well as short run. The purpose of the two,
however, differs.
In a short-run forecast seasonal patterns are of prime importance. Such a forecast helps in
preparing suitable sales policy and proper scheduling of output in order to avoid over
stocking or costly delays in meeting the orders. Besides giving an idea of likely demand.
Short-run forecasts also help in arriving at suitable price for the product and in deciding
about necessary modifications in advertising and sales techniques.
PURPOSE OF LONG-TERM FORECASTING
Long run forecasts are helpful in proper capital planning. When installing production
capacity, and element of flexibility in their availability has to be ensured to take care of
planned and expected changes in production. It is only after a decision regarding the
equipment and the process is taken, that the firm can plan for the personnel recruitment,
etc. Long term planning thus helps in saving the wastages in material, man-hours,
machine-time and capacity. In the long run forecasting, changes in variables like
population, age-group pattern, consumption pattern, etc., are included.
DETERMINANTS OF DEMAND
1. NON-DURABLE CONSUMER GOODS.
a. Purchasing power.
b. Price.
c. Demography.
2. DURABLE CONSUMER GOODS.
3. CAPITAL GOODS.

CRITERIA OF GOOD FORECASTING METHOD

1. Accuracy.
2. Simplicity and Ease of comprehension.
3. Economy.
4. Availability.
5. Maintenance of Timeliness.
I. SURVEY OF BUYERS’S INTENTIONS

The most direct method of estimating demand in the short run is to ask customers
what they are planning to buy for the forthcoming time period-usually a year. This
method, also known as opinion survey, is most useful when bulk of the sales is made to
industrial producer. Here the burden of forecasting is shifted to the customer. Yet it
would not be wise to depend wholly on the buyer’s estimates and they should be used
cautiously in the light of the seller’s own judgment. A number of biases may creep into
the surveys. If shortages are expected, customers may tend to exaggerate their
requirements. The customers may know what their total requirements are but they may
misjudge or mislead or may be uncertain about the quantity they intend to purchase
from a particular firm. This method is not very useful in the case of household
customers for several reasons, 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.

Delphi Method.
A variant of the opinion poll and survey method is Delphi method. It consists of an
attempt to arrive at a consensus in an uncertain area by questioning a group of experts
repeatedly until the Reponses appear to converge along a single line or the issues
causing disagreement are clearly define. The participants are supplied the responses to
previous questions from others in the group by a coordinator or leader of some sort.
The leader provides each expert with the responses of the others including their reasons.
Each expert is given the opportunity to react to the information or consideration
advanced by others but interchange is anonymous so as to avoid to reduce the ‘halo
effect’ It is facilitates the maintenance of anonymity of the respondent’s identity
throughout the course. Delphi renders it possible to p use the problem to the experts at
one time and has their response.

II. COLLECTIVE OPINION

Under this method, also called sales-force polling, sales men are required to
estimate expected sales in their respective territories and sections. The rationale
of this method is that salesmen, being the closest to the customers, are likely to
have most intimate feel of the market, i.e., customer reaction to the products of
the firm and their sales trends. The estimates of individual salesmen are
consolidated to find out the total estimated sales. They are then reviewed to
eliminate the bias of optimism on the part of some salesmen and 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 programmers, expected
changes in competition, 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. This method is known as the
‘Collective opinion method’.
 III. NAÏVE MODELS
Naïve forecasting models are based exclusively in historical observation of sales (or
other variables such as earnings, cash flows, etc). They do not explain the
underlying causal relationships, which produce the variable being forecast.

Three Naïve Models

1. A simple example of a naïve model type would be to use the actual sales of the
current period as the forecast for the next period.
Let us use the symbol Y’ t +1 as the forecast value and the symbol Yt as the
actual value. Then,
Y’t +1 = Yt
2. If we consider trends, then,

Y’t + 1 = Yt + (Yt – Yt –1)

-11-

This model adds the latest observed absolute period-to-period change to the
most recent observed level of the variable.
3. If we want to incorporate the rate of change rather than the absolute amount,
then,
Yt
Y’t + 1 = Yt
Yt – 1
Illustration:

Consider the following sales data:

Month 1 2 3 4 5 6 7 8 9 10 11 12
Monthly
Sales 305 298 367 291 334 406 475 551 528 550 581 610
(000’Rs 0 0 0 0 0 0 0 0 0 5 0 0
)
We can now make forecasts for Jan 1999 based on the aforesaid three models;

I. Y’t + 1 = Yt = Rs. 61,00,000

II. Yt + 1 = Yt + (Yt - Yt - 1) = Rs.6100 + (6100 – 5810)

+ Rs.6100 + 290 = Rs. 6390

That is, Rs.63,90,000

Yt 6100
III Yt + 1 = = Rs.6,100 X Rs.6100(1.05)
Yt - 1 5810
 = Rs.6405
The naïve models can be applied with very little need of a computer.

IV. SMOOTHING TECHNIQUES

MOVING AVERAGES
Moving averages are averages that are updated as new information is
received. With the moving average simply employs, the most recent observations, drops
the oldest observation, in the earlier calculation and calculates an averages, which is used
as the forecast for the next period.
Example;
Let us assume that the sales manager has the following sales data;

Date Jan 1 Jan2 Jan3 Jan4 Jan5 Jan6 Jan7

Actual
Sales 46 54 53 46 58 49 54
(Yt)
(oooRs)

Taking a six-day moving average. We get

46 + 54+53+46+58+49
Y’7 = = 51
6

54+53+46+58+49+54
Y’8 = = 52.3
6

V.ANALYSIS OF TIME SERIES AND TREND PROJECTIONS

A firm, which has been in existence for some time, will have accumulated
considerable data on sales pertaining to different time periods. Such data when arranged
chronologically yield ‘time series’. The time series relating to sales represent the past
pattern of effective demand for a particular product. Such data can be presented either in a
tabular from or graphically for further analysis. The most popular method of analysis of
time series is to project the trend of the time series. A trend line can be fitted through a
series either visually or by means of statistical techniques such as the method of least
squares. The analyst chooses a plausible algebraic relating (linear, quadratic, logarithmic,
etc) between sales and the independent variable, time. The trend line is then projected into
the future by extrapolation.

VI.USE OF ECONOMIC INDICATOR

The use of this approach bases demand forecasting on certain economic indicators,
e.g.,
(i) Construction contracts sanctioned for the demand of building materials, say,
cement:
 (ii) Personal income for the demand for consumer goods:
(iii)Agricultural income for the demand of agricultural inputs, implements,
fertilizers, etc:
(iv) Automobile registration for the demand of car accessories, petrol, etc.,
(v)

V1.CONTROLLED EXPERIMENTS

Under this method, an effort is made to vary separately certain determinants of

demand which can be manipulated, e.g. price, advertising, etc., and conduct the
experiments assuming that the other factors 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 markets. 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 must be noted that the market divisions here must be
homogeneous with regarded to income, tastes, etc.

VII. JUDGEMENTAL APPROACH

Management may have to use its own judgment when: (I) analysis of time series
and trend projections is not feasible because of wide fluctuations in sales or because of
anticipated changes in trends; and (ii) use of regression method is not possible because of
lack of historical data or because of management’s inability to predict or even identify
causal factors. Even when statistical methods are used, it might be desirable to supplement
them by use of judgment for the following reasons: (a) Even the most sophisticated
statistical methods cannot incorporate all the potential factors affecting demand as, for
example, a major incorporate all the potential factors affecting demand as, for example, a
major technological breakthrough in product or process design. (b) For industrial

products, demand may be concentrated in a small number of buyers. If the management

anticipates loss or addition of a few such large buyers, it could be taken into account only
through the judgmental approach. (c) Statistical forecasts are more reliable for larger
levels of aggregations. Thus while it may be possible to forecast the total national demand
more or less accurately, it may be more difficult to accurately forecast demand by sales
territory, sizes and models.

APPROACH TO FORECASTING

1. Identify and clearly state the objective of forecasting-short term or long-term:

market share or industry as a whole.
2. Select appropriate method of forecasting.
3. Identify the variables affecting the demand for the product and express them in
appropriate forms.
4. Gather relevant data or approximations to relevant data to represent the variables.
5. Through the use of statistical techniques, determine the most probable relationship
between the dependent and the independent variables.
6. Prepare the forecast and interpret the result. Interpretation is more important to the
management.
7. For forecasting the company’s share in the demand, two different assumptions may
be made;
a. The ratio of the company sales to the total industry sales will continue as in
the past.
b. On the basis of an analysis of likely competition and industry trends, the
company may assume a market share different from that of the past.
8. Forecast may be made either in terms of physical units or in terms of rupees of sales
volume. The latter may be converted into physical units by dividing it by the
expected selling price.
9. Forecasts may be made in terms of product groups and then broken for individual
products on the basis of past percentages. Product group may be divided into
individual products in terms of sizes, brands, labels, coleus, etc.
10. Forecasts may be made on annual basis and then divided month-wise or week-wise
on the basis of past records.

PRESENTATION OF A FORECAST TO THE MANAGEMENT

1. Make the forecast as easy for the management to understand as possible.

2. Avoid using vague generalities.
3. Always pinpoint his major assumptions and sources.
4. Give the possible margin of error.
5. Avoid making undue qualifications.
6. Omit details about methodology and calculations.
7. Make use of charts and graphs as much as possible for easy comprehension.
 UNIT: III
PRODUCTION FUNCTION

MEANING:
The term “production function” refers to the relationship between the inputs and
the outputs produced by them. The terms
“Factors of production” and resources are used interchangeably with the term
“inputs”. The relationship is purely physical or technological in the character, that is,
it ignores the prices of inputs and outputs.

FACTORS OF PRODUCTION:
1. Land
2. Labour
3. Capital and
4. Technical know how.

Land: as factors of production: In economics, the term Land as factors of production

has a wider meaning. Besides the surface of the earth, it includes agricultural land, building
sites, mines, fisheries, forests, rivers, underground water, air, sunshine, etc. It also
includes animals and cattle. All the natural resources of the country like mountains; lakes
waterfalls and valleys come under the category ‘ Land’ in economics. In short, land is
nature minus man.
Labour :as a factor of production: Labour is also a primary factors of production
and it is a human factor. Labour is any work of body or mind undertaken for a
reward, which results in production. As a factor of production labour has some
preculiaries. Labour is undertaken only for reward. Labour cannot be separated from
labourer. Labour is perishable. Labour is both means and end of economic activities.
Labour is less mobile.
Capital: Capital is not an original factor of production. It is produced means of
production. All capital is wealth, but all wealth is not a capital. An article of wealth
cannot be called capital unless it is used for further production of wealth. The chief
types of capital assets are machinery, factories, railways, vehicles and the like.
Organization; the first three factors, viz., land, labour and capital are powerless by
themselves. These three factors have to be gathered, planned, engineered and
managed in the productive operation. Only then production will be possible. It is
‘organization’ which does this function of co-ordination the factors of production.

THEORY OF PRODUCTION
LAW OF RETURNS
1. LAW OF DIMINSHING RETURNS.
2. LAW OF INCREASING RETURNS.
3. LAW OF CONSTANT RETURNS.
 LAW OF DIMINSHING RETURNS:
Marshall’s Definition of the Law:
Marshall defined the law of diminishing returns as follows: “ An increase in the
capital and labour applied in the cultivation of land causes in general a less than
proportionate increase in the amount of the produce raised, unless it happens to
coincide with an improvement in the arts of agriculture.
Let us suppose a farmer having a plot of land measuring 10 acres is interested
in increasing the output from his land by investing more and more capital and
labour. Let us assume that a unit of capital and labour is of a value of Rs.100. Now
we have to study how the inputs when increased as successive doses result in extra
output. The land is kept as a fixed factor and the input (labour and capital) has been
made a variable factor. Let us suppose the farmer gets the following results shown
in the below schedule.
From the table we infer that the plot of land (10 acres) is combined with one
unit of Capital and Labour worth Rs.100 (Input) and the output comes to 10 units of
corn. By combining the same plot with 2 units of capital and labour, i.e., Rs200, the
total output comes to 18 units. When 3 units of input are invested the output
becomes 24 units. Now we can distinguish three types of output from the table.
They are:
1. Total output or total returns.
2. Average output or average returns. And
3. Marginal output or marginal returns.

