Module 2

DEMAND INTRODUCTION

Demand is an economic concept that relates to a consumer's desire to purchase goods and services and
willingness to pay a specific price for them. An increase in the price of a good or service tends to
decrease the quantity demanded. Likewise, a decrease in the price of a good or service will increase the
quantity demanded.

Determinants of Demand

There are five main factors that drive demand:

• Product/service price

• Buyer's income

• Prices of substitute goods

• Consumer preferences

• Consumer expectations for a change in price

As these factors change, so can the demand for a product or service. In fact, they change all the time, so
demand can be constantly in flux.

The Law of Demand

The law of demand states that when prices rise, demand will fall. When prices fall, demand will rise.

Assumptions to the law of Demand

There will be no introduction of any substitutes

There will be no change in prices of substitute goods

There will be no anticipation of price change in future

There will be no change in the income level of the consumer

There will be no change in the taxation policy of the government

There will be no change in consumer’s taste, preference and habit

There will be no change in size, sex and age composition of the population

DEMAND CURVE

Demand Curve

A demand curve is a graph that displays the change in demand resulting from a change in price. It's a
visual representation of the law of demand.
The demand curve can be a useful tool for businesses because it can show them the prices at which
consumers start buying less or more. It can point out prices at which a company can maintain consumer
demand and support reasonable profits.

On the demand curve graph, the vertical axis denotes the price, while the horizontal axis denotes the
quantity demanded. A demand schedule, or table created by a business that lists the quantity of a
product that consumers will buy at particular price points, can provide the figures for the demand curve
chart.

The various reasons for operation of Law of Demand are:

1. Law of Diminishing Marginal Utility:

If the consumer gets more satisfaction, he will pay more. As a result, consumer will not be prepared to
pay the same price for additional units of the commodity. The consumer will buy more units of the
commodity only when the price falls. Law of diminishing marginal utility is considered as the basic
reason for operation of ‘Law of Demand’.

2. Substitution Effect:

Substitution effect refers to substituting one commodity in place of other when it becomes relatively
cheaper. When price of the given commodity falls, it becomes relatively cheaper as compared to its
substitute (assuming no change in price of substitute). As a result, demand for the given commodity
rises.

For example, if price of given commodity (say, Pepsi) falls, with no change in price of its substitute (say,
Coke), then Pepsi will become relatively cheaper and will be substituted for coke, i.e. demand for Pepsi
will rise.

3. Income Effect:

Income effect refers to effect on demand when real income of the consumer changes due to change in
price of the given commodity.

When price of the given commodity falls, it increases the purchasing power (real income) of the
consumer. As a result, he can purchase more of the given commodity with the same money income.

4. Additional Customers:

When price of a commodity falls, many new consumers, who were not in a position to buy it earlier due
to its high price, starts purchasing it. In addition to new customers, old consumers of the commodity
start demanding more due to its reduced price.

5. Different Uses:

Some commodities like milk, electricity, etc. have several uses, some of which are more important than
the others. When price of such a good (say, milk) increases, its uses get restricted to the most important
purpose (say, drinking) and demand for less important uses (like cheese, butter, etc.) gets reduced

Exceptions to Law of Demand:

As a general rule, demand curve slopes downwards, showing the inverse relationship between price and
quantity demanded. However, in certain special circumstances, the reverse may occur, i.e. a rise in price
may increase the demand. These circumstances are known as ‘Exceptions to the Law of Demand’.

1. Giffen Goods:

These are special kind of inferior goods on which the consumer spends a large part of his income and
their demand rises with an increase in price and demand falls with decrease in price.

This phenomenon, popularly known as’ Giffen’s Paradox’ was first observed by Sir Robert Giffen.

2. Status Symbol Goods or Goods of Ostentation:

The exception relates to certain prestige goods which are used as status symbols. For example,
diamonds, gold, antique paintings, etc. are bought due to the prestige they confer upon the possessor.
These are wanted by the rich persons for prestige and distinction. The higher the price, the higher will be
the demand for such goods.

3. Fear of Shortage:

If the consumers expect a shortage or scarcity of a particular commodity in the near future, then they
would start buying more and more of that commodity in the current period even if their prices are rising.
The consumers demand more due to fear of further rise in prices. For example, during emergencies like
war, famines, etc., consumers demand goods even at higher prices due to fear of shortage and general
insecurity.

4. Ignorance:

Consumers may buy more of a commodity at a higher price when they are ignorant of the prevailing
prices of the commodity in the market.

5. Fashion related goods:

Goods related to fashion do not follow the law of demand and their demand increases even with a rise
in their prices. For example, if any particular type of dress is in fashion, then demand for such dress will
increase even if its price is rising.

6. Necessities of Life:

Another exception occurs in the use of such commodities, which become necessities of life due to their
constant use. For example, commodities like rice, wheat, salt, medicines, etc. are purchased even if their
prices increase.

7. Change in Weather:

With change in season/weather, demand for certain commodities also changes, irrespective of any
change in their prices. For example, demand for umbrellas increases in rainy season even with an
increase in their prices. It must be noted that in normal conditions and considering the given
assumptions, ‘Law of Demand’ is universally applicable.
a) MEANING OF MOVEMENT ALONG THE DEMAND CURVE

Keeping all other factors the same, when there is a change in demand of a commodity due to change in
price, it is referred to as the change in quantity demanded. It is shown as a movement along the demand
curve when expressed graphically.

(b) UPWARD MOVEMENT OF DEMAND CURVE

•When the price of the commodity rises, the quantity demanded falls.

•it leads to the upward movement of the demand curve.

•It is also known as contraction of demand.

(c) DOWNWARD MOVEMENT OF DEMAND CURVE

•When the price of the commodity falls, the quantity demanded rises. It leads to the downward
movement of the demand curve.