Labour and Output of corn Average output of Marginal output of

Capital In units corn in units Corn in units
invested (Total output)
(Inputs in
units)
1 10 10 10
2 18 9 8
3 24 8 6
4 28 7 4
5 30 6 2
6 30 5 0
7 28 4 -2
8 24 3 -4

Total returns are the total output of corn for the total doses of capital and labour
applied. Column 2 of the table gives total returns for the total inputs. The total return is
increasing from 10 to 28,24,28,30 units, etc. However, the rate of increase is diminishing.
The total output is maximum when the input is 5 or 6 units. Average returns refers to the
output per unit of capital and about invested. This is arrives by dividing average output
with the total units of input. Column 3 of the table given average output, which is
decreasing. Marginal Returns refers to the output of corn due to increase in one unit of the
input. It refers to the extra output
Due to increase in input by one unit.
Y
 Total utility curve

cap & lab

MR

Output X

In the figure, X-axis represents inputs in units of capital and labour. Y-axis represents
the output of corn in units. TR curve represents total Returns: AR curve represents Average
Returns and MR curve represents Marginal Returns. The three curves illustrate two basic
facts, namely;
1. Total output increases at a diminishing rate.
2. Average and Marginal outputs decrease.

LAW OF INCREASING RETURNS:

The law of increasing returns is closely related to the law of diminishing returns. This
law also operates because efforts are many t increase the output by the producer. Marshall
has defined the law of increasing returns in the following way: “ An increase of labour and
capital leads generally to improved organization, which increases the efficiency of the work
of labour and capital. Therefore, in those industries which are not engaged in raising raw
produce, and increase more than in proportion, and further this improved organization
tends to diminish or even override any increased resistance which nature may offer to raise
increased amounts of raw produce”.

Doses of Labour & Marginal Returns Total production

Capital (Meters of cloth) (Meters of cloth)
First 1,000 1,000
Second 1,500 2,500
Third 2,000 4,500
Fourth 2,500 7,000
Fifth 3,000 10,000

If every dose of labour and capital is worth Rs.1, 000, we find that while the first dose gives
a return of 1,000 meters, the second dose affords a return of 1,500 meters and so on. We
are getting increasing marginal returns. The marginal returns indicated in the table can be
set in a graph as shown in Figure below by taking input on X axis and marginal output on
the Y axis.
 Y

MR
M output

Input X
Causes for increasing returns:
1. The first reason is the indivisibility of factors of production.
2. Secondly, the law of increasing returns arises out of division of labour and
specialization.
3. Thirdly, increasing returns are due to internal and external economies of production.

LAW OF CONSTANT RETURNS

The law of constant returns represents the transition from the increasing to deceasing
returns or vice versa. The law of constant returns is said to operate when the total output
increases exactly in proportion to the increase in the factors of production. Prof. Stigler has
defined the law of constant returns as follows: when all of the productive services are
increased in a given proportion, the product is increased in the same proportion.”
Theoretically, if in the process of production n increase in input is accompanied by
proportionate increase in output, i.e., the marginal returns are equal to input, we have
constant returns. If the input is doubled, the output will also be doubled. If it is trebled,
the output will also be trebled. But in practice, we cannot have such a condition though it is
not impossible. But when the firm passes from increasing to decreasing returns or vice
versa, theoretically there should be a point of constant return.

Doses of inputs Total output Marginal output

(Capital and labour)
First 1000 1000
Second 2000 1000
Third 3000 1000
Fourth 4000 1000

MODERN APPROACH TO THE LAWS OF RETURNS:

LAW OF VARIABLE PROPORTION
The level of output of a firm depends on the combination of different factors, viz., land,
labour, capital and organization. In order to bring about a change in the level of production,
the quantities of the various factors engaged in production will have to be changed. An
increase in production would be possibly had only when either the quantity of all the factors
is increased simultaneously, or when the quantity of some of the factors is increased while
that of others remains constant. Since all the factors are not easily available in the require
quantities, it becomes necessary to keep the scarce factor constant and increase the
quantity of other factors, while those whose supply can be easily changed are called
variable factors. Therefore to bring about an increase in the output, the producers would
use more and more of the variable factor with the given quantity of the fixed factors. In the
theory of production, the law, which examines the relationship between one variable factor
and output, keeping the quantities of other factors fixed, is called the law of variable
proportions.

Assumptions of the Law of Variable proportions.

1. The state of technology in production remains constant and unchanged.

2. Only one factor of input is made variable and other factors are kept constant.
3. It is possible to vary the proportions in which the various inputs are combined. This
law does not apply to those cases where the factors must be used in rigidly fixed
proportions to yield a product.
4. All units of the variable factor are homogeneous.
5. Finally it is also assumed that the entire operation is for short-run, as in the long run
all inputs can be variable.

Three Stages of the Law

Stage: I In this stage, the total product increases at an increasing rate. The Total product
curve (TP) increases sharply up to the point F, i.e., fourth combination where the marginal
product (MP) is at the maximum. Afterwards, i.e., beyond F, the total product curve
increases at a diminishing rate, as the marginal product falls, but is positive. The point F
where the total product stops increasing at an increasing rate and starts increasing at a
diminishing rate is called the point of inflexion. At this point the marginal product is at the
maximum. So stage I refers tot the increasing stage where the total product, the marginal
product and average product are increasing. It is the Increasing returns Stage.

Fixed Factor Variable Total Average Marginal

(Machine) Factor production Production production
(labour) in units in units In units
1+ 1 10 10.0 10
1+ 2 22 11.0 12
1+ 3 36 12.0 14
1+ 4 52 13.0 16
1+ 5 66 13.2 14
1+ 6 76 12.6 10
1+ 7 80 11.4 4
1+ 8 82 10.2 2
1+ 9 82 9.2 0
1+ 10 78 7.8 -4

Y I II III

Output
TP
 AP
MP

Variable factor (labour) X

Stage II: In the second stage, the total product continues to increase, but at a diminishing
rate until it reaches the point S where it completely stops to increase any further. At this
the second stage ends. In this stage, the marginal products and average products are
declining but are positive. At the end of the second stage, at point S the total product is at
the maximum and the marginal product is zero. It is cutting the X-axis. The second stage
is the stage of diminishing returns.
Stage II; in this stage, the total product declines and therefore the TP curve sloped
downwards. The marginal product becomes negative cutting the X-axis. This stage is
called the negative returns stage

THE PRODUCTION FUNCTION

The laws of returns, which bring out the functional relationship between the factors of
production used and the output realized. In modern terminology, the various factors like
land, labour, capital, organization skill, raw materials and other factors made use of in
production are given a wider coonotation called inputs. The product realized due to the
inputs is called output.
The production function can be algebraically expressed in an equation in which the
output is the dependent variable and inputs are the independent variables. This equation
can be expressed as:
Q = f (a, b, c, d, …….n)
Where, q stands for the rate of output of a given commodity.

A, b, c, d…. n are different factors (inputs) and services used per unit of time.

PRODUCTION FUNCTION – TABLE

Let us assume that for producing a commodity only two inputs, viz., labour and capital are
required. The table shows the quantity of output produced with some combination of two
inputs. It is a two-way table. Along the left hand side, the varying amounts of capital are
listed. It is rising from 1 to 6 units. Along the bottom are shown the amount of labour from
1 unit to 6 units. The intersection of the columns and rows may be called “cells”. Each cell
shows the output when the corresponding combinations of labour and capital are made.

PRODUCTION FUNCTION
OUTPUT X PER UNIT OF TIME
IN 6 692 980 1200 1386 1550 1692
 P 5 632 896 1296 1264 1410 1550
UT 4 564 800 980 1128 1264 1386
3 490 692 846 980 1096 1200
OF 2 400 564 692 800 896 980
1 282 400 490 564 632 692
CA
PI 1 2 3 4 5 6
TAL
INPUT OF LABOUR

According to the table when 2 units of labour and 2 units of capital are combined
as input, the corresponding output per unit time will be 564. The table indicated various
quantities of output when the input combination is varied. At the combination of 5 units of
labour and 5 units of capital the output stands at 1,410. In practice all factors will not be
changed. In the table, the combination of 6 units of labour and one unit of capital (output:
692) gives the same output as that of the combination of 3 units of labour and 2 units of
capital. The producer has to make decision about these two combinations giving the same
result. Which combination he will choose depends on the price of the two factors of
production and the ease with which the factors can be increased. Thus the production
function gives the input-output relationship. The producer has to take into account the
availability and productivity of the factors and select the most economical combination for
getting the desired output. This is done by means of least cost combination.

PRODUCTION FUNCTION THROUGH ISO-QUANT CURVES.

In production, the indifference curve technique is made use of in finding out

producer’s equilibrium. In this field, it assumes the name ‘equal product curve’ or Iso-quant
curve. This equal product curve shows different combinations of two factors of production,
let us say, labour and capital, which are capable of producing the same output. In the case
of theory consumer’s choice, the indifference curve showed different combination of two
commodities between which the consumer was indifferent. But in the case of production,
the equal product curve shows different combinations of two factors of production between
which the producer is indifferent, as any of these combinations is capable of producing the
same output. The particular combination selected by the producer in the equal product
curve, depends upon the relative prices of the two factors of production. This can be
explained with the help of below figure.
When the producer combines labour and capital to produce a commodity, he will do
it in such a way that he produces the maximum with minimum cost. In the figure, units of
labour and units of capital are shown on X axis and Y-axis respectively. Ic drawn is the
indifference curve relating to production. This curve relates to an output of 100 units of the
commodity produced. Any combination of factors of production (Labour and capital) on this
curve will yield the same result, viz., and production of 100 units. Hence this curve is called
Iso-product or iso-quant curve or equal product curve.

OPTIMUM FACTOR COMBINATION

LEAST COST COMBINATION PRINCIPLE:

A ration producer, as he is after maximizing profit, will try to combine the factors of
production in such a way that the cost involved in the ‘input’ is minimum or the least one
while the returns or the ‘output’ is the maximum. The choice of combination of factors in
production has to be made very carefully due to the operation of the law of diminishing
returns. At the same time the producer has to take into consideration the money cost
involved in different combinations of factors. A particular minimum physical combination
leading to maximum physical output need not be advantageous to the producer because of
the prices of different factors combined. It is not the minimum physical combination of
factors about which the producer is concerned. He is concerned about the cost of the
combination. So, as a producer would always try to substitute a cheap factor in the place of
a costly factor so far as it will not affect the maximum output. When a producer is
producing a given output with the least cost combination of inputs, he is said to be in
equilibrium and this condition is the optimum combination of the factors giving maximum
level of output with a particular level of technology.
The equilibrium position where there is no inducement for the producer to effect any
further change in the proportions of the different factors is a below:

Marginal productivity of factor A marginal productivity of Factor B

=
Price of Factor A Price of Factor B

Suppose the marginal physical product of factor A is 240 units of output and the price of
factor A is Rs.20. Then 240 20 = 12 is the additional physical output resulting from one
rupee spent on the factor A. This should be equal to the physical output resulting from one
rupee spent on the other factor, viz., B. To put it in a mathematical form for least cost
combination:

FACTOR SUBSTITUTION TABLE

Combination Factor A Factor B MRTS of A for B
First 1 24 -
Second 2 16 1:8
Third 3 10 1:6
Fourth 4 6 1:4
Fifth 5 4 1:2
Sixth 6 3 1:1

These are two factors of production A and B. The producer combines them in many ways to
produce the same level of output. He substitutes one factor for another. In the first
combination, he procures 1 unit of A and 24 units of B. This combination produces a
particular level of output. Now in the second combination, he substitutes one more of factor
A in the place of 8 units of factor B, so as to have the combination 2 and 16 to produce the
same output. The marginal rate of technical substitution is given by the slop of the equal
product curve at its various points. The slope of the cost line gives the price ratio of the
factors. At the equilibrium point marginal rate of technical substitution of two factors A and
B will be given by the formula as follows:

Pa
MRTSab =
Pb
Where Pa stands for the price of factor A and Pb stands for the price of factor B.

RETURNS TO SCALE
Difference between laws of returns and returns to scale;
Under laws of returns, we studied the behaviors of output when alteration in factor
proportions is made. Keeping one or more factors constant and other factors variable alters
factor proportions. It is a study of the changes in output when different combinations of
fixed and variable factors of inputs are made. It is a study about the differing proportions
of factor inputs leading to diminishing returns, constant returns or increasing returns.
Because the proportion in factors is change, this law has been called the law of variable
proportions. The concept of variable proportion is a short-term phenomenon, as in this
period, fixed factors cannot be changed and all factors cannot be changed. On the other
hand, in the long term, all factors can be changed or made variable. When we study
returns to scale. An increase in the scale means that all inputs of factors are increased in
the same proportion.

Changes in scale and Factor proportions

H R
Y

P
Cap

S T

Labour G X

Three phases of returns to scale:

 As in the case of variable proportions, here too, the return to increase in scale, may
be either equal, or more than equal, or less than equal in proportion. When the scale is
increased, we may get increasing returns, constant returns or decreasing returns.

Table showing returns to scale

Serial Scale Total product Marginal product
No. Of corn in units or returns in units
1 1 Labour + 2 acres of 4 4
2 land 10 6
3 2 ,, + 4 ,, 18 8
4 3 ,, + 6 ,, 28 10
4 ,, + 8 ,,
5 38 10
6 5 ,, + 10 ,, 48 10
6 ,, + 12 ,,
7 56 8
8 7 ,, + 14 ,, 62 6
8 ,, + 16 ,,

In the above table when 1 labourer and 2 acres of land are employed, the total
product is 4 units of corn. The input is doubled, i.e., 2 labourers and 4 acres are employed.
The output of corn is more than double as the marginal output goes up from 4 units to 6
units. When the scale is trebled, the total output is more than treble and the marginal
output goes up from 6 units to 8 units. Later on till S.No.6 the marginal output remains
constant at 10 units. This is the second stage or constant returns stage. Afterwards the
marginal output declines to 8 and 6 units.
ECONOMICES OF SCALE
The company major objectives are to earn maximum profit directly are indirectly this would
be the primary goals of any business concern . To achieve the target the company has to
go for mass production or it call it as large scale production. In what way company is going
to be utilized the factors effectively to achieve large scale production that is known as
Economies of scale.

ECONOMIES OF SCALE

INTERNAL ECONOMIES EXTERNAL ECONOMES

REAL ECO’S PECUNIARY ECO’S

Production marketing managerial Transport

Eco’s Eco’s Eco’s and storage
Economies

Labour Eco Advt.Eco’s Specialisation Bulk buying of

Materials of
Competitive price

Technical Eco’s Service Team work

Oblications experience Lower cost of
Capital
Inventory Economies of
Variations in Decentralisation Advt. At large
Models&design scale at lower price

Introduction of Modern
Managerial and organizational
Techniques.
COBB-DOUGLAS FUNCTION
A very popular production function which deserves special mention is the Cobb-
Douglas function. It relates output in American manufacturing industries from 1899 to 1922
to labour and capital inputs, taking the form

P = bLC1-a

Where,
P = Total output,
L = Index of employment of labour in manufacturing, and
-11-
C = Index of fixed capital in manufacturing.
The exponents  and 1- are the elasticities of production that is,  and 1- measure
the percentage response of output to percentage changes in labour and capital
respectively. The function estimated for the U.S.A. by Cobb and Douglas is:

P = 1.01 L.75 C.25

R2 = 0.9409
The production function shows that a 1 per cent change in labour input, capital
remaining constant, is associated with a 0.75 per cent change in output. Similarly, a
1 percent change in capital, labour remaining constant, is associated with a 0.25 per
cent change in output. The coefficient of determination (R2) means that 94 per cent
of the variations on the dependent variable (P) were accounted for by the variations
in the independent variables (L and C).
An important point to note is that the Cobb-Douglas function indicates constant
returns to scales. That is, if factors of production are each raised by 1 per cent, the
output will increase by 1 percent. This indicates that no economies or diseconomies
of large scale are evident; on the average, large or small-scale plant may be equally
profitable in the U.S. manufacturing industry.

MANAGERIAL USE OF PRODUCTION FUNCTIONS:

Though production functions may seem to be highly abstract and unrealistic, in fact,
they are both logical and useful. If the price of a factor of production declines
whereas that of another goes up, the former is likely to substitute the latter.
Production functions thus are not just theoretical and useless devices. On the other
hand, they can be used as aids in decision-making because they can give guidance in
two directions; (i) how to obtain the maximum output from a given set of inputs;
and (ii) how to obtain a given output from the minimum aggregation of inputs. Of
course, in more complex problems, with larger number of inputs and outputs, the
mathematics of optimization becomes complicated. But recently, the development of
linear programming has made it possible to handle these complex problems.

UNIT: IV
COST-OUTPUT RELATIONSHIP

COST CLASSIFICAIONS:
 1. Actual Cost and Opportunity Cost.
2. Incremental costs(differential costs) and sunk costs.
3. Past costs and future costs.
4. Fixed and Variable costs.
5. Direct and Indirect cost(Traceable and Common Costs)
6. Common Production costs(Costs of Multiple products)
7. Joint costs.
8. Sunk, shutdown and abandonment costs.
9. Urgent and postponable costs.
10. Out-of-pocket and Book costs.
11. Escapable and Unavoidable costs.
12. Replacement and Historical costs.
13. Controllable and Non-controllable costs.
14. Average cost, Marginal cost and Total cost

COST-OUTPUT RELATIONSHIP
The relation between the cost and output is technically described as the cost function. In
economic theory, there are mainly two types of cost functions, viz,

1. COST-OUTPUT RELATIONSHIP IN THE SHORTRUN.

2. COST-OUTPUT RELATIONSHIP IN THE LONGRUN.

COST-OUTPUT RELATIONSHIP IN THE SHORT RUN:

1. Average Fixed Cost and Output.

2. Average Variable cost and Output.
3. Average Total Cost and Output.

The cost output relationships can also be shown through the use of graphs. It will be seen
that the average fixed cost curve (AFC curve) falls as output rises from lower levels to
higher levels. The shape of the average fixed cost curve, therefore, is a rectangular
hyperbola. The average variable cost curve (AVC curve) first falls and then rises. So also
the average total cost cureve (ATC curve). However the AVC curve starts rising earlier than
the ATC curve starts rising earlier than the ATC curve. Further, the least cost level of
output corresponds to the point LT on the ATC curve and not to the point Lv which lies on
the AVC curve.

Units of Fixed Variable Total Marginal Average Average Average

output cost cost Cost Cost Cost Fixed Variable
 Rs. Rs. Rs. Rs Rs. Cost Cost
Rs. Rs.
0 176 0 176 - - - -
1 176 75 251 75 251 176 75
2 176 130 306 55 153 88 65
3 176 176 351 45 117 59 58
4 176 209 385 34 96 44 52
5 176 238 414 29 83 35 48
6 176 265 441 27 74 29 44
7 176 289 465 24 66 25 41
8 176 312 488 23 61 22 39
9 176 328 504 16 56 20 36
10 176 344 520 16 52 18 34
11 176 367 543 23 49 16 33
12 176 400 576 33 48 15 33
13 176 448 624 48 48 14 34
14 176 510 686 62 49 13 36
15 176 600 776 90 52 12 40

COST-OUTPUT RELATIONSHIP IN THE LONG RUN

The long-run, is a period long enough to make all costs variable including such costs as are
fixed in the short run. In the short run, variations in output are possible only within the
range permitted by the existing fixed plant and equipment. But in the long run, the
entrepreneur has before him a number of alternatives which include the costruction of
various kinds and sizes of plants. And all costs become variable. In view of this, the long
run costs would refer to the costs of producing different levels of output by changes in the
size of plant or scale of production.

The long run cost curve- a curve showing how costs would change when the scale of
production is changed.
 Output X

To draw a long run cost curve, we have to start with a number of short run average cost
curves(SAC curves), each such curve representing a particular scale or size of the plant,
including the optimum scale. One can now draw the long run cost curve which would be
tangential to the entire family of SAC curves, that is, it would touch each SAC curve at one
point.
The LAC curve is tangential to the various SAC curves. It is said to envelop them and is
often called as the “Envelope Curve” since no point on an SAC curve can ever be below the
LAC curve.
 UNIT:V
MARKET STRUCTURE AND COMPETITIONS

THE MARKET AND THE CRITERIA FOR MARKET CLASSIFICATION

According to Sidgwick: “ A market is a body of persons in such commercial relations
that each can easily acquaint himself with the rates at which certain kinds of exchanges of
goods or services are from time to time made by the others.”
Jevons, “The word market has been generalized so as to mean any body of persons
who are in intimate business relations and carry on extensive transactions in any
commodity”.
Ely,” Market means the general field within which the forces determining the price of a
particular commodity operate”.
Benham, market is “ any area over which buyers and sellers are in close touch with one
another, either directly or through dealers, that the price obtainable in one part of the
market affects the prices paid in other parts”.

Market has four basic components:

1. Consumers.
2. Sellers.
3. A commodity.
4. A Price

CRITERIA FOR MARKET CLASSIFICATION:

1. Classification by the ‘area’: When area is used as a basis of market classification, we

categories markets into: local markets, regional markets, national markets and
international market.
2. Classification by the nature of transactions: We can classify the markets on the
basis of nature of transactions into two broad categories: the spot market and the
future market. Where goods are physically exchanged on the spot the markets is
called spot markets. In case the transactions involve the agreements of future
exchange of goods, such markets are known as futures markets.
3. Classification by the ‘volume of business’: On the basis of the volume of business,
the markets are broadly classified into wholesale and retail markets. In the
wholesale markets goods are transacted in large quantities whereas in a retail
market transactions involve small quantities. Wholesale markets are, in fact, a link
between the producer and the retailer, while the retailer is a link between the
wholesaler and the consumer.
4. Classification on the basis of ‘time’: Sometimes the time element is used to classify
the market. The ‘time’ is classified as: very short period, short

5. period and long period. Very short period markets relate to transactions in those
commodities, which are fixed in supply of perishable in nature. The short period
markets are those where supply can be increased but only to a limited extent,
 whereas in the long-period markets the supply can be increased without any
limitations.
6. Classification by the ‘status of sellers’: During the process marketing a commodity
passes through a chain of sellers and middlemen. Markets can also be classifies on
the basis of the status of these sellers. On the basis of the status of sellers the
markets are broadly classified into three categories: Primary, Secondary and
Terminal markets.
7. Classification by regulation: On this basis the markets can be classified as regulated
and unregulated. For some goods and services, the government stipulates certain
conditions and regulations for their transactions. Market of such goods and services
is called regulated market.
8. Classification by the nature of competition: The most important form of market
classification is based on the nature of competition, i.e., the buyer-seller interaction.
The competition in the market depends upon three main factors;
(a) Substitutability factor.
(b) Interdependence factor
(c) Ease of entry factor.