•It is also known as expansion of demand.

e)EXPLANATION OF DIAGRAM

•When price rises from OP to OP2 demand falls from OQ to OQ2. This is known as contraction of
demand.

•When price falls from OP to OP1 demand rises from OQ to OQ1. This is known as expansion of demand.

When the demand of commodity changes due to change in other factors affecting demand rather than
the price of a commodity. It is also known as a change in demand. The reason for a change in demand is
due to the change in other factors than price. Like, changes in related goods price, income change, tastes
and preferences, and future expectations.

It is of two types:

1.Increase in demand.

2. Decrease in demand

An increase in demand causes a rightward shift of the demand curve due to an increase in income in the
case of normal goods, an increase in the price of substitute goods, a decrease in the price of
complementary goods.

The decrease in demand is causing a leftward shift of the demand curve due to a decrease in income in
the case of normal goods, a decrease in the price of substitute goods, increase in the price of
complementary goods.

Elasticity of Demand

Demand can be classified as elastic, inelastic or unitary.

An elastic demand is one in which the change in quantity demanded due to a change in price is large. An
inelastic demand is one in which the change in quantity demanded due to a change in price is small .
If the formula creates an absolute value greater than 1, the demand is elastic. In other words, quantity
changes faster than price. If the value is less than 1, demand is inelastic. In other words, quantity
changes slower than price. If the number is equal to 1, elasticity of demand is unitary. In other words,
quantity changes at the same rate as price.

The demands for some commodities are receptive to the change in its price, while the demands for
others are not so receptive to the price changes. The price elasticity of demand is the quantity of the
receptiveness of the demand for a commodity to change in its price.

The price elasticity of demand for a commodity is defined as the percentage of change in demand for the
commodity divided by the percentage change in its price. The price elasticity of demand for a good is
derived as follows:

Elasticity of demand = Percentage change in demand for the goods ÷ Percentage change in price for the

goods

Types of elasticity of demand

1. Price Elasticity of Demand

Any change in the price of a commodity, whether it’s a decrease or increase, affects the quantity
demanded for a product This measure of responsiveness of quantity demanded when there is a change
in price is termed as the Price Elasticity of Demand

2. Income Elasticity of Demand

The Income Elasticity of Demand, refers to the sensitivity of quantity demanded for a certain good to a
change in real income (the income earned by an individual after accounting for inflation) of the
consumers who buy this good, keeping all other things constant.

3. Cross Elasticity of Demand

measures the sensitiveness of quantity demanded of one good (X) when there is a change in the price of
another good (Y), and that’s why it is also referred to as Cross-Price Elasticity of Demand.

Advertisement elasticity of demand:

Advertising Elasticity of Demand (AED) is a measure of effectiveness of increase in expenditure of

advertising in increasing demand of a product. ( refer notes also for problem ).

Supply schedule and supply curve

•A supply schedule is a table that shows the quantity supplied at each price.

•A supply curve is a graph that shows the quantity supplied at each price. Sometimes the supply

curve is called a supply schedule because it is a graphical representation of the supply schedule.

Assumptions of Law of Supply or limitations of law of supply

1.The price of other commodities is constant.

2.The state of technology has not changed.

3.The price of factors of production is constant.

4.The taxation laws remain the same.

5.The producer’s objectives are constant.

Reason for Law of Supply

1. Profit Motive: Maximising profits is the primary goal of producers when they supply a good or service.
Their profits grow when the price of a commodity rises without a change in costs. Therefore, by
increasing production, manufacturers increase the commodity’s supply. On the other hand, as price fall,
supply also declines since low price result in lower profit margins.

2. Change in Number of Firms:

When the price of a specific commodity increases, potential producers are encouraged to enter the
market and produce the good to make money. The market supply rises as the number of businesses
increases. However, once the price begins to decline, some businesses that do not anticipate making any
money at a low price may stop production or cut it back. As the number of businesses in the market
declines, it decreases the supply of the given commodity.

3. Change in Stock:

When the price of an item rises, sellers are eager to supply additional things from their stocks. However,
the producers do not release significant amounts from their stock at a significantly cheaper price. They
work on building up their inventory in anticipation of potential price increases in the future.

Exceptions to the Law of Supply

1. Future Expectations:

The law of supply is not valid if sellers expect a fall in the price in the future. The sellers will be willing to
sell more in this situation, even at a cheaper price. However, if sellers expect an increase in the future
price, they will reduce supply to deliver the item later at a higher price.

2. Agricultural Goods:

Agricultural products are exempted from the rule of supply as they are produced in response to climatic
circumstances. If the production of agricultural goods is low because of unexpected weather changes,
supply cannot be expanded, even at higher prices.

3. Perishable Goods: Sellers are willing to offer more perishable commodities, such as fruits, vegetables,
and other foods, even if prices are dropping. This occurs because sellers cannot keep such things for an
extended period.

4. Rare Articles The law of supply does not apply to precious, rare, or artistic items. For example, even if
the price increases, the number of rare items like the Mona Lisa artwork cannot be increased.

5. Backward Countries: Due to the scarcity of resources, output and supply cannot be enhanced in
economically underdeveloped countries.
Shifts in supply

The position of a supply curve will change following a change in one or more of the underlying
determinants of supply. For example, a change in costs, such as a change in labour or raw material costs,
will shift the position of the supply curve.

Rising costs

If costs rise, less can be produced at any given price, and the supply curve will shift to the left.

Falling costs

If costs fall, more can be produced, and the supply curve will shift to the right.

Types of Elasticity of Supply

1.Perfectly Elastic Supply: A commodity becomes perfectly elastic when its elasticity of supply is infinite.
This means that even for a slight increase in price, the supply becomes infinite. For a perfectly elastic
supply, the percentage change in the price is zero for any change in the quantity supplied.