MARKET STRUCTURE
1. PURE OR PERFECT COMPETITION

A. Nature of Market: Homogeneous

B. No. Of Buyers: Large
C. No. Of Sellers: Large
D. Entry Conditions: Free entry, free exit
E. Price: Uniform everywhere
F. Nature of Decision: Only Output.

2. SIMPLE MONOPOLY

A. Nature of Market: Homogeneous

B. No. Of Buyers: Large
C. No. Of Sellers: One
D. Entry Conditions: Entry barriers
E. Price: High
F. Nature of Decision: Both price and output is within control

3. DISCRIMINATING MONOPOLY
A. Nature of Market: Homogeneous
B. No. Of Buyers: Large
C. No. Of Sellers: One
D. Entry Conditions: Entry barriers
E. Price: High
F. Nature of Decision: Discrimination in prices by decidi Charge different prices from
different Customers or groups of customers.
4.MONPOLISTIC COMPETITION

A. Nature of Market: Product differentiation by each firm.

B. No. Of Buyers: Large
C. No. Of Sellers: Many
D. Entry Conditions: Product differentiation acting as entry Barriers.
E. Price: Higher than perfect competition.
F. Nature of Decision: The nature and extent of product
Differentiation, and, therefore, the levels Of selling expenses and advertisement.

5. DUOPOLY
A. Nature of Market: Homogeneous or differentiated.
B. No. Of Buyers: Large
C. No. Of Sellers: Two
D. Entry Conditions: Entry barriers created artificially
E. Price: High
F. Nature of Decision: Price, product differentiation and selling
Expenses including advertisement, but
These decisions primarily depending
Upon competitors strategies.

6. OLIGOPOLY
A. Nature of Market: Homogeneous or differentiated.
B. No. Of Buyers: Large
C. No. Of Sellers: Few
D. Entry Conditions: Entry barriers created artificially
E. Price: High
F. Nature of Decision: Price, product differentiation and selling
Expenses including advertisement, but
These decisions primarily depending
Upon competitors strategies.

7. BILATERAL MONOPOLY
A. Nature of Market: Homogeneous.
B. No. Of Buyers: One
C. No. Of Sellers: One
D. Entry Conditions: Entry barriers
E. Price: Prevailing price depending upon whether
The buyer or the seller is more powerful.
F. Nature of Decision: Price and output.
 8. MONOPSONY
A. Nature of Market: Homogeneous.
B. No. Of Buyers: One
C. No. Of Sellers: Large
D. Entry Conditions: Free entry.
E. Price: Tendency of paying lowest possible price.
F. Nature of Decision: Adjusting output according to expected
Price.

9. OLIGOPSONY
A. Nature of Market: Homogeneous. Or heterogeneous
B. No. Of Buyers: A few buyers with only some of them
Main buyers
C. No. Of Sellers: Large
D. Entry Conditions: Free entry.
E. Price: Large buyers to push the price as low
As possible.
F. Nature of Decision : No single buyer can afford to ignore the
Reactions of his rivals to policies he might
Initiate.

VARIOUS FROMS OF MARKET STRUCTURE

The economist has classified industries or groups of firms into several

categories on the basis of above mention competitive condition.
There exists a subtle different between the pure competition and perfect
competition. Pure competition is said to exist when only two conditions exists;
1. There are large number of buyers and sellers of the product.
2. The products of the firms must be homogeneous.
On the other hand, perfect competition is supposed to fulfill some additional
conditions, like:
3. Perfect knowledge of the market with both the buyers and the sellers.
4. Perfect mobility of consumers and goods.
5. There is not transport cost.

In the literature the following market forms also find mention;

1. Predatory competition.
2. Cutthroat competition.
3. Destructive competition.
4. Effective or workable competition.
5. Potential competition.

1.CUT-THROUT COMPETITION:
This is a market situation where sellers successively reduce prices to a point where
no seller is in a position to recover his cost and earn fair return on investment. In other
words, there is a price war between sellers, which arises due to the existence of idle
capacity with the producer and the presence of high fixed costs.
2.EFFECTIVE OR WORKABLE COMPEITITON;
A competitive situation among sellers (though not perfectly competitive) offering
real alternative to consumers sufficient to compel sellers to offer better quality, service
and price significantly to attract consumers.
3. DESTRUCTIVE COMPETITION:
There may be a situation where a firm suffers from idle capacity and the problem
of recovery its fixed cost. Such a situation may lead firms to successively cut prices and
ultimately land in a situation where none of them is able to recover his costs and earn a
fair return on is investment. Such a competition is known as cutthroat competition or
destructive competition or condition of price warfare.

4. PREDATORY AND DISCRIMINATROY COMPEITION;

Some sellers are motivated by an urge to obtain future monopoly power and profit.
Such seller engages in predatory and discriminatory competition. In case of
predatory competition a seller cuts price of the product for the sole purpose of
eliminating a competitor. In this case the seller confines this act to only that portion
of his sales that compete with the sales of others.
5. POTENTIAL COMPETITION:
It is a situation where producers do not overcharge from those whom they sell and
do not overpay those from whom they buy. The precondition for such a competition
to exist is the freedom of entry or exists.

PRICING POLICIES
GENERAL CONSIDERATIONS
Formulating price policies and setting the price are the most important
aspects of managerial decision-making. Price, in fact, is the source of revenue which
the firm seeks to maximize. Again, it is the most important device a firm can use to
expand its market. If the price is set too high, a seller may price himself out of the
market. If it is too low, his income may not cover costs or at best, fall short of what
is could be. However, setting prices is a compiles problems and there is no cut and
dried formula for doing so. Whether to set a low price or a high price. Moreover, the
pricing decision is critical not only in the beginning but it must be reviewed and
reformulated from time to time.
Certain general considerations which must be kept in view while formulating the
price policy are given below;
1. Objectives of business.
2. Competitive situation in which the company is placed.
3. Product and promotional policies.
4. Nature of price sensitivity.
5. Conflicting interests of manufacturers and middle men.
6. Routinization of pricing
7. Active entry of non business groups into the determination of prices.
OBJECTIVES OF PRICING POLICY
1. maximization of profits for the entire product line.
2. Promotion of the long-range welfare of the firm. E.g., discouraging the entry of
competitors.
3. adaptation of prices to fit the diverse competitive situations faced by different
products.
4. Flexibility to vary prices to meet changes in economic conditions affecting the various
consumer industries.
5. Stabilization of prices and margin.

ROLE OF COST IN PRICING.

Cost data constitute the fundamental elements in the price setting process. Higher
costs including promotional expenses involved in connection with advertising or personal
selling as well as taxation may necessitate an upward adjustment of price. For example,
the increase in drugs prices in India in recent years has been due to the changes in the
costs of raw materials, packing materials, wages, other establishment expenses and central
and state taxes. If costs go up, prices rise can be quite justifies. However, their relevance
to the pricing decisions must neither be underestimated nor exaggerated. For setting
prices, apart from costs, a number of other factors have to be taken into consideration. On
the other hand, an increased in demand may make an increase in prices possible even
without any increase in costs. All this discussion does not purpose to show that cost should
be ignored altogether while setting brief.. Costs have to be taken into consideration like
many other important factors. In fact, in the long run, prices must cover costs. If in the
long run, costs are not covered manufacturers will withdraw from the market and supply will
be reduced which, in turn, may lead to higher prices. The posing that needs emphasis is
that cost is not the only factor in setting prices. Cost must be regarded only as an indicator
of the price which ought to be set after taking into consideration the demand and the
competitive situation.

DEMAND FACTOR IN PRICING

The pricing policy of a firm would spend upon the elasticity of demand as well. If the
demand is inelastic, it would not be profitable for the firm to reduce it s prices. On the
other hand, a policy of price increase would prove profitable if the demand is inelastic.
Conversely, if the demand is elastic, it is a policy of price reduction rather than a policy of
price increase which would be profitable for a firm to adopt.

CONSUMER PSYCHOLOGY AND PRICING

Sensitivity to price change will vary from consumer to consumer. In a particular
situation, the behavior of one individual may not be the same as that of the other, and may
not follow the ‘Law of Demand’. In fact, the pricing decision ought to rest on a more
incisive rational than simple elasticity. Some important characteristics of consumer
behavior as revealed by research and experience are given below:
1. From the point of view of consumers, prices are quantitative and unambiguous,
whereas product quality, product image, customer service, promotion and similar
factors are qualitative and ambiguous.
2. Price constitutes a barrier to demand when it is too low just as much as when it is too
high. If the price is too low , consumers will tend to think a product of inferior quality
is being offered.
 3. Price inevitably enters into the consumer’s assessment of quality
4. With an improvement in incomes, the average consumer becomes quality conscious.
An improvement may, therefore, lead to an increase in demand.
5. Consumers may be persuaded to pay more for heavily advertised goods.
6. Whether the price is considered a bargain or not would depend upon the average
market price of the item.
7. In a comprehensive survey of consumer consciousness. It was revealed that the basic
postulate of the demand theory, i.e., the consumer has an appropriate knowledge of
market prices, was not fundamentally wrong.

REDUCTION IN PRICES
A reduction in price may be made too achieve the following adjectives;
1. Prices may be reduced to offset a possible loss of sales resulting from a lower
advertising budget.
2. When a firm is expanding its capacity, temporary price cut may help the new plant to
reach capacity operation more quickly.
3. Lower prices may help the firm to broaden the market for it production.
4. Prices may have to be reduced to meet competitive pressures form domestic or foreign
companies producing the same product or substitute products.
5. Price may be reduced drastically to prevent the entry of potential competitors.
6. Technological developments may lead to reduced costs and manufacturers may wish to
pass on the benefit to the consumers.

INCREASE IN PRICES
Very often a company might be faced with a situating where costs may have increased
and it might be consideration whether to increase prices or not. The decision would depend
upon how the demand would affected by increase in prices. In fact, prices are usually
increased where the market demand is strong and the business is having a boom. Prices
are never increased during periods of depression and falling incomes. Thus while it may be
true that cost may be rising at the time prices are increased, it is the rising demand which
makes it possible to pass on the increase in costs to customers without any adverse effect
on sales.

FUNDAMENTAL WHICH MAY AFFECT PRICE DECISIONS

1. Consumer situation.
2. Cost considerations.
3. Competitive and market considerations.
4. Market structure and promotional policies.
5. Other consideration – Individual, firm or General Economic.

PRICING METHODS
1. COST-PLUS OR FULL COST PRICING.
2. PRICING FOR A RATE OF RETURN, ALSO CALLED TARGET PRICING.
3. MARGINAL COST PRICING.
4. GOING RATE PRICING.
5. CUSTOMARY PRICES.
COST PLUS OR FULL COST PRICING
This is the most common method used for pricing. Under this method, the price is set
to cover costs (materials, labour and overhead) and a predetermined percentage for profit.
The percentage differs strikingly among industries, among member-firms and even among
products of the same firm. This may reflect differences in competitive intensity, differences
in cost base and differences in the rate of turnover and risk.

PRICING FOR A RATE OF RETURN

An important problem that a firm might have to face is one of adjusting the prices to
changes in costs. For this purpose the popular policies that are often followed are as under;
1. revised prices to maintain a constant percentage mark-up over costs.
2. revise prices to maintain profits as a constant percentage of total sales.
3. revise prices to maintain a constant return on invested capital.
Rate of return pricing is a refined variant of full cost pricing. Naturally, it has the same
inadequacies. Viz., it tends to ignore demand and fails to reflect competition adequately. It
is used upon a concept of cost which may not be relevant to the pricing decision at hand
and overplays the precision of allocated fixed costs and capital employed.