2.More than Unit Elastic Supply: When the percentage change in the supply is greater than the
percentage change in price, then the commodity has the price elasticity of supply greater than 1.

3.Unit Elastic Supply: A product is said to have a unit elastic supply when the change in its quantity
supplied is proportionate or equal to the change in its price. The elasticity of supply, in this case, is equal
to 1.

4.Less than Unit Elastic Supply: When the change in the supply of a commodity is lesser as compared to
the change in its price, we can say that it has a relatively less elastic supply. In such a case, the price
elasticity of supply is less than 1.

5.Perfectly Inelastic Supply: Product supply is said to be perfectly inelastic when the percentage change
in the quantity supplied is zero irrespective of the change in its price. This type of price elasticity of
supply applies to exclusive items. For example, a designer gown styled by a famous personality.

DEMAND FORECASTING TECHNIQUES

Qualitative Techniques

Qualitative techniques rely on collecting data on the buying behaviour of consumers from experts or
through conducting surveys in order to forecast demand.These techniques are generally used to make
short term forecasts of demand. Qualitative techniques are especially useful in situations when historical
data is not available; for example, introduction of a new product or service. These techniques are based
on experience, judgment, intuition, conjecture, etc.

Survey Methods

Survey methods are the most commonly used methods of forecasting demand in the short run. This
method relies on the future purchase plans of consumers and their intentions to anticipate demand.
Thus, in this method, an organization conducts surveys with consumers to determine the demand for
their existing products and services and anticipate the future demand accordingly. The two types of
survey methods are explained as follows:

Complete enumeration survey: This method is also referred to as the census method of demand
forecasting. In this method, almost all potential users of the product are contacted and surveyed about
their purchasing plans.

Sample survey: In this method, only a few potential consumers (called sample) are selected from the
market and surveyed. In this method, the average demand is calculated based on the information
gathered from the sample.

Opinion poll

Opinion poll methods involve taking the opinion of those who possess knowledge of market trends, such
as sales representatives, marketing experts, and consultants. Expert opinion method: In this method,
sales representatives of different organisations get in touch with consumers in specific areas. They
gather information related to consumers’ buying behaviour, their reactions and responses to market
changes, their opinion about new products, etc.

Delphi method: In this method, market experts are provided with the estimates and assumptions of
forecasts made by other experts in the industry. Experts may reconsider and revise their own estimates
and assumptions based on the information provided by other experts.

Market studies and experiments:

In this method, organisations initially select certain aspects of a market such as population, income
levels, cultural and social background, occupational distribution, and consumers’ tastes and preferences.

Quantitative Techniques

Quantitative techniques for demand forecasting usually make use of statistical tools. In these techniques,
demand is forecasted based on historical data.

These methods are generally used to make long-term forecasts of demand. Unlike survey methods,
statistical methods are cost effective and reliable as the element of subjectivity is minimum in these
methods.

Time series analysis or trend projection method is one of the most popular methods used by
organisations for the prediction of demand in the long run. The term time series refers to a sequential
order of values of a variable (called trend) at equal time intervals. Using trends, an organisation's can
predict the demand for its products and services for the projected time.

Smoothing Techniques

In cases where the time series lacks significant trends, smoothing techniques can be used for demand
forecasting. Smoothing techniques are used to eliminate a random variation from the historical demand.
This helps in identifying demand patterns and demand levels that can be used to estimate future
demand.

Barometric methods are used to speculate the future trends based on current developments. This
methods are also referred to as the leading indicators approach to demand forecasting
Econometric methods make use of statistical tools combined with economic theories to assess various

economic variables (for example, price change, income level of consumers, changes in economic policies,
and so on) for forecasting demand.

RELATION OF REVENUE AND ELASTICITY

The “Total Revenue Test” Uses elasticity to show how changes in price will affect total revenue (TR).

Ex: If the demand for gas is inelastic, what will happen to total revenue for gas stations if price increases?

Inelastic Demand

Price increase causes TR to increase (P↑= TR↑)

Price decrease causes TR to decrease (P↓= TR↓)

Elastic Demand

Price increase causes TR to decrease (P↑= TR↓)

Price decrease causes TR to increase (P↓= TR↑)

Unit Elastic

Price changes and TR remains unchanged

MODULE 3
CONSUMER AND PRODUCER BEHAVIOR

Consumer behavior, also called buyer behavior is the process and act of decision making of people
involved in buying and use product. Consumer behaviour refers to human behaviours which go in making
purchase decisions. When consumers make decisions, they are engaged in a problem-solving talks, that
is, satisfying a perceived need. This is called Consumer Behavior.

Consumer behavior refers to the act of consuming a good or service. Consumer behavior is the study of
how individuals, groups and organizations select, buy, use and dispose of goods, services, ideas, and
experiences to satisfy their needs and wants(Kotler).

These characteristics can be described as below:

a. The Consumer is the King

b. The Consumer Behavior can be known

c. The consumer’s behavior can be influenced

Why study consumer behavior?

a. It will help to segment the market usefully

b. It will aid in development of an effective marketing mix

c. It will help to assess new market opportunities

UTILITY:

The utility is a psychological phenomenon; that implies the satisfying power of a good or service. It
differs from person to person, as it depends on a person’s mental attitude. The measurability of utility is
always a matter of contention.

The two principal theories for the utility are cardinal utility and ordinal utility. many traditional
economists hold the view that utility is measured quantitatively, like length, height, weight, temperature,
etc. This concept is known as cardinal utility concept.

On the other hand, ordinal utility concept expresses the utility of a commodity interms of ‘less than’ or
‘more than’.

Definition of Cardinal Utility

The notion of Cardinal utility was formulated by Neo-classical economists, who hold that utility is
measurable and can be expressed quantitatively or cardinally, i.e. 1, 2, 3, and so on. The traditional
economists developed the theory of consumption based on cardinal measurement of utility, for which
they coined the term ‘Util ‘expands to Units of utility. It is assumed that one util is equal to one unit of
money, and there is the constant utility of money.
Further, it has been realized with the passage of time that the cardinal measurement of utility is not
possible, thus less realistic. There are many difficulties in measuring utility numerically, as the utility
derived by the consumer from good or service depends on a number of factors such as mood, interest,
taste, preferences and much more.

Definition of Ordinal Utility

Ordinal Utility is propounded by the modern economists, J.R. Hicks, and R.G.D. Allen, which states that it
is not possible for consumers to express the satisfaction derived from a commodity in absolute or
numerical terms. Modern Economists hold that utility being a psychological phenomenon, cannot be
measured quantitatively, theoretically and conceptually. However, a person can introspectively express
whether a good or service provides more, less or equal satisfaction when compared to one another.

In this way, the measurement of utility is ordinal, i.e., qualitative, based on the ranking of preferences for
commodities. For example: Suppose a person prefers tea to coffee and coffee to milk. Hence, he or she
can tell subjectively, his/her preferences, i.e., tea > coffee > milk.

Indifference curve

What is Indifference Curve?

An indifference curve is a graphical representation of a combined products that gives similar kind of
satisfaction to a consumer thereby making them indifferent. Every point on the indifference curve shows
that an individual or a consumer is indifferent between the two products as it gives him the same kind
futility.

Indifference Curve Analysis

The indifference curve analysis work on a simple graph having two-dimensional. Each individual axis
indicates a single type of economic goods. If the graph is on the curve or line, then it means that the
consumer has no preference for any goods, because all the good has the same level of satisfaction or
utility to the consumer.

Indifference Map

The Indifference Map refers to a set of Indifference Curves that reflects an understanding and gives an
entire view of a consumer’s choices. The below diagram shows an indifference map with three
indifference curves.

The characteristics of indifference curves (IC) are as follows:

(i) Indifference curves are negatively-sloped or downward-sloping: An indifference curve slopes

downwards from left to right. It shows that more of one commodity implies less of the other, so that the
total satisfaction (at any point on the IC) remains constant.

(ii) Indifference curves are convex to the point of origin: An indifference curve will ordinarily be convex to
the point of origin. This is because of diminishing marginal rate of substitution

(iii) Higher indifference curve represents higher level of satisfaction: On an indifference map, a higher
indifference curve represents those combinations which yield higher level of satisfaction than
combination son the lower indifference curves.

(iv) Indifference curves never intersect one another: As each IC represents one level of satisfaction which
remains constant, two different in difference curves can never cross or intersect each other.

Explain the conditions of consumer's equilibrium using indifference curve analysis.

Consumer's equilibrium refers to a situation when a consumer maximiser his satisfaction, spending his
given income across different goods and services. In terms of IC analysis, a consumer attains equilibrium
when:

(i) IC and the budget line are tangent to each other, i.e. when the slope of IC equals the price ratio of the
goods.

(ii) IC is convex to the origin, at the point of equilibrium.

AB is the budget or price line. IC 1 , IC 2, IC 3 are indifference curve. A consumer can buy any of the
combinations, A, B, C, D and E of good X and good Y shown on the price line AB. He cannot attain any
combination on IC 3. as it is above the price line AB. He can buy those combinations which are not only
on the price line AB but also coincide with the highest indifference curve which is IC2. In this case. Out of
A , B, C, D and E combinations, the consumer will be in equilibrium at combination 'E' because at this
point, the price line (AB) is tangent to the highest indifference curve. IC2.. No doubt, the consumer can
buy `C' or D' combinations as well but these will not give him maximum satisfaction as they are situated
on lower indifference curve IC1. It means that the consumer's equilibrium point is the point of tangency
of price line and indifference curve. At equilibrium, Slope of indifference curve = Slope of budget or price
line or MRS xy =Px/Py

Also, at point E, IC 2 is convex to the origin. Accordingly, equilibrium is stable. In a state of equilibrium,
the consumer is buying O L amount of good Y and OM amount of good X. It is here that he is maximizing
his satisfaction. Any departure from this point would only mean lesser satisfaction.
What is Production Function?

• The basic relationship between the factors of production and the output is referred toas a Production
Function.

• The firm’s production function for a particular good (q) shows the maximum amount of the good that
can be produced using alternative combinations of capital(K) and labor (L).

• Mathematically production function can be written as

Q= f (L1, L2, C,O,T)

Where “Q” stands for the quantity of output and L1, L2, C,O,T are various input factors such as land,
labor, capital and organization and technology.

Assumptions:

Production function has the following assumptions.

1. The production function is related to a particular periodoftime.2. There is no change in technology.

3. The producer is using the best techniques available.

4. The factors of production are divisible.

5.Production function can be fitted to a short run or to long run.

Types of production function

These two types of relationships have been explained in the form of laws. i) Law of variable proportions (
short run production function)ii)Law of returns to scale ( long run production function)

I. Law of variable proportions:

“When total output or production of a commodity is increased by adding units of a variable input while
the quantities of other input are held constant, the increase in total production becomes after some
point, smaller and smaller”.

Assumptions of the Law:

The law is based upon the following assumptions:

i) The state of technology remains constant. If there is any improvement in technology, the average and
marginal output will not decrease but increase.

ii) Only one factor of input is made variable and other factors are kept constant. This law does not apply
to those cases where the factors must be used in rigidly fixed proportions.

iii) All units of the variable factors are homogenous.

Three stages of law:

• In the first stage, total product increases at an increasing rate. The marginal product in this stage
increases at an increasing rate resulting in a greater increase in total product. The average product also
increases.

• The second stage comes to an end where total product becomes maximum and marginal product
becomes zero.