MARGINAL COST PRICING

Both under full cost pricing and the rate of return pricing. Prices are based on total
costs comprising fixed and variable costs. Under marginal cost pricing, fixed costs are
ignored and prices are determined on the basis of marginal cost. The firm uses only those
costs that are directly attributable to the output of a specific product. A pricing decision
involves planning into the future, and as such it should deal solely with the anticipated and ,
therefore, estimated revenues, expenses, and capital outlays. All past outlays which give
rise to fixed costs are historical and sunk.

ADVANTAGES.
1. With marginal cost pricing, prices are never rendered uncompetitive merely because
of higher fixed overhead structure, or because hypothetical unit fixed costs are
higher than those of the competitors.
2. marginal costs more accurately reflect future as distinct from present costs levels
and cost relationships.
3. marginal cost pricing permits a manufacturer to develop a far more aggressive
pricing policy than does full cost pricing.
4. Marginal cost pricing is more useful for pricing over the few cycle of product, which
requires short run marginal cost and separable fixed cost date relevant to each
particular stage of the cycle, not long run full cost data.

GOING RATE PRICING

Instead of the cost, the emphasis here is on the market . the firm adjusts its own
price policy to the general pricing structure in the industry. Where costs are particularly
difficult to measure, this may seem to be the logical first step in a rational pricing policy. It
may also reflect the collect wisdom of the industry. Many cases of this type are situations
of price leadership. Where price leadership is well established, charging according to what
competitors are charging may be the only safe policy. It may simply be a way in which
firms try to escape the hazards or price rivalry in an oligopolistic market. It may be less
costly and troublesome to the business than the exact calculation of costs and demand and
superficially seems to have practical advantage over a highly individualistic pricing policy.

CUSTOMARY PRICES
Prices of certain goods become more or less fixed, not by deliberate action on the
sellers’ part but as a result of their having prevailed for a considerable period of time. For
such goods, changes in costs are usually reflected in changes in quality or quantity. Only
when the cost change significantly, the customary prices of these goods are changed.
Customary prices may be maintained even when product s are changed. For
example, the new model of an electric fan may be priced at the same level as the
discontinued model. This is usually so even in the face of lower costs. A lower price may
cause an adverse reaction on the competitors leading them to a price war as also on the
consumers who may think that the quality of new model is inferior. Perhaps, going along
with the old price is the easiest thing to do. Whatever be the reasons, the maintenance of
existing prices as long as possible is a factor in the pricing of many products.

GUIDELINES FOR PRICE FIXATION

1. Find out what your costs are over the range of output that is relevant.
2. Take prime costs as your starting point and consider what the price would be if you
add to this an allowance for over head costs sufficient to keep you in business and
the amount of profit necessary to keep your shareholders happily.
3. Find our how your costs compact with those of your competitors.
4. Keep an eye on the market; if orders are hard to get, the chances are the price will
have to drop a bit and competitors are likely to find themselves in much the same
position.
5. If the costs of your raw materials and labour increase, this may present you with an
opportunity to raise your prices because your competitors may be expected to follow
suit.
6. If on the other hand, costs are rising at a time when sales are hard to get, you may
be able to refrain from raising your prices without setting off a price war.
7. Keep an eye on how you are using your factory. Production should be concentrated
on the profitable lines or the prices of the less profitable lines increased.
8. The goodwill of customers is probably better developed by an advertising campaign
than by keeping prices below costs.
9. If your prices seem to be higher than your competitor although they scarcely cover
costs, this may indicate that your costs are too high and your production method or
factory organization is defective.
10. If you can sell your output at prices that give you’re a substantiation profit.
11. If you find that your sales vary seasonally, consider whether demand can be
smoothed and profits increased by charging higher prices when demand is high and
low prices when demand is low.
12. If your are one of a limited number of producers Iran industry, what your
competitors are likely to do may well be a more important consideration in fixing
prices than any question of costs.
PRICING PROBLEMS
PRICING OVER THE LIFE CYCLE OF A PRODUCT
Many products generally have a characteristic know as ‘perishable distinctiveness’. This
means that a product which is distinct when new degenerates over the years into a common
commodity. The process by which the distinctiveness gradually disappears as the product
merges with other competitive products has been rightly termed by Joel dean as the “the
cycle of competitive degeneration”.
There are five distinct stages in the life cycle of a product as shown in below diagram:

1. INTRODUCTION; Research or engineering skill leads to product development. The

product is put on the market: awareness and acceptance are minimal. There are high
promotional costs. Volume of sales is low and there may be a heavy losses.
2. GROWTH: The product begins to make rapid sales gains because of the cumulative
effects of introductory promotion, distribution, and word-of-mouth influence. High
and sharply rising profits may be witnessed. But to sustain growth, consumers
satisfaction must be ensured at this stage.
3. MATURITY: Sales growth continues, but at a diminishing rate, because of the
declining number of potential customers who remain unaware of the
-10-
product or who have taken no action. Also, the last of the unsuccessful competing
brands will probably withdraw from the market. For this reason sales are likely to
continue to rise while the customers for the withdrawn brands are mopped up by the
survivors. There is no improvement in the product but changes in selling effort are
common. Profit margins slip despite rising sales.
4. SATURATION: Sales research and remain on a plateau marked by the level of
replacement demand. There is little additional demand to be stimulated.
5. DECLINE: Sales begins to diminish absolutely as the customers begin to tire of the
product and is gradually edged out by better products or substitutes.
1.PRICING BY RETAILERS
1. Retailers know their major cost accurately than do most manufacturers. In the
case of retailers, costs are independent of the volume of sales. Invoice cost plus a
margin, which is more or less fixed, is a sound basis in the case of retailers. In the
case of manufacturers, costs are determined more by hindsight.
2. Retailers ordinarily sell many more related items than do manufacturers. They
ordinarily lure the consumer in their stores for purchasing a particular product and
then prompt him to buy others.
3. Retailers sell directly to ultimate consumers whereas manufacturers generally sell
to other businessmen. Consumers usually do not search for alternative sources
while businessmen do. Manufacturers’ prices are examined by specialists in buying
whose responsibility it is to search out various sources of supply and to find those
offerings the most advantageous terms.

2.RESALE PRICE MAINTENANCE

Resale price maintenance means maintenance of uniform retail selling price of
branded products by their manufacturers who fix and stipulate the prices below which
goods should not be resold at any outlet. It is a vertical price control by the
manufacturers between the stage of production and the successive stages in the
distribution channel. A distinctions is made between collective and individual resale
price maintenance depending on the mechanisms of enforcement. Under the former,
the manufacturers of different brands of the same product or a close substitute thereof
enter into an agreement to observe retail price maintenance and notify it as a condition
to all traders who draw supplies from them. Any trader who reduces the price attracts
sanctions not only from the manufacturers of the cut-price brand but also from all
manufacturers who are parties to the collective agreement.

3EXPORT PRICING
Price is the most important single consideration in international marketing. The
international market is highly competitive and extremely sensitive to the price factor.
What is more, individual exporters have practically no control over the price. Export
pricing decisions must be based on complete understanding of the varied marketing
situations which differed from country to country, product to product and also from
time to time. It may, however, be noted that price is not the only factor, though it is
the most important. The important non-price factors are assured deliveries, display
and demonstration as also after – sales service in engineering goods, prompt
settlement of claims, ability to supply in a large quantities and a complete range of
products and liberal credit facilities. Indian exporters have also very often pointed out
that a price is not a problems provided aggressive marketing and sales promotion are
effectively undertaken.

4.DUAL PRICING
Dual pricing is a price control device and refers to a two-price system. In a
system of dual prices, fixed price concept applies only to a part of the output and the
remaining output is allowed to be sold at prices determined by market forces. The dual
pricing system thus sets up a free market system in respect of supplies and demand
 that come to that market: this market equals not the entire output of the commodity
but only the excess output and excess demand. The fixed price may be so determined
as to cover the cost of production and a reasonable profit margin. But it is lower than
the price that would have prevailed in the absence of such a price control. There are
also cases where a price is fixed at a level higher than what would have prevailed
under a free market situation(a in tariff protection).

5.ADMINISTERED PRICES
Administered prices are prices fixed by the Government normally on the basis of
cost plus a stipulated margin of profit. Some examples of commodities subject to
administered prices are steel, coal, aluminums and fertilizers. Commodities sold at the
fair price shops under the public distribution system are also subject to administered
prices. The objective of administering prices are: (i) to maintain the prices of essential
commodities as also of essential inputs to avoid trigger price escalation, and (ii) to
ensure economic prices to uneconomic units.

6.TRANSFER PRICING
An important question which arises, when two or more interdependent departments
are concerned, pertains to the price to be put on the goods or services transferred by
one department to another. The transfer price must satisfy the following two criteria:
1. It should help establish the profitability of each division or department; and
2. It should permit and encourage maximization of the profits of the company as a
whole rather than of individual divisions or departments.
3. For computing the transfer price, the three alternative methods are: (i)
market price basis, (ii) Cost basis, an (iii) cost plus basis.
4.
PRICING POLICY IN THE PUBLIC SECTOR
The basic problem of pricing in the public sector is how to reconcile the conflicting
objectives set before the public sector unit, “Each of the multiple objectives confers on the
unit extra costs, additional managerial responsibility and very limited scope for price
adjustments….. For most public sector enterprises, selling prices are administered rather
than market oriented and that this approach to pricing has been influenced over the years
by conflicting considerations.”
On the one hand, these public sector units are expected to keep their prices low
because many of them are in the areas of basic industries. High prices of these products
could push up costs over a large segment of the economy. On the other hand, from the
Third plan onwards, they are expected to contributed increasingly to the invisible resources
of the state. In fact, there is a conflict between’ the public utility approach’ and the ‘rate of
return approach’.
PIONEER PRICING:
Pricing in the early stages of production has some initial problems like,
- estimating demand for the entirely new product
- finding the competitive range of prices in the market
- discovering probable volumes of sales corresponding to different possible
prices: and
 - considering the possibility of retaliation from established firms in the field.
Assuming that the firm can solve these problems, one can discuss about its pricing
strategy. The innovatory, who brings a new product to the market, has two main
lines of strategy open to him:
- Skimming price; and
- Penetration price.
SKIMMING PRICE:
The innovator can set a high price for a while, and “milk” the customers who are willing
to pay that high price. Then, after he has made sales to these prime customers and after
competitions have come into the industry due to high margin of profits, he reduces the price
of his product.
PENENTRATION PRICING:
According to this strategy, the innovator sets a lower price to start with. The underlying
idea of this strategy is to ‘widen the market’ at the start by getting more customers
acquainted with the product. The widened market and consequently the mass production of
the product, it is expected, will reduce the cost of production.
TRANAFER PRICING:
There is general belief that large, multi-product, multi-process companies generally
suffer from managerial diseconomies of scale due to lags in communication, weakening of
administrative control, etc. One of the ways often used by such firms is to divide the
establishment into smaller units (like departments, divisions, etc) and making each unit an
independent profit center. This results in transfer of goods services and money from one
unit to another within the organization. Many companies have a complex system of infra-
company transfer of goods. For example, a multinational company may have many source
of raw material. It may allocate the heterogeneous raw material to different points. Its
production may be organized for may different types or qualities of products and may have
many marketing channels and sale outlets. The managerial decisions of this company are
taken at different plants and departments. In order that quick and effective decisions are
taken, different departments of the company are allowed considerable autonomy. The
divisions/departments transfer goods among themselves. The prices at which these goods
are transferred affect divisional/departmental performance. If transfer prices understate or
overstate values and costs, the divisional decisions would go counter to the company’s
corporate objectives. The manner in which the transfer price is fixed will influence the
output decision of each division and of the firm as a whole, and thus the overall profits of
the firm. As this influences the profitability of each profit center, having an appropriate
transfer pricing system is essential for the management morale, promotion avenues and
policies, and thereby long-run efficiency of the management group. Thus, one of the vital
problems of a large firm while dealing with transfer pricing is: What should be the price
which one division charges from the other division of the firm for the product sold to the
latter?
The transfer price rules which the group management lays down must be such that they
pursue the following goals simultaneously:
1. Maximizations of group profits: and
2. Maximizations of profits at each profit-centre, treating each division as an autonomous
unit.
PRODUCT LINE PRICING
Any multi-product firm cannot expect all its products to earn the same profits. There
are some products which give larger margin (called high profit intensive products), while
others give lower margin (called low profit-intensive products). The former help the latter
to survive by any product does not remain constant over time. Once these profit margins
change (because of change is demand conditions, competitiveness, emergence of
substitutes, etc), the firms are faced with problems of adding new products, improving the
old products or dropping a product from the product line and buying it from the market.
Thus, changes in the margins also lead to changes in the product-mix, Let us consider the
changes in the product-line in detail.
1. Improving the old product.
2. Buying a product.
3. Dropping a product from the product line.
4. Adding a new product.
(i) Excess capacity
(ii) Changes in overall economic, political and social environment.
(iii) Profit maximizations.
(iv) In case a better substitutes.
(v) Complementary.