• The marginal product becomes negative in the third stage. So the total product also declines. The
average product continues to decline. We can sum up the above relationship thus when ‘A.P. ’ is rising,
“M.P. ’rises more than “ A. P; When ‘A. P.” is maximum and constant, ‘M.P.’ becomes equal to ‘A. P. ’
when ‘A. P. ’ starts falling, ‘M. P.’ falls faster than ‘ A. P.’

Definition of Short Run Production Function

The short run production function is one in which at least is one factor of production is thought to be
fixed in supply, i.e. it cannot be increased or decreased, and the rest of the factors are variable in nature.
Definition of Long Run Production Function

Long run production function refers to that time period in which all the inputs of the firm are variable. It
can operate at various activity levels because the firm can change and adjust all the factors of
production and level of output produced according to the business environment. So, the firm has the
flexibility of switching between two scales.

The law of Return to Scale in Production Functions

Changes in output when all factors change in the same proportion are referred to as the law of return to
scale. This law applies only in the long run when no factor is fixed, and all factors are increased in the
same proportion to boost production. There are three stages in all.

•Increasing the scale’s return

•Constant scale returns

•Decrease in Returns on the scale

Increasing returns to scale

It describes a condition in which all of the factors of production are raised, resulting in a higher rate of
output. For example, if input are raised by 10%, the output will be increased by 20%. Reasons

• Due to the economy of scale

• Specialization through better division of labor

OX axis represents increase in labour and capital while OY axis shows increase in output. When labour
and capital increases from Q to Q1, output also increases from P to P1 which is higher than the factors of
production i.e. labour and capital.

Constant returns to scale

It describes a condition in which all of the factors of production are increased at the same time, resulting
in a steady growth in output. For example, if inputs are raised by 10%, the output is also
increasedby10%. Reasons

As the firm’s production grows, it reaches a point where all of the economy’s resources have been fully
utilized, and output equals input. we see that increase in factors of production i.e. labour and capital are
equal to the proportion of output increase. Therefore, the result is constant returns to scale.

Diminishing returns to scale

When all of the production factors are increased simultaneously, output grows at a slower rate. For
example, if inputs are raised by 10%, the output will be increased by 5%. Reasons

•The major cause of diminishing returns to scale is large-scale economies, diseconomies of scale occur
when a company has grown to such a size that it is difficult to manage

•Lack of coordination

On OX axis, labour and capital are given while on OY axis, output. When factors of production increase
from Q to Q1 (more quantity) but as a result increase in output, i.e. P to P1 is less. We see that increase
in factors of production is more and increase in production is comparatively less, thus diminishing
returns to scale apply.

Economies and Diseconomies of Scale

• Economies of scale may be defined as the cost advantages that can be achieved by an organization by
the expansion of their production in the long run. Therefore, the advantages of large scale expansion are
known as Economies of Scale.

• Economies of Scale are a long term concept that is achieved when there is an increase in the sales of
an organization.

• Due to the lowering of production cost, the organisation can save more and invest it in buying a bulk
of raw materials which can again be obtained at a discount.

• Diseconomies of Scale may arise due to internal issues resulting from technical, organizational, or
resource constraints.

Types of Economies of Scale

Internal Economies: Internal Economies are the real economies that arise from the expansion of the
organisation. These economies are the result of the growth of the organisation itself.

External Economics: External Economics are the economies that originate from factors outside the
organisation. These economies result in the increase in the main organisation by the increase in the
quality of factors outside the organisation like better transportation, better labour, infrastructure, etc.
Due to the betterment of these external factors, the cost of production per unit of an item in the
organisation decreases.

Types of Diseconomies of Scale

Similar to the Economies of Scale, Diseconomies of Scale is of two types- Internal Diseconomies of Scale
and External Diseconomies of Scale.

Internal Diseconomies of Scale: Internal Diseconomies of Scale are the Diseconomies resulting from the
internal difficulties within the organisation. The Internal Diseconomies are the factors that raise the cost
of production of an organisation like lack of supervision, lack of management and technical difficulties.
External Diseconomies of Scale: External Diseconomies of Scale are the external factors that result in
the increasing the production per unit of a product within an organisation. The external factors that act
as a restrain to expansion may include the cost of production per unit, scarcity of raw materials, and low
availability of skilled labors

Break even analysis

Break -even analysis is the study of cost , revenue and sales of a firm and finding out the volume of sales
where the firms cost and revenue will be equal.

A break even analysis indicates that at what level cost and revenue are in equilibrium.

Break-even is a circumstance where a company neither makes a profit nor loss but recovers all the
money spent.

Components of Break-Even Analysis

•Fixed costs: These costs are also known as overhead costs. These costs materialize once the financial
activity of a business starts. The fixed prices include taxes, salaries, rents, depreciation cost, labour cost,
interests, energy cost, etc.

•Variable costs: These costs fluctuate and will decrease or increase according to the volume of the
production. These costs include packaging cost, cost of raw material, fuel, and other materials related to
production.

Importance of Break-Even Analysis

• Manages the size of units to be sold: With the help of break-even analysis, the company or the owner
comes to know how many units need to be sold to cover the cost. The variable cost and the selling price
of an individual product and the total cost are required to evaluate the break-even analysis.

• Budgeting and setting targets: Since the company or the owner knows at which point a company can
break-even ,itis easy for them to fix a goal and set a budget for the firm accordingly. This analysis can also
be practiced in establishing a realistic target for a company.

• Manage the margin of safety: In a financial breakdown, the sales of a company tend to decrease. The
break-even analysis helps the company to decide the least number of sales required to make profits.
With the margin of safety reports, the management can execute a high business decision.

• Monitors and controls cost: Companies’ profit margin can be affected by the fixed and variable cost.
Therefore, with break-even analysis, the management can detect if any effects are changing the cost

. • Helps to design pricing strategy: The break-even point can be affected if there is any change in the
pricing of a product. For example, if the selling price is raised, then the quantity of the product to be sold
to break-even will be reduced. Similarly, if the selling price is reduced, then a company needs to sell extra
to break-even.

Uses of Break-Even Analysis

•New business: For a new venture, a break-even analysis is essential. It guides the management with
pricing strategy and is practical about the cost. This analysis so gives an idea if the new business is
productive.

•Manufacture new products: If an existing company is going to launch a new product, then they still
have to focus on a break-even analysis before starting and see if the product adds necessary expenditure
to the company.

•Change in business model: The break-even analysis works even if there is a change in any business
model like shifting from retail business to wholesale business. This analysis will help the company to
determine if the selling price of a product needs to change.

• Choosing promotion -mix: - break even analysis helps a seller in deciding the appropriate decision
based on promotion mix.

• Equipment selection- break even analysis helps in selecting the suitable equipment and also helps in
comparing the different ways of doing a job.

• Production planning - it will also help in production planning so as to give maximum contribution
towards profit and fixed cost .

Break-Even Analysis Formula

Break-even point = Fixed cost/-Price per cost – Variable cost

Example of break-even analysis

Company X sells a pen. The company first determined the fixed costs, which include a lease, property
tax, and salaries. They sum up to ₹1,00,000. The variable cost linked with manufacturing one penis
₹2perunit.So, the pen is sold at a premium price of ₹10. Therefore, to determine the break-even point of
Company X, the premium pen will be:

Break-even point = Fixed cost/Price per cost – Variable cost

= ₹1,00,000/(₹12 – ₹2)

= 1,oo,000/10

= 10,000

Therefore, given the variable costs, fixed costs, and selling price of the pen, company
Xwouldneedtosell10,000 units of pens to break-even.

Assumptions Underlying Break-Even Analysis:

(i) All costs can be separated into fixed and variable components,
(ii) Fixed costs will remain constant at all volumes of output,

(iii) Variable costs will fluctuate in direct proportion to volume of output,(iv) Selling price will remain
constant,

(v) Product-mix will remain unchanged,

(vi) Productivity per worker will remain unchanged,

(vii) There will be no change in the general price level.

LIMITATIONS

• It is a mere interpretation of the future by past business functions.

•Break-Even Analysis considers only cost and output for profit determination when management skills,
market conditions, technological factors, etc. also affect the business .•It is assumed that the selling
price is constant, and the cost function is linear, which is not the case in reality.

•There exist no tax provisions in the break-even chart.

•Break-even analysis always relates cost to the output, which may not be the case every time.

•It may result in a poor analysis if the company lacks an efficient accounting system. •It is not suitable
for determining long-term profits due to the assumption of the linear relationship between cost,
revenue and output since many other factors affect the business operations in the long run.

Module 4
MARKET STRUCTURE AND PRICINGPRACTICES
Market
A specific place where sale and purchase of goods will happen. Components of a market
1. consumers
2. sellers
3. commodity
4. price
Market Structure
• Market structure means how firms are differentiated and categorized based on the type of
goods they sell
. • Market structure makes it easier to understand the different characteristics of diverse
markets.
Types of Market Structure
The four different types of market structure are discussed
• Perfect Competition Market Structure: In a perfectly competitive market, the forces of supply
and demand determine the number of goods and services produced as well as market prices
set by the companies in the market.
Perfect Competition Examples
• Foreign exchange markets. •Agricultural markets. •Internet-related industries
Assumptions
• Free entry and exit of the firm
• The efficiency of all the firm is same
• All the factors of production is homogeneous in nature
• Technology remain same
• All firms are aware about the price and output prevailing in the market.
Characteristics
• Large number of buyers and sellers: Under perfect competition, there are a large number of
buyers and sellers in the market.
• Free entry and exit: firms are free to exit and enter the market at any point in time. This
means that there Is no obstruction for a new firm to produce a similar product produced by the
existing firms in the market
• Perfect Knowledge: firms can't charge high prices as both sellers and buyers have perfect
knowledge about the goods and their prices.
• Homogeneous product: The products offered by different firms are homogeneous. . The goods
are similar in terms of quality, size, packing, etc.
• Under competition, the firms have no control over the price. They have to sell the products at
a price predetermined by the industry.
Monopoly
• refers to a market structure where there is only one seller of a commodity.
• Monopolist ‘s product has no close substitute.
• the demand curve slope downward from left to right.
• there ultimate aim is to have maximum profit.
Features
• Single firm
• No substitute
• Price maker they are the price maker not the taker
• Downward sloping curve
• Entry Barriers: there are certain barrier for entry .
• Monopolistic Competition Market Structure: it refers to a market situation where there are
many firms selling differentiated products .
Features
• Fairly large number of seller
• Product differentiation : the product of different producers are close substitute of each other
but not perfect substitute.
• Selling Costs: it includes cost of advertisement, sales promotion like that, and also play a very
important role
• Transport cost : transport cost under monopolistic competition makes the price of similar
articles different in different places.
• Nature of demand curve : the demand curve slopes downward to the right.
• Free entry
• Large number of buyers
• independent price policy