PRICING STRATEGIES
1. STAY-OUT-PRICING
When a firm is not certain about the price at which it will be able to sell its product,
it starts with a very high price. If at this high price quotation it is not able to sell, it then
lowers the price of its product. It will keep on lowering the price till it is able to sell the
targeted amount of the product. This approach helps the firm to ascertain the maximum
possible price it can charge from its customers.

2. PRICE LINING;
Here, price of one product in the total range of the products is fixed. Price of rest of
the commodities is automatically determined by the relationship of the commodity
whose price has been fixed and the rest of the commodities in the range. For
example, if a firm producing shoes or shirts fixes up the price for a particular size,
price of rest of the sizes is then fixed simultaneously on the basis of the differences
in their sizes. Also, when price of one size of shoes or shirts changes, prices of rest
in the line of the product get automatically adjusted.

3. ODD NUMBER AND ROUND NUMBER PRICING:

This is not truly a method of pricing but of pricing-tagging. Here a firm fixes the
price of its product in a manner which gives the impression of being low . For
example, if the price of a product is fixed at Rs.89.90 rather than Rs. 90, it may have
the psychological impact on consumers that price is in 80s rather than in 90s. This
may have some impact on sales. For example, the BATA shoe company has been
following this price policy with some success. On the other hand, some firms round
their prices to the next higher rupee so that accounts can be kept easily
 4. LIMIT PRICING:
A firm (or firms) may also try to establish a price that reduces or eliminates the
threat of entry of new firms into the industry. This is called “limit pricing” . For limit
price to be effective some sort of collusion is necessary among existing firms.

GOVERNMENT INTERVENTION AND COMMODITY MARKETS

In a non-socialist economy pricing is often left to the market forces, hoping
that the equilibrium prices would be equal to the cost of production plus a reasonable
margin of profit. In reality, it does not always happen in developing economies
because there are certain structural bottlenecks in production resulting in shortages
of goods and services. In order that the essential goods are mode available and
agriculture are provided for production, etc., the government has to intercede with
administered prices or regulated prices. Government also resorts to dual pricing,
with a low retention price for supply of the good for essential use and an open
market price (which is higher than the retention price) for other uses of the good.
The experience of government intervention with pricing shows that in the
absence of buffer stock of a good or its imports, such an intervention results in the
emergence of black market in that good. Moreover, government intervention over
long run generally affects supply adversely. Thus, such an intervention should not
only be a short run measure but, to be effective, it must be backed by adequate
supplies of a the good with the governmen

MARKET DEFINITION:
Generally the term ‘market’ has come to signify a public place in which goods and services
are bought and sold. It is the act or technique of buying and selling. The term marketing
has numerous common meanings. To the housewife, it is shopping: to the farmer, it stands
for the sale of his produce; to the wholesale businessmen, it is the scientific method of
advertising and sales promotion and to the industrialists of the country, it is the discovery of
foreign outlets for goods manufactured.
In the language of economics the term market should imply certain things;
1) There should be buyers as well as sellers (producers) of the commodity.
2) The establishment of contact between the buyers and sellers is essential for the market:
other wise there will not be a market.
3) The buyers and sellers deal with the same commodity or variety. Since the market in
economics is identified on the basis of the commodity, similarity of the product is very
essential.
4) There should be price for the commodity bought and sole in the market.

SIZE OF THE MARKET

The extent or the size of the market depends on two important factors, viz., and the nature
of commodity and external factors or conditions.
1) Nature of demand.
2) Durability.
3) Portability.
4) Grading and sampling.
5) Adequate supply.
6) Political stability.
7) Government policy.
8) Speedy Transport and communication.
9) Stable currency and efficient banking system.
10)Scientific methods of business.

DISTINCTION BETWEEN NORMAL PRICE AND MARKET PRICE

MARKET PRICE NORMAL PRICE

1. It is a short period price. 1. It is a long period price.

2. It is a temporary equilibrium. 2. It is comparatively permanent equilibrium
Between demand and supply. Between demand and supply.
3. It is more influenced by demand factor. 3. It is largely determined by supply factor
And cost of production.
4. Market price fluctuates frequently, 4. Normal price is stable.
Even daily.

5. Market price may be higher than cost 5. Normal price is equal to the cost of
Of production. Production.
6. All goods have a market price. 6. Only reproducible goods alone have
Normal price.

However, economists have classified market form or situations under the following
categories;
1. Perfect competition.
2. Imperfect competition.
a. Monopoly.
b. Monopolistic competition.
c. Oligopoly.
d. Duopoly.

CLASSIFICATION OF DIFFERENT MARKET FORMS:

Market form Number of firms Nature of Degree of Condition

Firms Product Control of Entry
Over Price

Perfect Large number Homogeneous None

Free
Competition of firms Product

Monopoly One Unique Considerable Closed to

Without Others
Substitutes
Monopolistic Many but not Product differ- Slight Free
Too many ention but close
Substitutes or
without difference
Oligopoly Few firms Homogeneous Considerable Restricted
Or Hetero- through
geneous agreement

PRICING UNDER PERFECT COMPETITION

Perfect competition is defined in different ways and there is no agreed common definition.
Prof.Frank Knight expresses the term ‘perfect competition’ as a condition of market in which
there will be fluidity and mobility of factors of production so that the number of firms and
the size of firms can freely increase or decrease. According to him, perfect competition
entails “rational conduct on the part of buyers and sellers, full knowledge, absence of
friction, perfect mobility and perfect divisibility of factors of production and completely static
condition”.

Features and conditions of perfect competition

1. Large number of buyers and sellers:

In a perfectly competitive market, there will be a large number of buyers and sellers.
Many firms producing the commodity will offer their quantity in the market and sell it
at market price. If we say that in perfect competition there will be a large number of
buyers and sellers and all the sellers will be selling the commodity at the market
price, then what is the difference between this type of market and the ordinary
market? The market too can be defined as having large number of buyers and
sellers.

2. Homogeneous product:
The second condition in the perfect market is that the commodity offered should
be homogeneous and identical in all respects. All firms in the market produce the
same quality or variety of the commodity and practically there will be no difference
in the product of the two firms.

3. Free entry and exit conditions:

The third important condition in perfect competition is that there are no artificial
restrictions either preventing the entry of new firms into the market or compelling
the existing firms to continue. The firms have full liberty to choose either to
continue or go out of the industry.

4. Perfect knowledge on the part of buyers and sellers:

The fourth condition of the perfectly competitive market is the existence of perfect
knowledge on the part of buyers and sellers about market conditions. The buyers
know in full about the commodity sold and the price prevailing in the market.

5. Perfect mobility of factors of production:

The existence of perfect competition depends on perfect mobility of factors of
production. The factor should be free to move from one use to another easily
depending on the remuneration they get. They are free to come out of the industry if
they consider the remuneration inadequate and they get better remuneration
elsewhere.
 6. Absence of Transport cost:
In perfectly competitive market, it is assumed that there are no transport costs. If
transport cost is incurred, prices should be different in different sector of the market.
We have stated that in perfect competition there will be no price difference and the
commodity will be sold at uniform price throughout the market. If firms incur
transport charges on supply, then firms nearer to the market can charge a lesser
price that the firms far away. Hence to obviate this difficulty, it is assumed that in
perfect competition the firms work so closet each other that they do not incur
transport charges.

7. Absence of Government or artificial restriction:

Lastly it is assumed that there are no artificial restrictions from any quarter hindering
the smooth functioning of perfect competition. There are no government control or
restrictions on supply, pricing, etc., and the price should be free to change in
response to changes in demand-supply conditions. If all these conditions are
fulfilled, then the market can be termed perfect and this perfection cannot be had in
practical side.

PRICE DETERMINATION UNDER PERFECT COMPETITION

Price under perfect competition is determined by the interaction of the two forces, viz.,
demand and supply. Though individuals cannot change the price, the aggregate force of
demand and supply can change the price. The demand side is governed by the law of
demand based on marginal utility of the commodity to the buyers.

The price determined by the interaction of demand and supply is called the
equilibrium price. We know that the demand curve of the market will slope
downwards from left to right indicating that buyers will demand larger quantities at a
lower price. We know that the supply curve in the industry normally slopes upwards
from left to right indicating that more supplies will be forthcoming, at higher prices. The
level at which the demand curve intersects the supply curve determines the equilibrium
price. The price which will come to prevail in the market is one at which quantity
demanded is equal to quantity supplied. Equilibrium price is that price at which quantity
demanded is equal to the quantity of the product supplied. At this price the two factors,
viz., demand and supply balance each other and the balanced quantity at this price is
called equilibrium amount.

This can be illustrated by a figure showing the demand and supply curves. The demand
schedule of the market is the summation of the individual demand. The supply schedule
gives the quantity supplied at different prices. With the help of the demand and supply
schedules we can draw the market demand curve and the market supply curve. The
intersection of the two curves shows the equilibrium point
MONOPOLY
FEATURES OF MONOPOLY MARKET
1. It should have only single control.
2. The commodity produced should not have any close substitute.
3. No freedom to other entrepreneurs to enter and compete with the existing seller
having full control over the market.
4. The monopolist may use his monopolistic power in any manner in order to realize
maximum revenue. He may adopt price discrimination.
Kinds of Monopoly
Private and Public monopolies
When monopolistic control exists in private sector we can call it private monopoly. If the
state controls the production and pricing of the commodity, it is public or state monopoly.
Many of the public sector undertakings come under this category.
Pure Monopoly
It is a phenomenon, which exists only in a public sector. Production of a particular
commodity will be the exclusive privilege of the state or state sponsored undertaking. For
example electricity board in India is a pure monopoly.
Simple monopoly
There are larger possibilities of simple monopoly in the real world. It is a situation where
the single producer produces a commodity having only a remote substitute. In pure
monopoly there are no substitute commodities for the product produced by the monopoly
firm. But in simple monopoly, the product of the firm may have some substitute. But in
economic analysis we take that the monopoly firm produces a commodity have no close
substitute.
Discriminating Monopoly
The monopolist may charge different prices for different customers or markets. He has not
only the power to fix the price of the commodity the but also charge different prices from
different customers. The monopolist will be discriminating between the markets.
Monopoly power;
1. Power given by the government.
2. Legal power.
3. Technical power.
4. Combinations.
5. Bias of the consumer.