• Monopolistic Competition Examples

• Restaurants
• Hairdressers
• Clothing
• TV programs

OLIGOPOLY
• .It is a market of few sellers, offering either homogeneous or differentiated products.
 • That are few sellers who understand their mutual dependence. • Eg : auto mobile industry ,
cold drink industry
Price Determination under Oligopoly:
Kinked Demand Curve (Rigid Prices)
• Prof. Sweezy presented the kinked demand curve analysis to explain price rigidities observed
in oligopolistic markets
. • He assumes that if the oligopolistic firm lowers its price, its rivals will react by matching that
price in order to avoid losing their customers.
• Thus the firm lowering the price will not be able to increase its demand much.
• This portion of its demand curve is relatively inelastic.
• On the other hand, if the oligopolistic firm increases its price, its rivals will not follow it and
change their prices.
• Thus the quantity demanded of this firm will fall considerably
. • This portion of the demand curve is relatively elastic.
• In these two situations, the demand curve of the oligopolistic firm has a kink at the prevailing
market price which shows the price rigidity.
Assumptions:
1) There are few firms in the oligopolistic industry.
(2) The product produced by one firm is a close substitute for the other firms.
(3) The product is of the same quality. There is no product differentiation.(4) There are no
advertising expenditures.
(5) There is an established or prevailing market price for the product at which all the sellers are
satisfied.
(6) Each seller’s attitude depends on the attitude of his rivals.
(7) Any attempt to increase the sales by reducing the price of his product will be counteracted
by the other sellers who will follow the same .
(8) If they raises the price, others will not follow him. Rather they will stick to the prevailing
price and cater to the customers.
• Sweezy came up with the kinked demand curve hypothesis to explain the reason behind this
price rigidity under oligopoly.
• According to the kinked demand curve hypothesis, the demand curve facing an oligopolist has
a kink at the level of the prevailing price. This kink exists because of two reasons:
• 1. The segment above the prevailing price level is highly elastic.
• 2. The segment below the prevailing price level Is in elastic.
• The following figure shows a kinked demand curved Dd with a kink at point P
• i. The prevailing price level = P
• ii. The firm produces and sells output = OM
• iii. Also, the upper segment (dP) of the demand curve (dD) is elastic.
• iv. The lower segment (PD) of the demand curve(dD) is relatively inelastic.
• This difference in elasticities is due to an assumption of the kinked demand curve hypothesis.

Assumption: Each firm in an oligopoly believes the following two things:

a. If he lowers the price below the prevailing level, then the competitors will follow him.
b. If he increases the price above the prevailing level, then the competitors will NOT follow him.
2. Collusive Oligopoly
• Collusive oligopoly is a situation in which firms in a particular industry decide to join together
as a single unit for the purpose of maximizing their joint profits and to negotiate among
themselves to share the market
Cartels:
• A cartel is an association of independent firms within the same industry. The cartel follows
common policies relating to prices, outputs, sales and profit maximization and distribution of
products
Two most common types of cartels:
(1) Joint profit maximization or perfect cartel; and
(2) Market-sharing cartel.
1. Joint Profit Maximization Cartel:
• In this, firms producing a homogeneous product forma centralized cartel board in the industry.
• The individual firms surrender their price-output decisions to this central board. The board
determines output quotas for its members, the price to be charged and the distribution of
industry profits.
Assumptions:
1. Only two firms A and В are assumed in the oligopolistic industry that forms the cartel.
2. Each firm produces and sells a homogeneous product that is a perfect substitute for each
other
3. The number of buyers is large.
4. The market demand curve for the product is given an dis known to the cartel.
5. The cost curves of the firms are different but are known to the cartel.
6. The price of the product determines the policy of the cartel.
7. The cartel aims at joint profit maximisation.
2. Market-Sharing Cartel:
• The firms enter into a market-sharing agreement to form a cartel “but keep a considerable
degree of freedom concerning the style of their output, their selling activities and other
decisions. There are two main methods of market-sharing:
(a) Non-price competition
(b) Quota system
a) Non-Price Competition Cartel:
• It is a loose form of cartel. Under this type of cartel, the low-cost firms press for a low price
and the high-cost firms for a high price.
• But ultimately, they agree upon a common price below which they will not sell.
• Such a price must allow them some profits.
• The firms can compete with one another on a non-price basis by varying the colour, design,
shape, packing, etc. of their product and having their own different advertising and other selling
activities.
(b) Quota Agreement:
Here main agreement relates to the sharing of the market equally among member firms so that
each firm gets profits on its sales.