DETERMINATION OF PRICE IN MONLOPLY

It would be a mistake to suppose that the monopolist will always push up his prices
higher and higher. If he does so, he must consider the effect of such a procedure on
demand, which will shrink as prices rise. The monopolist cannot compel the consumer to
buy at a higher price. The very important point to be borne in mind is that unlike
competitive firm, a monopolist firm will have a sloping down demand curve and his average
revenue will dwindle as the output is increased because the buyers will take up larger
quantities only at a lower price. The monopolist can charge a higher price, but he will sell
less. If he wants to sell more, he has to keep the price less. So, the monopolist does not
have, really speaking, full control in the market. He can have control, over the supply and
leave the price to be decided by the consumers, or fix the price and leave the quantity to be
purchased at that level. The monopolist cannot fix the price as well as output.
In the following figure, DD is the demand curve. According to the figure, the
monopolist cannot for example fix his output at OM and expect to be able to sell it at price
K2M2 per unit. If he decides to fix the price at K2M2 the output has to be automatically
fixed by him at OM2, because at price K2M2 he can sell only OM2 units
Out of any number of possible prices, the monopolist endeavor to choose that price
which yields him the highest net monopoly revenue. Net monopoly revenue is the profit
realized by the monopolist by selling the commodity at a particular price. It is the total
amount realized at a certain price minus the expenses of producing that quantity. The
expenses of production include among other things, normal profit secured under conditions
of competition.
Price-output determination or Monopoly Equilibrium
In the case of perfect competition, we have seen that both AR and MR is the same line
horizontal to X-axis and equal to the price. But in monopoly, this is not so: the AR curve
will be at a higher level sloping down and the MR curve will be at a lower level sloping down.
The principle of profit maximization is the same as that of perfect competition. The
monopolist will maximize his net monopoly revenue by keeping the marginal cost and the
marginal revenue at the same level. The profit maximization formula MR = MC holds goods
here also. The monopolist will be in equilibrium where he gets the maximum profit. He will
go on producing till additional units of output sold add more revenue than the cost. He will
stop at the point beyond which additional units cost him more than the revenue realized.

With AR curve falling and MR curve below it and cost curves, the monopolist comes to
equilibrium at point E where MR = MC and produces OM units of the commodity fixing the
price at OP. At this price and output, the monopolist realizes the maximum profit shown by
the shaded rectangle PQRS. In the diagram, we can see that unto OM output the marginal
revenue is less than marginal cost. So equilibrium output is OM. This output OM can be
sold in the market at a price Op according to the demand curve (AR curve), (OP = QM). At
this level of output, the difference between average cost and average revenue is QR. So
the profit average is QR and the total profit is average profit multiplied by output i.e., QR x
SR (SR = OM). The total profit therefore is equal to PQRS.
The monopolist firm has come to equilibrium and it is earning maximum profit. The
monopoly price is higher than the marginal revenue and marginal cost. The equilibrium for
the short period is also for the long period under monopoly as there will not be any
competitor entering the field.
PRICE DISCRIMINATION
Price discrimination means the practice of selling the same commodity of different
prices to different buyers. Under the monopoly, the producer usually restricts the output
and sells it at a higher price, thereby making a maximum profit. If the monopoly charges
different prices from different customers for the same commodity, it is called price
discrimination or Discriminating monopoly.
TYPES OF PRICE DISCRIMINATION
1. PERSONAL DISCRIMINATION:
In this case, the monopolist will charge different prices from different customers on
the basis of their ability to pay. Rich customers will be asked to pay more and poor
customers to pay less. This is possible in specialized personal services of doctors
 and lawyers. The doctor may charge higher fees from a patient who is very rich and
charge less from poor or middle class people for the same services rendered.
2. PLACE DISCRIMINATION:
Monopolist having different markets in different regions may charge different prices
for the same commodity in the different regions or localities. The locality in which
market is situated will be the criterion in fixing up the price. Supposing a monopolist
has a shop in an aristocratic locality and also in a slum. He will charge higher prices
in the former shop and lesser price in the slum shop on the understanding that
aristocrats will not go for shopping in slum. Generally the extra price charged in an
aristocratic locality will not be felt by the customers, as this shop would cater their
extra needs such as ‘drive – in’ facility, ‘door-delivery’ and very courteous reception,
etc., about which the aristocrats are very particular.
3. TRADE DISCRIMINATION;
This can also be called ‘use discrimination’. By this method, the monopolist will
charge different prices for different types of uses of the same commodity. For
instance, electricity will be sold at cheaper rates for industrial establishments and
bulk consumptions, while it will be charged at a higher rate for domestic
consumption. Similarly accessories like small springs, bolts, nuts, screws, etc., will
be charged at a higher price for automobiles and a lower price when the same
material is used for bicycles and for domestic purposes.

DEGREES OF PRICE DISCRIMINATION

1. First order price discrimination.

2. Second order price discrimination.
3. Third order price discrimination.
First order degree, the producer exploits the consumer to the maximum possible extent
by asking him to pay the maximum he is prepared to pay rather than go without the
commodity. This means that the monopolist will not allow any consumer’s surplus for the
buyer. This type of price discrimination is called perfect discrimination.
Second order degree, the markets are divided on the basis that in each market the lowest
price, which the poorest members of the group are prepared to pay, will be charged in the
market for all consumers. In such a case those who are prepared to pay more will get
consumer’s surplus while the poorest will not get any consumer’s surplus. Here the
principle is that the market is divided discriminately on the basis of consumer’s surplus and
all will have some consumer’s surplus except the marginal buyers. This is the method
adopted by railway companies.
Third order degree, which has been commonly practiced by the monopolist. In this case,
the markets are divided into many sub-markets and in each sub-market the price charged
would not be the minimum price but the price depending on the output and demand of that
market. With the quantum of output on had which is fixed; the monopolist will fix the price
in each sub-market on the basis of the demand curve in each.
The market demand curve is broken up into demand curves for three separate markets
or sub-markets under monopolist’s control. Assuming that the monopolist is selling in each
market the same quantity OM, he will charge a price OP1 in market I represented by
demand curve D1. The price in Market II will be OP2 and in Market III, OP3, as shown in
the figure. When producer under takes ’dumping’ and charges for the same commodity one
price in one country and a different price in another country, it is also a case of price
discrimination of the third degree. This is the only practical method.

PRICING UNDER DISCRIMINATING MONOPOLY

Under simple monopoly, the producer will charge the equilibrium price on the basis of
total output, and the marginal revenue and marginal cost will decide the equilibrium of the
monopoly firm. In order to discriminate prices, the entire market will be divided into sub-
markets on the basis of the elasticity of demand for the product. Already we have
mentioned that only if the elasticity of demand is different, price discrimination will be
profitable. After dividing the market, the producer has to decide the supply for each sub-
market. Here the decision of output for each sub-market depends on the equilibrium
condition of each sub-market with the total cost condition and the revenue curves of the
sub-market. The monopolist should decide two things on the basis of his cost and revenue
curves. (i) How much total output should be produced? (ii) How the total output should be
shared between the sub-markets and what prices should be charged in each of his
sub=markets?
For the sake of simplicity, we shall take a monopolist divides his market into two sub-
markets; sub-market A and B and finds the AR curve different in these two. Let us analyze
how price discrimination is done in these two sub-markets.
The below figures illustrates the revenues curves of the two sub-markets A and B and
the aggregate situation in the entire market under the control.

Quantity Quantity
Quantity
SUB-MARKET A SUB-MARKET B TOTAL
MARKET
In the sub-market A, the extreme left, AR1 is the demand curve or the average
revenue curve of the market. In sub-market B, AR2 is the demand curve or the average
revenue curve of the market. Note that the elasticity of demand in these two sub markets
is different. In sub-market A the demand curve shows inelastic nature and in sub-market B
the curve shown elastic nature. In the two sub-markets the respective marginal revenue
curve of the respective sub-markets. The figure on the extreme right shows the total
market where the aggregate condition of the revenue curves is shown. The total average
revenue curves of the two sub-markets have been shown in the total market as AAR.
Similarly the aggregate of two marginal revenue curves of the sub-market has been shown
as AMR. According to the figure, AR1 + AR2 = AAR: MR1 + MR2 = AMR combined at
various levels of output. Since the output is under single control, we have shown the
Marginal cost curve in the aggregate figure. MC in the total market shows the marginal cost
or the entire production

Therefore quantity OM1 will be sold in sub-market A and quantity OM2 in sub-market B. At
the equilibrium point E1 in sub-market A the price of the commodity will be P1M1 as at the
level of equilibrium output the average revenue is P1M1. In sub-market B, at the
equilibrium output, the average revenue is P2M2. So, the price of the commodity in that
sub-market will be P2M2.
Thus the monopolist producing OM quantities of commodity will sell OM1 quantities in
sub-market A at a price P1M1. He will sell OM2 quantity in sub-market B at a price P2M2.
We can see from the figure that the price is higher in sub-market A and lower in B. He has
discriminated the two and charges different prices for the same commodity. The principle of
equilibrium under discriminating monopoly is that MR2 = MC of total output.

MONOPOLISTIC COMPETITION
Assumptions and Features;
1. Existence of large Number of Firms.
2. Product differentiation.
3. Selling Costs.
4. Freedom of entry and exist of firms.
PRICE DETERMINATION
Price –output determination under monopolistic competition is governed by the cost
and revenue curves of the firm. Laws of production govern the cost curves. The revenue
curves will not be very elastic, as to be a parallel to X axis, as in perfect competition. It will
not be very steep falling curves as in monopoly. The average revenue curve of the firm
under monopolistic competition will be a sloping down curve, the slope being neither too
steep nor too flat. It will not be flat or parallel straight line because the firm may not have
very slightly different from that of other firms. The firm cannot sell unlimited quantities at
the established price as the products of other firms are close because, the demand under
monopolistic competition will be much more sensitive to small changes in price as any fall in
price could ensure more customers using the substitute product of other firms. Similarly
any rise in price will drive out many customers from the firm to go demanding other firm’s
product. Thus under monopolistic competition, the AR curve will be a fairly sloping down
curve and MR curve will lie below it.
EQUILIBRIUM OF THE INDIVIDUAL FIRM
The monopolistic competitive firm will come to equilibrium on the same principle of
equalizing MR to MC. Each firm will choose that price and output where it will be
maximizing its profit, the below figure shows the equilibrium of the individual firm in the
short period.
With the revenue curve and cost curves the firm comes to equilibrium at E1 point the firm is
marking the minimum loss P1Q1R1S1 shown by the shaded rectangle. The price is P1. The
firm incurs loss in the short run because average cost is higher than average revenue.
GROUP EQUILIBRIUM IN THE LONG PERIOD
Now we have to discuss the long run changes in monopolistic competition where the’
Group’ of firms comes to be in equilibrium. We have to explain how the firms whose
products are close substitutes make price-output adjustments. We have already explained
that the different firms in the group adopt independent price-output policies because of their
monopolistic position with reference to the peculiarity of the product. But we should bear in
mind that the product is a close substitute of other firms. In the short run when firms make
huge profit, the tendency will be for the new producers to enter the field. But the difficulty
of finding out the group equilibrium arises out of diversity of conditions of various firms
constituting the group. Each firm in its own way caters the specific tastes and preferences
of the group of consumers. So, each firm will have different demand curves and cost curves
depending on their efficiency.
Chamberlin solved the difficulty by making some ‘heroic’ assumptions of uniformity to
arrive at long run equilibrium of the group.
1. The firms competing in the group are producing more or less similar products.
2. The firms competing have equal share of the market demand, which means that the
shape of the AR curve will be the same for all.
3. All firms have equal efficiency in production and therefore cost curves are similar: and
4. The number of firms is fairly large and each firm regards itself as independent in the
group.

The abnormal profits earned in a short period will attract newcomers to the group. The
newcomers will fix lower prices than the price charged by the existing firms. This will
compel the existing firms to reduce prices. As a result of such a keen competition, price will
fall. Consequently the AR curve will shift to a lower

position. The AC curve will shift to a higher position due to increased demand on factors of
production. Thus the distance between AR and AC will be narrowed down and the abnormal
profits will be removed. Ultimately the firms will earn only normal profits. The group
equilibrium in the long run under monopolistic competition is shown in the below figure:
LPAR and LPMR indicate the long period average and marginal revenues. LPMC and LPAC
show the long period marginal and average cost curves. The point E is the equilibrium
where MR = MC and the output is OM. At the equilibrium output the average revenue or
the price of the product is OP. The figure shows that the firm produces OM units and sells it
at a price OP per unit making only normal profit. The figure shows that the AR curve just
touches the AC curves at the level of equilibrium output. So the AC = AR. The firm is not
making any abnormal profit but only normal profit. Over a long period of time under
monopolistic competition every firm will earn only normal profit. This situation is exactly
similar to the perfect competition, long run equilibrium. The main difference is that in
perfect competition the AR curve is horizontal touching the AC curve at the lowest point
showing that the AC is the minimum cost and the price is also minimum. So long as the
shape of the average cost curve ‘U’ shaped. The long-period equilibrium of a firm producing
under monopolistic competition will necessarily result in smaller output than in perfect
competition.
Selling cost and Monopolistic competition;
Selling cost literally means the cost of selling a product in the market. It denotes the
expenses incurred in connection with salesmanship, propaganda, and advertisement in
order to push up the sales of a product. It refers to the expenditure incurred by the firm to
canvass or persuade the buyers to buy its product rather than the product of any other firm.
It is an attempt to net a large number of buyers to become the customers of the firm.

OLIGOPOLY MARKET
CLASSIFICATION OF OLIGOPOLY
(i) Pure or perfect Oligopoly and differentiated of imperfect Oligopoly:

Oligopoly is said to be pure or perfect based on the product. If firms competing

produce homogeneous product it is perfect oligopoly. If there is product differentiation
where the products of the few competing firms are only close substitutes but not perfect
substitutes it is called imperfect or differentiated
oligopoly. Production of cement, aluminum industry can be taken as the example of the
former type while production of talcum powder or aspirin tablets may be taken as the
example of the latter.

(ii) Open and Closed Oligopoly;

In the former, the new firms can enter the market and compete with the existing firms.
But in closed oligopoly, entry into the industry is not possible.

(iii) Collusive and competitive Oligopoly:

When the few firms of the oligopolistic market come to a common understanding
or act in collusion with each other in fixing price and output it is collusive
oligopoly. A non-collusive oligopoly denotes lack of understanding between the
firms and they may be competing making the market competitive oligopoly.
(iv) Partial and Full Oligopoly;
Oligopoly is partial when one large firm, which is considered or looked upon as
the leader of the group, dominates the industry. The dominating firm will be the
price leader. The rest of the smaller firms would follow the leader in fixing prices
of their products. In full oligopoly, the market will be conspicuous by the
absence of price leadership.
(v) Syndicated and Organized Oligopoly;
The extent and degree of Co-ordination between the firms will decide this type of
classification. Syndicated oligopoly refers to that situation where the firms sell
their product through a centralized syndicate. Organized Oligopoly refers to the
situation where the firms organize themselves into a central association for fixing
prices, output, quotas, etc.
CHARACTERISTICS OF OLIGOPOLY
1. Interdependence.
2. Indeterminate Demand Curve.
3. Importance of selling cost.
4. Group Behavior.
5. Elements of Monopoly.
6. Price Rigidity.
PRICING UNDER OLIGOPOLY

MAIN FEATURES OF OLIGOPOLY

1. Sellers are few in number.
2. Any of them is of such a size that an increase and decrease in his output will
appreciably affect the market price. In fact, the size of each seller’s output in
relation to the total supply is the test.
3. Each seller knows his competitors individually in each market.

KINKED DEMAND CURVE – SWEEZY’S MODEL

Price rigidity under oligopoly is better explained by Kinked demand curve used by
prof.Paul M. Sweezy. The kinked demand model represents a condition in which the firm
has no incentive either to increase the price or to decrease the price but keep the price rigid
at a particular level. The firm believes that the rival firms will not follow suit if it raises the
price. But if it cuts down the price, the rival firms will follow suit. Acting on this belief the
firm maintains the present price. If

it increases the price, sales will be decreased automatically and the position will prove
advantageous to the rivals who have not increased the price. If price reduction is resorted,
the rivals also would do likewise and ultimately the sales might not improve appreciably.
Hence to stick on to the present price is very expedient. Only in the event of any drastic
changes in demand and cost condition the firm could think of changing the pric

Under such a condition the demand curve of the firm, as anticipated by the firm could
be kinked. This means that the curve will have a kink at a present price. The above figure
shows kinked demand curve according to sweezy’s model.
In the above figure the demand curve with a kink at point P has been shown P is the
price at which the firm is selling the product by producing ON units. Above the price P the
demand curve as anticipated by the firm is DP. The curve is elastic. Below the price P the
anticipated demand will be PB, which is inelastic. This shows that when the firm increases
the price above P and if all other firms maintain at the old price, then the demand for the
firm’s product would fall off. So, the demand curve is highly elastic above P (DP portion).
The total revenue and profits of the curve is also shown in the figure (MR). If the firm
decreases the price, the demand curve becomes much less elastic and the demand curve is
shown as PB.
Why is PB curve inelastic? As already stated the reduction in price will be followed by other
firms and the sales may not increase revenue curve is shown as
MR1. When the demand curve is DP the marginal
revenue curve is positive. When the demand curve is PB the marginal curve becomes
negative. When there is no scope of better profit in either way why should the firm think of
changing the price from what it is (P)? So the price PN as shown in the figure becomes
rigid.
DUOPOLY
MEANING & DEFINITION OF DUOPOLY
DUO means two and Duopoly refers to a market situation in which there are only two
sellers. Each seller tries to guess the rivals motives and actions. The two firms may either
resort to competition or collusion. The object behind the former being to eliminate the rival
and become a monopolist. In the other, realizing the difficulties and disadvanges of
cutthroat competition, the two firms may agree to co-operate and fix the price. The
competition will be in advertisement only.
Under duopoly, there is no product differentiation and goods are identical. The
consumers are indifferent between the two producers and both must charge same price in
the long run, otherwise a seller charging a higher price may not be

able to sell more. They must fix the price as if they were a single monopolist. Only by this
method they can maximize their profits. In case there is price war between them, they will
be able to earn only normal profit as in the case of perfect competition.

COURNOT’S MODEL
Augustin cournot has taken the example of a mineral spring saturated side by side
and owned by two persons who market their commodity. This is a condition of duopoly
without product differentiation. There is no question of cost of production as they get the
“Commodity’ without cost of producti
In the figure, the demand curve confronting the two sellers of mineral water is
the straightened DM. Suppose ON=NM is the maximum daily output of each mineral spring.
The total output of both is ON+NM = OM. It will be seen from the figure that if the total
output of OM is offered in the market for sale, the long run equilibrium price would have
been zero and the actual output produced would be equal to OM. This is because the cost
of production is assumed to be zero. If two producers produce the maximum quantity OM,
the price would become zero. Cournot assumes that the first producer Mr. X starts
production without the second Mr. Y getting into the field. The first producer Mr. X will
produce that quantity which will maximize his profit. Under profit maximization

formula (MR = MC) he will produce ON, i.e., ½ OM quantity of mineral water and fix the
price at OP. The maximum profit would be ONCP as shown in the figure. Now, the second
producer Y gets into the field and finds that his share of the demand curve is CM and that
the could maximize his profit by taking CR2 as the marginal revenue curve. So, Mr., Y will
produce NQ quantity i.e., ½ NM, for it is at this output his MR is equal to MC. The price
fixed by him is OP1. The total output of the two sellers now will be ON+NQ i.e., OQ which is
¾ of the output of the two springs. Since the second producer has brought down the price
to OP1 the first producer Mr. should also bring down the price to OP1.
PRICING UNDER MONOPSONY:
MONOPSONY refers to a market in which there is a single buyer or a single
purchasing agency. The whole or nearly whole of a commodity or service will be purchased
by this single agency. It is possible that the single buyer may be facing a single seller. i.e.,
monopsony facing monopsoy or monopsony facing a few sellers or oligopoly.

MAIN FEATURES OF MONOPSONY

1. There is only one buyer of the goods or services.
2. Rivalry from buyers who offer substitutive outlets is so remote as to be insignificant.
3. As a result, the buyer is in a position to determine the price he pays for the goods or
services he buys.
Actual cases closely approximating monopsony are rare. An example approximating
monopsony is that of Indian Railways in relation to the Wagon industry. Monopsony
may also arise where resources are immobile. If for any reason, workers are unable
to move to other localities or other firms within the same area, their existing
employer has, in effect, a monopsony position over them.
COSTS OF MONOPSONISTS: The monopsonist must choose between paying
higher wages that will enable him to attract more workers or limiting his working
force to the smaller number of workers he can obtain at lower wages. This means
that when he adds a man to his labour force, he adds to his costs not merely the
wage of the new worker, but also the total of wage increases that must be paid to
his old employees at the new worker, but also the total of wage increases that must
be paid to is old employees at the new rate. Thus in monopsonistic buying, marginal
expenditure of each input level exceeds average expenditure given in the below
table. Suppose a tailor employs six workers at Rs.500 per month. To have an
additional worker, he must pay Rs.550 per month to each worker. If he employs the
seventh worker, his total costs, thus, will increase by Ts. 850. To represent the
position graphically, two curves are needed- one to show the average expenditure
and the other to show the marginal expenditure. The marginal expenditure (ME) the
consistently higher than the average expenditure (AE), and the slope of the marginal
expenditure curve is steeper than that of the average expenditure curve.
COST OF MONOPSONISTIC TAILORING FIRM HIRING WORKERS
WORKERS AVERAGE TOTAL MARGINAL
EXPENDITURE EXPENDITURE (TE) EXPENDITURE (ME)
PER WORKER RS. RS.
(AE) RS.
6 500 3,000 ---
7 550 3,850 850
8 600 4,800 950
9 650 5,850 1,050
10 700 7,000 1,150
11 750 8,250 1,250

OLIGOPSONY
MAIN FEATURES OF OLIGOPSONY
 1. Buyers in a particular market are few in number.
2. Each one of them is of such a size that an increase or decrease in his demand will
considerably affect the price.
3. No single buyer can afford to ignore the reactions of his rivals to policies he might
initiate. E.g., the offer of a higher price. This is the basic feature of oligopsony.

HOMOGENEOUS AND HETEROGENOUS OLIGOPSONY

Oligopsony may appear in markets in which the buyers are just alike or in which they
are slightly differentiated. When the terms and conditions of oligopsonistic buyers are
identical, we speak of ‘homogeneous oligopsony’ when they are different, we speak of
‘heterogeneous ologopsony’ . The actual business situations are mostly heterogeneous
rather than homogeneous.
A situation similar to oligopsony is said to exist when the industry has interlayer, a few
large buyers though many small buyers may exist side by side. A large buyers will
ordinarily be able either to set the price at which the buys or to negotiate for a favorable
price. He can either set or barban on price because he buys enough and by restricting his
purchases, or by threatening to do so, he can affect the sales volume of sellers enough to
force them to accept a lower price or to bargain. The existence of a few large buyers tends
to result in lower buying prices for them. Several of them may collude together to achieve
the same.