Price Leadership:
• Price leadership is imperfect collusion among the oligopolistic firms, where in an industry all
firms follow the lead of one big firm.
 • There is a agreement among the firms to sell the product at a price set by the leader of the
industry.
• Whatever price changes take place, the leader announces from time to time, and the other
firms follow him
3 common price leadership models
1. The Low-Cost Price Leadership Model: Here an oligopolistic firm having lower costs than the
other firms sets a lower price which the other firms have to follow. Thus the low-cost firm
becomes the price leader
2. The Dominant Firm Price Leadership Model: - There is one large dominant firm and a number
of small firms in the industry. - The dominant firm fixes the price for the entire industry and the
small firms sell as much product as they like and the remaining market is filled by the dominant
firm itself. -It will select that price which brings more profits to it.
3. The Barometric Price Leadership Model: -There is no leader firm but one firm among the
oligopolistic firms with the wisest management announces a price change first - rest of firms in
the industry follows -The barometric price leader may not be the dominant firm with the lowest
cost or even the largest firm in the industry
Game Theory
• Game theory is the study of how people behave in strategic situations.
• Strategic decisions are those in which each person, in deciding what actions to take, and
consider how others might respond to that action.
• Payoff matrix is a table showing the possible combination f outcomes (payoffs) depending on
the strategy chosen by each player
• Game Features
• Players – the decision makers. These can be individuals, organizations, nations
• Actions – all the alternatives between which players decide to choose
• Outcomes – the payoffs from all possible e actions
• Information – what players know about other players ’ payoffs and actions
• Communication – can players share information and/or make commitments
ASSUMPTIONS
• total no. of participants are known before starting the competition
• every one want to minimize their losses and maximize their profit or gains
• in the absence of direct communication , they will take their own decisions
• one competitor gain and the other one loss and vice versa
• competitors are rational and intelligent
• every competitor take individual decisions.
• for every competitors decision of the game can be positive ,negative or zero.
• pay off are determined for different courses of competitors
• pay off should be determined on the basis of some predetermined set of rules
• before staring competition every competitors gains and losses are fixed.
Strategies
Prisoners’ Dilemma
• Because the number of firms in an oligopolistic market is small, each firm must act
strategically.
• Each firm knows that its profit depends not only on how much it produces but also on how
much the other firms produce
.• The prisoners’ dilemma provides insight into the difficult yin maintaining cooperation.
• Often people (firms) fail to cooperate with one another even when cooperation would make
them better off
Nash Equilibrium
• Cooperative game theory involves a set of outcomes or agreements that is known to each
player and each player has preferences over these outcomes.
• Non-cooperative game theory assumes players have a series of strategies they could use to
gain an outcome and that each player has a preference over their desired outcome.
• Firms that care about future profits will cooperate in repeated games rather than cheating in a
single game to achieve alone-off gain.
STATIC GAMES
• in a static game there is no repetition and both firm decide at the same time
• static game of complete information :here players take decision without knowing the
actions taken by other players
Assumptions
i) players are rational and self- interested
ii) players have full information about all the elements of game. iii) all the players have the
common knowledge .
static game of incomplete information:
Basic assumptions
I. players are rational and self interested
II. some players have incomplete information
Game of incomplete information or asymmetric information are also called “ Bayesian
games ”because, it involves the existence of private information that is known to specific
players and not to others .
DYNAMIC GAMES
• here players move sequentially or repeatedly. it is useful to make dynamic game in extensive
form. This show s these quench of moves and the actions each player can make at each move.
Dynamic game of complete information
-players take decision one after another.
-thus some players may know the actions taken by other players before choosing its own .
Why is game theory useful?
• Identifies the most pertinent issues – helps identify the right strategies.
• Game theory shows consequences of strategic inter dependence – but breaks a complex
world down to key components.
• Game theory can be used to show clear reasoning behind strategies to colleagues.
• Can be used to predict and analyse behaviour
Penetration pricing strategy
• The new product is introduced at a low price in the markets o that it penetrates the market as
quickly .
• The low price of the product compels a large number of customers to buy the product,
• thus generating high sales for the company.
• though the profit margin for the company is low, it can generate profits through greater
number of sales.
 • Because of greater sales, the company is able to decrease its costs, which allows companies
to further decrease their price.
• The reasons behind adopting penetration pricing are as under:
• New product offered by the firm is already provided by other well-established brands.
• The low price will lure customers to switch to the new product, who are already familiar with
other brands.
• It can help in increasing sales of the product in short period.
• It restricts new entrance from entering the market.
Skimming pricing strategy-
• The company sets a high introductory price for their product s so that they gain maximum
profits in a short time, by targeting those customers that are ready to pay a high mark-up for the
products.
• The company sells a lesser number of products in the beginning, but the profit margin will be
high.
• With the passage of time, the price is gradually decreased so as to attract the next segment of
the market
• i.e, those customers who are willing to adopt the high-priced product at a reduced price
• To adopt a skimming price strategy, there are certain conditions that have to be fulfilled.
• Firstly, the product should be one that is unique and introduces features for the first time in
the market. Such product has no substitute in the market, and customers pay the high price
because of the uniqueness of the product.
• Secondly, the company should be able to sustain its distinctiveness, i.e., product should not be
copied easily by competitors.
• Finally, there should be a category of customers in the market who give value to the unique
product and wish to be the first ones to buy it; hence, they pay a surplus or premium to acquire
it.
THE PEAK LOAD PRICING
• The Peak Load Pricing is the pricing strategy where in the high price is charged for the goods
and services during times when their demand is at peak.
• When demand during peak times is higher than the capacity of the firm, the firm could
engage in peak load pricing.
• This is where people are charged more at times of peak demand and less at off peak times.
• Examples: Call charges for telephones are much higher during weekdays than in the evenings
and weekends.
• Rail and airfares, prices in cinemas and restaurants(higher in the evenings), charges made by
health and sports clubs (higher at weekends and in the evenings)
PRICING METHODS/ APPROACHES
COST PLUS PRICING OR FULL COST PRICING
• This is commonly adopted method
• Under this , price is set to cover costs(materials, labour and overhead) and a predetermined
percentage for profits.
• these percentage differ among industries, among member firms and even among products of
the same firm.
Advantages of cost plus pricing
i) very easy and convenient method to follow, even during firms handling multiple products
• it fulfills the objective of profit maximisation
• this methods reduce the cost of decision making
• the price fixed is considered fair from the view point of consumers
Limitation
-It completely ignores customers preference and demand
-it is one sided as they take into consideration only firms profit and cost.
-it fails to reflect the forces of competition .
- this method cannot be applied to industries dealing with perishable goods.
LOSS LEADER PRICING
a loss leader traps the customer due to its low price, who buy some other products of the
company.
- it is not priced at loss but comparatively in a lower price.
-the profit earned by them is little less but the sale and profit for the other product will
compensate for this.
PRODUCT LINE PRICING Strategy
• This is suitable for companies which produce multiple e products of same family.
• complemented products are grouped together and priced in a group.
• they aim to maximize sale of different product by creating complementary rather than
creating competitive products.
Under product line pricing it comes
1) Price bundling - this method of pricing is adopted for maintaining continuous sale of product.
Mainly used for perishable products or consumer facilities l like hotel rooms etc.
2) Premium pricing - this method is used by companies which manufacture different models of
same products, suiting to different strata of society.
3) Image pricing - used for pricing of similar products from different companies or the same
company.
4) Complementary pricing : this is the additional price to be paid by the customers for taking the
possession or for enjoying the product.
5)Captive pricing strategy: to captivate the customer and to promote, they offer complement
along with their regular product
eg: toothpaste with a brush, shaving gel with at win blade.
6) Two part pricing : many products carry two part pricing ,eg: clubs having member ship fees
and separate charges for using its facilities.